Cost of Capital – Worked Solutions

ost of Capital – Worked Solutions

1. Understanding Cost of Capital

The cost of capital represents the return rate required by investors for providing capital to a company. It includes the cost of equity, debt, and preferred stock, and is used as a discount rate for evaluating investment projects.

2. Cost of Debt

The cost of debt is the effective rate that a company pays on its borrowed funds. It is often calculated after tax since interest expenses are tax-deductible.

Formula: $\text{Cost of Debt (after-tax)}=\text{Interest Rate}\times (1-\text{Tax Rate})$

Example: A company has a loan with an interest rate of 6% and the corporate tax rate is 30%. $\text{Cost of Debt (after-tax)}=6\%\times (1-0.30)=4.2\%$

3. Cost of Equity

The cost of equity is the return required by equity investors. It can be estimated using the Capital Asset Pricing Model (CAPM).

CAPM Formula: $\text{Cost of Equity}=\text{Risk-Free Rate}+\text{Beta}\times (\text{Market Return}-\text{Risk-Free Rate})$

4. Cost of Preferred Stock

The cost of preferred stock is the dividend required by preferred stockholders.

Formula: Cost of Preferred Stock=Preferred DividendPrice of Preferred Stock\text{Cost of Preferred Stock} = \frac{\text{Preferred Dividend}}{\text{Price of Preferred Stock}}Cost of Preferred Stock=Price of Preferred StockPreferred Dividend​

5. Weighted Average Cost of Capital (WACC)

WACC is the average rate of return a company must earn on its investment projects to maintain its market value and attract funds. It is calculated based on the proportion of each component of capital (debt, equity, preferred stock) and their respective costs.

Where:

• $E$ = Market value of equity
• $D$ = Market value of debt
• $P$ = Market value of preferred stock
• $V$ = Total market value of the company's financing (Equity + Debt + Preferred Stock)