Cost of Capital Formula

Cost of Capital Formula (Table of Contents)

• Cost of Capital Formula
• Examples of Cost of Capital Formula (With Excel Template)
• Cost of Capital Formula Calculator

Cost of Capital Formula

Cost of capital is the cost or fund required to build a project like building a factory, malls etc. Cost of capital is a combination of cost of debt and cost of equity. As to complete the project, funds are required which can be arranged either of taking loans that is debt or by own equity that is paying money self. Many companies use both debt and equity together for that weighted average of all capital that is known as (WACC) Weight average cost of capital. It is also an opportunity cost of investment that means if the same amount has been invested in other investment the rate of return one could have earn is the cost of capital.

The simple formula of cost of capital is, it is the sum of the cost of debt and cost of equity. Formula for Cost of Capital can be written as:-

Examples of Cost of Capital Formula (With Excel Template)

Let us take an example to understand the Cost of Capital formula in a better manner.

Cost of Capital Formula – Example #1

Suppose, a company started a project of shopping mall construction for that it took a loan of $1,000,000 from the bank, cost of equity is $500,000. Now, one has to calculate the cost of capital for the project.

Cost of Capital is calculated using below formula,

Cost of Capital = Cost of Debt + Cost of Equity

• Cost of Capital = $1,000,000 + $500,000
• Cost of Capital = $1,500,000

So, the cost of capital for project is $1,500,000.

In brief, the cost of capital formula is the sum of the cost of debt, cost of preferred stock and cost of common stocks.

Cost of Capital = Cost of Debt + Cost of Preferred Stock + Cost of Equity

Where,

• Cost of Debt: Cost of debt is the effective interest rate that company pays on its current liabilities to the creditor and debt holders.

Cost of Debt = Interest Expense (1- Tax Rate)

• Cost of Preferred Stocks: Cost of preferred stock is the rate of return required by the investor.

Cost of Preferred Stocks (k_p) = Dividend (D_o) / Current Market Price(P₀)

• Cost of Equity: Cost of equity is the rate of return an investor required for investing equity into business. There are multiple types of cost of equity and model to calculate same they are as follows:-

Capital Asset Pricing Model

It takes risk into consideration and formula for same:-

R_i = R_f + β * (R_m – R_f )

Where,

• R_i – Expected return on asset.
• R_f – Risk free rate of return.
• R_m – Expected market return.
• β – Measure of risk.

If

• β < 1, Asset is less volatile.
• β = 1, Asset volatility is the same rate as market.
• Β > 1, Asset is more volatile.

Dividend Capitalization Model

It is applicable that pay dividend it also assume that dividend will grow at a constant rate.

R_e = D₁ / P₀+ g

Where,

• D₁ – Dividends/Share next year
• P₀ – Current share price
• g – Dividend growth rate
• R_e – Cost of Equity

As we know,

Cost of Capital = Cost of Debt + Cost of Preferred Stock + Cost of Common Stocks

Cost of Capital = Interest Expense (1- Tax Rate) + D₀ / P₀+ R_f  + β * (R_m – R_f )

Or

Cost of Capital = Interest Expense (1- Tax Rate) + D₀ / P₀ + D₁ / P₀ + g

Weight average cost of capital = w_d r_d + w_p r_p + w_e r_e

Where,

• w_d – Proportion of debt in the capital structure.
• w_p – Proportion of preferred stock in the capital structure.
• w_e – Proportion of common stock in the capital structure.
• r_d – Cost of debt.
• r_p – Cost of preferred stock.
• r_e – Cost of equity.

Now, let us see an example based on this formula.

Cost of Capital Formula – Example #2

Suppose a company wants to raise capital of $100,000 to expand its business for that company issue 8,000 stocks with a value of $10 each where the rate of return on equity is 5% which have generated fund of $80,000 and it borrowed loan from bank of $20,000 at rate of interest of 10%. The tax rate applicable is 30%.

Weight average cost of capital is calculated as:

• WACC = (80,000 / 100,000) * 10 + (20,000 / 100,000) * 5% * (1 – 30%)
• WACC = 8.01%

So, weight average cost of capital is 8%.

Weight Average Cost of Capital

Weight average cost of capital is a calculation of a company’s cost of capital in which each category of capital is proportionately weighted it short it computes a cost of each source of capital. In WACC all type of capital is included like common stocks, preferred stock etc.

The formula for Weight Average Cost of Capital can be written as:-

WACC = E/ V * R_e + D/ V * R_d * (1 – T)

• R_e – Cost of Equity
• R_d – Cost of Debt
• E – Market value of Equity
• D – Market value of Debt
• E/ V – Percentage of financing equity
• D/ V – Percentage of financing debt
• T – Tax rate

Let’s see an example to calculate WACC.

Cost of Capital Formula – Example #3

An investor wants to calculate WACC of two companies that is Apple and Google. Below is the various required element for both the companies. Let beta of stocks be 1.2 and credit spread 2%.

Cost of Equity is calculated using below formula

Cost of Equity (ke) = Rf + β (E(Rm) – Rf)

Cost of Equity of Apple

• Cost of Equity of Apple = 5% + 7% * 1.2
• Cost of Equity of Apple = 13%

Cost of Equity of Google

• Cost of Equity of Google = 6% + 8% * 1.2
• Cost of Equity of Google = 16%

Cost of Debt is calculated using below formula

Cost of Debt = (Risk Free Rate + Credit Spread) * (1 – Tax Rate)

Cost of Debt of Apple

• Cost of Debt of Apple = (5% + 2%) * (1 – 40%)
• Cost of Debt of Apple = 4%

Cost of Debt of Google

• Cost of Debt of Google = (6% + 2%) * (1 – 40%)
• Cost of Debt of Google = 5%

WACC for Apple

• WACC for Apple = 6/7 * 13% + 1/7 * 4% *(1 – 40%)
• WACC for Apple = 12%

WACC for Google

WACC for Google = 10/18 * 16% + 8/18 * 5% *(1 – 40%)

WACC for Google = 9%

So, Google has lesser WACC then Apple depending on the rate of return investor can take the decision of investment in a particular company.

Uses of Cost of Capital Formula

There are multiple uses of the cost of capital formula, they are as follows:-

• Cost of capital formula used for financial management of a company.
• It is used by an investor to choose the best investment option.
• Cost of Capital formula also helps to calculate the cost of the project.
• WACC is used to find DCF valuation of the company.

Cost of Capital Formula Calculator

You can use the following Cost of Capital Calculator.

Conclusion

Cost of capital affected by a financial decision, market condition and economical condition but it helps in financial management of a company. It also helps to calculate dividend to be paid. Cost of capital is a very important tool in the valuation of business one can track its growth through the cost of capital formula.

Recommended Articles

This has been a guide to a Cost of Capital formula. Here we discuss How to Calculate the Cost of Capital along with practical examples. We also provide Cost of Capital Calculator with downloadable excel template. You may also look at the following articles to learn more –

1. Formula for Free Cash Flow
2. Formula for Asset to Sales Ratio
3. How to Calculate Beta?
4. Guide to Amortization Formula