COST OF CAPITAL

COST OF CAPITAL DEFINED
Cost of capital is defined as the rate of return that is necessary to maintain the market value of the
firm (or price of the firm’s stock). Managers must know the cost of capital, often called the minimum
required rate of return in:
(1) making capital budgeting decisions;
(2) helping to establish the optimal
capital structure; and
(3) making decisions such as leasing, bond refunding, and working capital management.
The cost of capital is computed as a weighted average of the various capital components, which are
items on the right-hand side of the balance sheet such as debt, preferred stock, common stock, and
retained earnings.

COMPUTING INDIVIDUAL COSTS OF CAPITAL
Each element of capital has a component cost that is identified by the following:
ki=before-tax cost of debt
kd=ki (1 t)=after-tax cost of debt, where t=tax rate
kp=cost of preferred stock
ks=cost of retained earnings (or internal equity)
ke=cost of external equity, or cost of issuing new common stock
ko=firm’s overall cost of capital, or a weighted average cost of capital
Cost of Debt
The before-tax cost of debt can be found by determining the internal rate of return (or yield to
maturity) on the bond cash flows, which was discussed in detail in Chapter 7. However, the following
shortcut formula may be used for approximating the yield to maturity on a bond:

where I=annual interest payments in dollars
M=par value, usually $1,000 per bond
V=value or net proceeds from the sale of a bond
n=term of the bond in years
Since the interest payments are tax-deductible, the cost of debt must be stated on an after-tax basis. The
after-tax cost of debt is:

kd= ki(1-t)

where t is the tax rate.
EXAMPLE.1 Assume that the Carter Company issues a $1,000, 8 percent, 20-year bond whose net proceeds
are $940. The tax rate is 40 percent. Then, the before-tax cost of debt, ki, is:

Therefore, the after-tax cost of debt is: