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What is the cost of capital?

Author:
Harold Averkamp, CPA, MBA

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%
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About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

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