What is the cost of capital?

Definition of Cost of Capital

The cost of capital is the weighted-average, after-tax cost of a corporation's long-term debt, preferred stock (if any), and the stockholders' equity associated with common stock.

The cost of capital is expressed as a percentage and it is often used to compute the net present value of the cash flows in a proposed investment. It is also considered to be the minimum after-tax internal rate of return to be earned on new investments.

For a profitable U.S. corporation, the costs of bonds and other long-term loans are usually the least expensive components of the cost of capital. One reason is that the interest is deductible for income taxes. For example, a corporation paying 6% on its loans may have an after-tax cost of 4% when its combined federal and state income tax rate is 33%. On the other hand, the dividends paid on the corporation's preferred and common stock are not tax deductible.

The cost of common stock (paid-in capital and retained earnings) is considered to be the most expensive component of the cost of capital because of the risks involved.

Example of Cost of Capital

Assume that a corporation has the following:

  • $40 million of long-term debt with an after-tax cost of 4%
  • $10 million of 7% preferred stock
  • $50 million of common stock and retained earnings with an estimated cost of 15%

The corporation's weighted-average, after-tax cost of capital is:

  • Long-term debt cost of $1.6 million ($40 million X 4%)
  • Preferred stock cost of $0.7 million ($10 million X 7%)
  • Common stock cost of $7.5 million ($50 million X 15%)
  • Equals a total cost of $9.8 million which divided by $100 million is 9.8%