Cost of Capital

1. Cost of Capital
What is capital?
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Capital Components
A firm’s Capital Components are
○ Debt
• Borrowed money, either loans or bonds
○ Common equity
• Ownership interest
○ Preferred stock
• A hybrid security, a cross between debt and equity
Capital structure is the mix of the three capital
components - generally expressed in percentages

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4. What is cost of Capital
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The cost of capital is the average rate paid for the use of the
firm’s capital funds
The cost of capital provides a benchmark against which to
evaluate investment returns

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Returns on Investments and the
Costs of Capital Components
Investors provide capital by purchasing securities
○ Returns paid to investors adjusted for taxes and administrative
expenses are the firm’s costs
The risk levels of Capital Component securities differ
○ Leads to different investor returns for each component
• And different costs to the issuing firm for each component
○ Equity is the riskiest investment, earns the highest return, and has
the highest cost
○ Debt is the safest investment, earns the lowest return, and costs
the firm least
○ Preferred Stock offers investors intermediate risk and return levels
and has a cost between that of equity and debt

7. Computation of overall cost of Capital
involves :
1. Computation of cost of Specific source
of finance
2. Computation of Weighted cost of
capital
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The Weighted Average
Calculation—The WACC
A firm’s cost of capital is a weighted average
of the costs of the three capital components
where the weights reflect the $ amounts of
each component in use
Referred to in two ways
○ k, the cost of capital
○ WACC, for weighted average cost of capital

9. Cost of Debt
It is the rate of interest payable on debt.
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11. Example
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15. Cost of Preference share
capital
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16. Computation of cost of
Preference share capital
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