Cost of Capital

Cost of Capital

Cost of capital consists of the cost of debt and cost of equity. This concept is used to describe a company’s “required return necessary to make a capital budgeting project”, also, “it determines how a company can raise money by stock issues or borrowing” (Investorpedia.com).

The cost of debt has a constant annual payment and the value is determined by the interest rate or yield paid to bondholders. When determining the current debt companies may measure the amount before or after taxes are deducted. Considering that interest rates are tax deductable, cost of debt usually is shown after taxes. The after tax cost of debt is found by the yield to maturity multiplied by one minus the tax rate.

Cost of preferred stock is similar to cost of debt in that it is paid annually, but unlike cost of debt, cost of preferred stock does not maintain a maturity date on when the principal payment needs to be made (Block and Hirt, Chap. 11, pg. 3, 2005). Determining the interest rate for preferred stock is simpler then determining yield to maturity. To calculate the cost of preferred stock one divides the annual dividend of the preferred stock by the price of the preferred stock minus the selling price or float. The dividend of the preferred stock is not a taxed deductable expense so unlike cost of debt there is no after tax value.

Cost of common equity can be determined by using the valuation approach. The current price of common stock can be calculated by dividing the dividend at the end of the previous year by the required rate of return minus the constant growth rate of dividends. This formula can also be reworked to find the required rate of return of the common stock. An alternative to determining the required rate of return would be the capital asset pricing model. Cost of retained earnings is “The residual of an entity's earnings over expenditures, including taxes and dividends that are reinvested in its business. The cost of these funds is always lower than...