Definition of Cost of Capital
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%