Cost of Capital Formula

What is the Cost of Capital Formula?

Cost of Capital formula calculates the weighted average cost of raising funds from the debt and equity holders and is the sum total of three separate calculation – weightage of debt multiplied by the cost of debt, weightage of preference shares multiplied by the cost of preference shares, and weightage of equity multiplied by the cost of equity. It is represented as,

Cost of Capital = Weightage of Debt * Cost of Debt + Weightage of Preference Shares * Cost of Preference Share + Weightage of Equity * Cost of Equity

Calculation of Cost of Capital (Step by Step)

  1. Find the Weightage of Debt


    The weight of the debt component is computed by dividing the outstanding debt by the total capital invested in the business, i.e., the sum of outstanding debt, preferred stock, and common equity. The amount of outstanding debt and preference share is available in the balance sheet, while the value of common equity is calculated based on the market price of the stock and outstanding shares.

    Weightage of debt = Amount of outstanding debt ÷ Total capital

    Total capital = Amount of outstanding debt + Amount of Preference share + Market value of common equity

  2. Find the Cost of debt


    The cost of debt is calculated by multiplying the interest expense charged on the debt with the inverse of the tax rate percentage and then dividing the result by the amount of outstanding debt and expressed in terms of percentage. The formula for the cost of debt is as follows:

    Cost of debt = Interest Expense * (1 – Tax Rate) ÷ Amount of outstanding debt

  3. Find the Weight of the Preference share


    The weight of the preference share component is computed by dividing the amount of preference share by the total capital invested in the business.

    Weightage of Preference Share = Amount of preference share ÷ Total capital

  4. Find the Cost of Preferred Stock


    The cost of preferred stock is simple, and it is calculated by dividing dividends on preference share by the amount of preference share and expressed in terms of percentage. The formula for the cost of preference share is as follows:

    Cost of Preference Share = Dividend on preference share ÷ Amount of Preferred Stock

  5. Determine the Weightage of Equity


    The weight of the common equity component is computed by dividing the product of a market value of stock and an outstanding number of sharesOutstanding Number Of SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read moreOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read moreOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read more (market cap) by the total capital invested in the business.

    Weightage of Equity = Market value of common equity ÷ Total capital

  6. Find the Cost of Equity


    The cost of equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read moreCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read moreCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more is composed of three variables- risk-free return, an average rate of return from a group of a stock representative of the market, and beta, which is a differential return that is based on the risk of the specific stock in comparison to the larger group of stocks. The cost of equity is expressed in terms of percentage, and the formula is as follows:

    Cost of Equity = Risk-Free Return + Beta * (Average Stock Return – Risk-Free Return)

Cost of Capital Formula Example (with Excel Template)

Let us take an example of a company ABC Limited to see if it is able to generate returns.

You can download this Cost of Capital Formula Excel Template here – Cost of Capital Formula Excel Template

The company has reported a return for its last fiscal year as 10.85%. The company has outstanding debt of $50,000,000, preference shares of $15,000,000 and common equity valued at $70,000,000. The tax rate is 34%. It has paid $4,000,000 as an interest expense on its debt. The preference shares paid a dividend of $1,50,000. The risk-free rate of return is 4%, while the return on the Dow Jones Industrials is 11%, and ABC Limited’s beta is 1.3.

First we have to calculate the following –

Total Capital:

cost of capital example1.1

So, Total capital = $50,000,000 + $15,000,000 + $70,000,000

  • Total capital = $135,000,000

Weightage of Debt:

cost of capital example1.2

So, Weightage of debt = $50,000,000 ÷ $135,000,000

  • Weightage of debt = 0.370

Cost of Debt:

cost of capital example1.3

Therefore, Cost of debt = $4,000,000 * (1 – 34%) ÷ $50,000,000

  • Cost of debt = 5.28%

Weightage of Preference Share:

cost of capital example1.4

Hence, Weightage of preference share = $15,000,000 ÷ $135,000,000

  • Weightage of preference share = 0.111

Cost of Preference Share:

example1.5

So, Cost of preference share = $1,500,000 ÷ $15,000,000

  • Cost of preference share = 10.00%

Weightage of Equity:

example1.6

So, Weightage of equity = $70,000,000 ÷ $135,000,000

  • Weightage of equity = 0.519

Cost of Equity:

example1.7

So, Cost of equity = 4% + 1.3 * (11% – 4%)

  • Cost of equity = 13.10%

So from the above, we have gathered the following information.

example1.8

Therefore, Calculation of the Cost of Capital Formula will be –

cost of capital example1.9

The formula in excel will be –

cost of capital example1.10

Based on the above calculations, ABC Limited’s return of 10.85% is adequately higher than its cost of capital of 9.86%.

Cost of Capital Calculator

You can use the following calculator for the cost of capital.

Weightage of debt
Cost of debt
Weightage of preference share
Cost of preference share
Weightage of equity
Cost of equity
Cost of capital =
 

Cost of capital = (Weightage of debt x Cost of debt) + (Weightage of preference share x Cost of preference share) + (Weightage of equity x Cost of equity)
(0 x 0) + (0 x 0) + (0 x 0) = 0

Relevance and Use

Recommended Articles

This article has been a guide to the Cost of Capital Formula. Here we discuss how to apply the Cost of Capital Equation along with practical examples and downloadable excel templates. You can learn more about Financial Analysis from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *