Cost of capital
A company’s cost of capital is the cost of all its debt (borrowed money) plus the cost of all its equity (common and preferred share capital). Each component is weighted to express the cost as a percentage—called the weighted average cost of capital (WACC). It is a real cost of doing business, so it is important to understand.
To calculate its cost of capital, a business must add the cost of its debt to the cost of its preferred share equity and the cost of its common share equity:
Cost of capital = Cost of Debt + Equity cost of preferred shares + Equity cost of common shares
Each of these elements is determined differently:
- Cost of debt is easy to determine because the interest rates on all loans are listed in a company’s notes to the financial statements. Because interest payments are paid before tax, they must be adjusted downward to get the after-tax cost of debt.
- Cost of equity from preferred shares is also easy to determine because the dividend payments are also stated in the notes to the financial statements. Dividend payments are paid out after tax, so there is no need to adjust them further.
- Cost of equity from common shares is hard to determine because there are no stated terms of payment in the notes to the financial statements. So, analysts use various methods to estimate the cost of common equity—none is 100% precise. One quick way to estimate this cost is to take the cost of debt and add a mark-up for the risk of common equity ownership. Industry averages are used as a guide.
More about cost of capital
Here’s how to calculate the WACC for ABC Company given the following information:
The balance sheet shows us that:
- ABC Co. has $100,000 in total capital
- The weightings of it capital sources are: 50% debt, 25% preferred share equity and 25% common share equity
From the notes to the financial statement we can see that:
- The after-tax cost of interest on its debt is 4%
- It pays 10% of its net profit out to preferred shareholders
From the industry:
- We know that common shareholders are paid a 12% risk premium over their after-tax cost of their debt
Given these inputs, the WACC for ABC Co. is:
So ABC Company’s after-tax cost of capital is 8.5%.