The cost of capital is the weighted-average, after-tax cost of a corporation's long-term debt, preferred stock, and the stockholders' equity associated with common stock. The cost of capital is 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 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 will be deductible for U.S. 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.
Let's compute the cost of capital by assuming that a corporation has $40 million of long-term debt with an after-tax cost of 4%, $10 million of 7% preferred stock, and $50 million of common stock and retained earnings with an estimated cost of 15%. Its weighted-average, after-tax cost of capital is: ($40 million X 4% = $1.6 million) + ($10 million X 7% = $0.7 million) + ($50 million X 15% = $7.5 million) = $9.8 million divided by $100 million = 9.8%.