What is the Cost of Capital Formula?

The cost of Capital formula calculates the weighted average cost of raising funds from the debt and equity holders and is the total of three separate calculations – weightage of debt multiplied by the cost of debt, weightage of preference shares multiplied by the cost of preference shares, and weightage of equity multiplied by the cost of equity. It is represented as,

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Calculation of Cost of Capital (Step by Step)

Cost of Capital Formula Example (with Excel Template)

Let us take an example of a company ABC Limited to see if it can generate returns.

  • Find the Weightage of Debt The outstanding debt and preference share are available on the balance sheet. The weight of the debt component is computed by dividing the outstanding debt by the total capital invested in the business, i.e., the sum of outstanding debt, preferred stock, and common equity. At the same time, the value of common equity is calculated based on the stock’s market price and outstanding shares.Weightage of debt = Amount of outstanding debt Total capitalTotal capital = Amount of outstanding debt + Amount of Preference share + Market value of common equity Find the Cost of debt The cost of debt is calculated by multiplying the interest expense charged on the debt with the inverse of the tax rate percentage and dividing the result by the amount of outstanding debt and expressed in terms of percentage. The formula for the cost of debt is as follows:Cost of debt = Interest Expense * (Tax Rate) Amount of outstanding debt Find the Weight of the Preference Share The weight of the preference share component is computed by dividing the amount of preference share by the total capital invested in the business.Weightage of Preference Share = Amount of preference share Total capital Find the Cost of Preferred Stock The cost of preferred stock is simple, and it is calculated by dividing dividends on preference shares by the amount of preference share and expressed in percentage. The formula for the cost of preference share is as follows:Cost of Preference Share = Dividend on preference share Amount of Preferred Stock Determine the Weightage of Equity The weight of the common equity component is computed by dividing the product of a market value of stock and the great number of shares (market cap) by the total capital invested in the business.Weightage of Equity = Market value of common equity Total capital Find the Cost of Equity The cost of equity is composed of three variables- risk-free return, an average rate of return from a group of a stock representative of the market, and beta, which is a differential return that is based on the risk of the specific stock in comparison to the larger group of stocks. The cost of equity is expressed in terms of percentage, and the formula is as follows:Cost of Equity = Risk-Free Return + Beta * (Average Stock Return Risk-Free Return)

The outstanding debt and preference share are available on the balance sheet. The weight of the debt component is computed by dividing the outstanding debt by the total capital invested in the business, i.e., the sum of outstanding debt, preferred stock, and common equity. At the same time, the value of common equity is calculated based on the stock’s market price and outstanding shares.Weightage of debt = Amount of outstanding debt Total capitalTotal capital = Amount of outstanding debt + Amount of Preference share + Market value of common equity

The cost of debt is calculated by multiplying the interest expense charged on the debt with the inverse of the tax rate percentage and dividing the result by the amount of outstanding debt and expressed in terms of percentage. The formula for the cost of debt is as follows:Cost of debt = Interest Expense * (Tax Rate) Amount of outstanding debt

The weight of the preference share component is computed by dividing the amount of preference share by the total capital invested in the business.Weightage of Preference Share = Amount of preference share Total capital

The cost of preferred stock is simple, and it is calculated by dividing dividends on preference shares by the amount of preference share and expressed in percentage. The formula for the cost of preference share is as follows:Cost of Preference Share = Dividend on preference share Amount of Preferred Stock

The weight of the common equity component is computed by dividing the product of a market value of stock and the great number of shares (market cap) by the total capital invested in the business.Weightage of Equity = Market value of common equity Total capital

The cost of equity is composed of three variables- risk-free return, an average rate of return from a group of a stock representative of the market, and beta, which is a differential return that is based on the risk of the specific stock in comparison to the larger group of stocks. The cost of equity is expressed in terms of percentage, and the formula is as follows:Cost of Equity = Risk-Free Return + Beta * (Average Stock Return Risk-Free Return)

First we have to calculate the following –

Total Capital:

So, Total capital = $50,000,000 + $15,000,000 + $70,000,000

  • Total capital = $135,000,000

Weightage of Debt:

So, Weightage of debt = $50,000,000 ÷ $135,000,000

  • Weightage of debt = 0.370

Cost of Debt:

Therefore, Cost of debt = $4,000,000 * (1 – 34%) ÷ $50,000,000

  • Cost of debt = 5.28%

Weightage of Preference Share:

Hence, Weightage of preference share = $15,000,000 ÷ $135,000,000

  • Weightage of preference share = 0.111

Cost of Preference Share:

So, Cost of preference share = $1,500,000 ÷ $15,000,000

  • Cost of preference share = 10.00%

Weightage of Equity:

So, Weightage of equity = $70,000,000 ÷ $135,000,000

  • Weightage of equity = 0.519

Cost of Equity:

So, Cost of equity = 4% + 1.3 * (11% – 4%)

  • Cost of equity = 13.10%

So from the above, we have gathered the following information.

Therefore, Calculation of the Cost of Capital Formula will be –

The formula in excel will be –

Based on the above calculations, ABC Limited’s return of 10.85% is adequately higher than its cost of capital of 9.86%.

Cost of Capital Calculator

You can use the following calculator for the cost of capital.

Relevance and Use

  • Understanding the cost of capital is very important as it plays a pivotal role in the decision-making process of financial management. The objective of the cost of capital is to determine the contribution of the cost of each component of a company’s capital structure based on the proportion of debt, preference shares, and equity. A fixed-rate interest is paid on the debt, and the preference shares are given a fixed dividend yield. Although a company is not required to pay a fixed rate of return on equity, there is a certain rate of return expectedRate Of Return ExpectedThe hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment required by the manager or investor. It is also known as the company’s required rate of return or target rate.read more of the equity portion.Based on the weighted average of all the cost components, the company analyses if the actual rate of return can exceed the cost of capital, which is a positive sign for any business. Based on this, various management decisions are taken about dividend policyDividend PolicyDividend policy is the policy that the company adopts for paying out the dividends to the company’s shareholders, which includes the percentage of the amount at which the dividend is to be paid out to the stockholders and how frequent the company pays the dividend amount.read more, financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more, capital structure, working capital management, and other financial decisions, etc.

This article has been a guide to the Cost of Capital Formula. Here, we discuss applying the Cost of Capital Equation along with practical examples and downloadable excel templates. You can learn more about Financial Analysis from the following articles –

  • Risk-Free RateRisk-Free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read moreCalculate Beta CoefficientSMLSMLThe security market line (SML) is the Capital Asset Pricing Model (CAPM). It gives the market’s expected to return at different levels of systematic or market risk. It is also called the ‘characteristic line’ where the x-axis represents the asset’s beta or risk, and the y-axis represents the expected return.read moreValuation Interview Questions and AnswersValuation Interview Questions And AnswersThe most crucial valued interview questions are: what is free cash flow to the firm?, what is free cash flow to equity?, dividend discount model? and the difference between Enterprise value and equity value?read more