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,
Calculation of Cost of Capital (Step by Step)
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
Step #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
Step #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
Step #4 – Find the Cost of Preferred Stock
The cost of preferred stock is simple and it is calculated by dividing dividend on preference share by the amount of preference share and expressed in terms of percentage. The formula for cost of preference share is as follows:
Cost of Preference Share = Dividend on preference share ÷ Amount of Preferred Stock
Step #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 shares (market cap) by the total capital invested in the business.
Weightage of Equity = Market value of common equity ÷ Total capital
Step #6 – Find the Cost of Equity
The cost of equity 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.
The company has reported 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 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 –
So, Total capital = $50,000,000 + $15,000,000 + $70,000,000
- Total capital = $135,000,000
Weightage of Debt:
So, Weightage of debt = $50,000,000 ÷ $135,000,000
- Weightage of debt = 0.370
Cost of Debt:
Therefore, Cost of debt = $4,000,000 * (1 – 34%) ÷ $50,000,000
- Cost of debt = 5.28%
Weightage of Preference Share:
Hence, Weightage of preference share = $15,000,000 ÷ $135,000,000
- Weightage of preference share = 0.111
Cost of Preference Share:
So, Cost of preference share = $1,500,000 ÷ $15,000,000
- Cost of preference share = 10.00%
Weightage of Equity:
So, Weightage of equity = $70,000,000 ÷ $135,000,000
- Weightage of equity = 0.519
Cost of Equity:
So, Cost of equity = 4% + 1.3 * (11% – 4%)
- Cost of equity = 13.10%
So from the above, we have gathered the following information.
Therefore, Calculation of the Cost of Capital Formula will be –
The formula in excel will be –
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 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
- The understanding of the cost of capital is very important as it plays a pivotal role in the decision-making process of financial management. The objective of the cost of capital is the determination of the contribution of the cost of each component of a company’s capital structure based on the proportion of debt, preference shares, and equity.
- A fixed-rate of interest is paid on the debt and the fixed dividend yield is given on the preference shares. Although a company is not required to pay a fixed rate of return on equity, there is a certain rate of return expected of the equity portion.
- Based on the weighted average of all the cost components, the company analyses if the actual rate of return is able to exceed the cost of capital which is a positive sign for any business. On the basis of this, various management decisions are taken pertaining to dividend policy, financial leverage, capital structure, working capital management, and other financial decisions, etc.
This 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 –