TYPES AND
COSTS OF
FINANCIAL
CAPITAL
CHAPTER 5
CONTENTS
01 COST OF CAPITAL
UNDERSTANDING
02
COST OF CAPITAL
IMPORTANCE OF
03 COST OF CAPITAL
FOR BUSINESS
Cost of capital is the price a company
incurs to borrow money or raise capital from
investors to fund its operations or
investments. This cost includes both the
interest rate paid on debt and the return
expected by investors for providing equity
financing. Basically, it’s the price a company
pays for the privilege of using other people’s
money.
Understanding Cost of Capital
Cost of capital refers to the total financing
amount a company incurs to raise funds from
both debt and equity sources. It represents
the minimum rate of return a company must
achieve on its investments to satisfy the
expectations of its investors and lenders.
Calculating the price of capital involves
assessing the risk associated with each
funding source and determining the
appropriate capital cost for each.
This information is essential for a
company when deciding which projects
to pursue, as it allows them to assess the
potential profitability of each
investment opportunity. By
understanding the capital requirements,
a company can make informed decisions
about how to finance its operations and
investments, and ensure that it is
maximizing its financial returns.
Importance of cost of capital for
business
Cost of capital is like a compass that
guides a company toward its financial
goals. It’s important because it helps a
company determine the minimum
return it needs to generate from its
investments to satisfy the expectations
of its investors and lenders.
By calculating this cost, a company
can also make informed decisions
about which funding sources to use
and which projects to pursue.
Ultimately, understanding the price
of capital can help a company
maximize its profitability and avoid
getting lost in the financial
wilderness.
1. Debt Cost: the cost a company incurs
when raising funds through debt, including
interest payments and other fees.
2. Equity: the return that investors expect to
earn when investing in a company’s stock,
taking into account dividends and capital
gains.
3. Preferred Stock Cost: the cost a company
incurs when raising funds through
preferred stock, which typically pays a fixed
dividend.
4. Weighted Average Cost (WACC): the
average price of all of a company’s
capital sources, taking into account the
proportion of each type of funding used.
5. Marginal Cost: the cost of raising
additional funds beyond the current level
of funding.
6. After-Tax Cost: the cost of capital
adjusted for the tax benefits of debt
financing.
Methods of Cost of Capital
Here are some common methods:
1. Dividend Discount Model (DDM):
estimates the cost of equity by calculating
the present value of expected future
dividend payments.
2. Capital Asset Pricing Model (CAPM):
estimates the price of equity by considering
the risk-free rate of return, the expected
market return, and the company’s beta.
3. Bond Yield Plus Risk Premium: estimates
the cost of debt by adding a risk premium to
the yield of comparable bonds.
4. Weighted Average Cost of Capital (WACC):
calculates the average price of all of a
company’s capital sources, weighted by the
proportion of each type of funding used.
5. Marginal Cost: estimates the cost of
raising additional funds beyond the current
level of funding.
How to Calculate Cost of Capital
1. Cost of debt
The cost of debt refers to interest rates
paid on any debt, such as mortgages and
bonds. Interest expense is the interest paid
on current debt.
Total interest / total debt = cost of
debt
2. Cost of equity
Cost of equity refers to the return a
company requires to determine if capital
requirements are met in an investment.
Cost of equity also represents the amount
the market demands in exchange for
owning the asset and therefore holding
the risk of ownership.
The cost of equity is approximated by the
capital asset pricing model (CAPM):
In this formula:
Rf= risk-free rate of return
Rm= market rate of return
Beta = risk estimate
3. Weighted average cost of capital (WACC)
The cost of capital is based on the weighted
average of the cost of debt and the cost of
equity.
In this formula:
E = the market value of the firm's
equity
D = the market value of the firm's debt
V = the sum of E and D
Re = the cost of equity
Rd = the cost of debt
Tc = the income tax rate
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