Cost of Capital

A company's cost of capital is the rate of return it requires to undertake a new project that is of the same riskiness as the existing business. It is calculated as an average of the costs of the various sources of financing it uses.

As sources of financing, companies use equity (stock), debt (bonds or bank loans), and sometimes preferred stock. Each of these sources has a different cost, or required rate of return, which is based on its relative level of riskiness. From the investor's perspective, debt is the safest. If the company misses an interest payment or in some other way defaults, the various debt holders can take over the company to be repaid. Because of this power, debt holders are said to have a primary claim on a company's cash flows.

Preferred stock, if a company has any outstanding, is the next most risky financing tool. It is riskier than debt, because a company is not obligated to make preferred stock dividend payments; if the company is doing badly, it can omit the preferred stock dividend without risking bankruptcy. It is less risky than stock, from the investor's perspective, because typically if a company omits its preferred dividend payment then it cannot pay any common stock dividends until the preferred dividends are paid.

Common stock is the most risky investment because the debt holders and the preferred stockholders must all be paid before the common stockholders can receive anything. Because of this the cost of debt, rd, is usually less than the cost of preferred stock, rPf, which is less than the cost of common stock, rS.

The cost of debt, rd, is just the yield on the outstanding bonds, or the interest rate on the debt owed to a bank. However, because the company gets to deduct interest payments from income when calculating taxes, the actual cost to the company is rd (1 – T), where T is the company's tax rate. The cost of preferred stock with constant per share dividend, D, and current market price P, is rPf = D/P. The cost of equity is usually calculated using the capital asset pricing model. See the Capital Asset Pricing Model entry for this calculation. The overall cost of capital is just a weighted average of these costs:

where wd = market value of debt divided by the total value of the firm (the market values of the debt plus preferred stock plus common stock), wPf = market value of preferred stock divided by the total value of the firm, and wS = market value of common stock divided by the total value of the firm. The firm's cost of capital is also called its weighted average cost of capital, or WACC.

For example, consider a publicly traded managed care company with the following financing information:

[Page 111]The proportion of debt, wd, is 50 ÷ (100 + 50 + 10) = 0.3125 = 31.25%. The proportion of preferred stock is 10/160 = 0.0625 = 6.25%, and the proportion of equity is 100/160 = 0.625 = 62.5%. The required rate of return on the preferred stock is its annual dividend divided by the current price, 6/100 = 0.06 = 6%. Given this information, the cost of capital is

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