Cost of Capital:
Average cost of capital: The average percentage cost that a company pays for the money that it is currently using (i.e., money raised in the past). Not very useful, except to public utilities.
Marginal cost of capital: The average percentage cost that a company will have to pay to raise money now (i.e., money to be raised in the future).
Cost of debt: The rate of return that must be earned on the investment of borrowed money in order to keep the common stock price unchanged.
Cost of preferred stock: The rate of return that must be earned on the investment of money raised from the sale of preferred stock in order to keep the common stock price unchanged.
Cost of retained earnings: The rate of return that must be earned on the investment of retained earnings in order to keep the common stock price unchanged.
Cost of new common equity: The rate of return that must be earned on the investment of money raised from the sale of new common stock in order to keep the common stock price unchanged.
Companies raise money from a variety of sources: (1) short-term sources such as accounts payable, bank loans, and commercial paper, and (2) long-term sources such as bonds, preferred stock, retained earnings, and sale of stock. When companies invest this money (in the companies’ assets), they obviously want to earn at least the average cost of raising the funds. In other words, it would be foolish to raise money at an average cost of 7% and then invest that money in the company to earn less than 7%. In other words, the cost of raising the money, called the cost of capital, becomes the minimum desired rate of return for investing the money. If the cost of capital is 8.5%, then the minimum desired rate of return for investing the money is 8.5%.
However, while it might be interesting to calculate the average cost of raising money from all these sources, it may not be very useful. This is because companies rarely finance their assets by raising money across the board from all these sources.
However, companies do follow the matching principle, which says that short-term assets should be financed with short-term liabilities and long-term assets should be financed with long-term sources. While we might be able to survive a mistake in purchasing short-term assets, mistakes in purchasing long-term assets stay with us much longer and are more expensive. Therefore, we want to ensure that fixed assets earn at least the cost of financing them. If we want to avoid making a major mistake like this, it is particularly important that we calculate accurately the cost of capital raised from long-term sources. The most accurate term for this would be "the cost of long-term capital" but it is generally shortened to the term "cost of capital."
The cost of capital is simply a weighted average of the cost of the individual sources (i.e., bonds, preferred stock, retained earnings, and sale of new common stock). For example, assume that you raise 40% of your money in the form of debt, 20% in preferred stock, and 40% in common equity. Given the cost of each shown in the table below, the weighted cost of capital for the company would be 7.0%.
Proportion * Cost = Wt. Cost
0.40 * 5% = 2.0%
0.20 * 7% = 1.4%
0.40 * 9% = 3.6%
Cost of Capital = 7.0%
Let’s look at a few details for calculating the cost of each component.
Debt is special in the sense that its interest payments are tax-deductible. While this is a good thing, it does present a problem when comparing its cost with the cost of the other components, whose costs are not tax-deductible. The solution? Simply place the cost of debt on an after-tax basis – the same basis as the other sources. We do this by simply multiplying the interest rate times [1 - the tax rate]. For example, if a company pays an interest rate of 8% and is in the 40% tax bracket, the after-tax cost of debt would be:
Cost of debt = interest rate * (1 – tax rate)
Cost of debt = 8% * (1 – 0.40)
Cost of debt = 4.8%
The cost of money raised by selling preferred stock is, generically, the dollar cost divided by the amount of money raised. If a company sells $1 million worth of preferred stock, pays the investment banker $100,000 for its help with the sale, and pays $70,000 in annual preferred stock dividends, the cost of preferred stock is equal to:
Stockholders let the company’s management keep some of the earnings and reinvest them back into the company (rather than paying it to them in the form of dividends). This does not mean that these retained earnings are free however – the stockholders still expect to earn a rate of return on the company’s investment of this money. The rate of return that the company must earn on the investment of this money (in order to keep the shareholders happy) is called the cost of retained earnings. The formula for calculating the cost of retained earnings is shown below:
The cost of raising money through the sale of new common stock is the same as the cost of retained earnings, with one exception: flotation costs. Money earned in the company’s operations (i.e., retained earnings) is readily available with paying any outside agency; money raised from outside the company often comes with commissions and fees (i.e., flotation fees) attached. The formula for the cost of new common equity is as follows:
Assume that Genuine Products, Inc. is raising money for expansion of its operation. It has part of the money already set aside in the form of cash from this year's addition to retained earnings. In order to stay at its optimal capital structure, it has decided to raise the money in the following proportions: 40% debt, 10% preferred stock, 20% retained earnings, and 30% from the sale of new common stock. Assuming that the company can raise money at the costs calculated above, the company's marginal cost of capital will be:
Proportion * Cost = Wt. Cost
0.40 * 4.80% = 1.92%
0.10 * 7.78% = 0.78%
0.20 * 11.00% = 2.20%
0.30 * 11.50% = 3.45%
Cost of capital = 8.35%