Time Value of Money
Kinds of Interest Rates
Future Value of an Uneven Cash flow
Probability Distribution
Standard Deviation
Security Market Line
Bond Valuation
Stock Valuation
Cost of Capital
The Balance Sheet
Capital Budgeting
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Cost of Capital

How can a company raise money to build, for example, a new factory?

What are the Capital Components?

  • Common Stock

  • Preferred Stock

  • Bonds (debt)

  • Retained Earnings - (profit the company makes, but does not give to the shareholders in the form of dividends)

Each of these components has a cost. We can determine the cost of each capital component.

Cost of Retained Earnings

This is kind of weird to think about. It takes some time to understand so take it slowly. After a company makes money (earnings), who owns that money? The shareholders, right? But when you retain earnings you are not giving the money to the shareholders. You are keeping it. In a way, you are investing it for them in your company. Well those shareholders want some return on that money you are keeping.. How much return do they expect? They want the same amount as if they had gotten the retained earning in the form of dividends, and bought more stock in your company with them. THAT is the cost of retained earnings. You as a financial genius, have to ensure that if you are retaining earning, that the shareholders will get at least as good a return on the money as if they had re-invested the money back into the company.

If you don't understand this, re-read it and re-think it until you do get it. There is really no "cost" in the cost of retained earnings. I mean, no money is changing hands. You aren't paying anyone anything. But you are keeping the shareholders money. You can't say it is "free" money. Frankly if you did, it would screw up your capital budgeting. So when you are doing your capital budgeting, to ensure that the shareholders are getting a decent rate of return, you "guess" a cost of retained earnings. How?? One way is CAPM. Another way is the bond yield plus risk premium approach, in which you take the interest rate on the company's own long term debt and then add between 5% and 7%. Again, you are kind of guessing here. A third way is the discounted cash flow method, in which you divide the dividend by the price of stock and add the growth rate. Again, a lot of guessing.

Cost of Issuing Common Stock

Flotation Cost of Common Stock = Costs of issuing the actual stock (ink, printing, paper, computers, etc.) + The cost of retained earnings.

Cost of Preferred Stock

Cost of Preferred Stock = What you give. divided by What you get.
Cost of Preferred Stock = Dividend divided by Price - Underwriting Costs

Cost of Bonds (debt)

Cost of Debt = Coupon rate on the bonds minus The Tax Savings

Interest on bonds is tax deductible. So we can reduce our taxable income by the amount of money we pay to the bondholders.

WACC - The Weighted Average Cost of Capital.

Every company has a capital structure - a general understanding of what percentage of debt comes from retained earnings, common stocks, preferred stocks, and bonds. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. This is the weighted average cost of capital.

Capital Component Cost Times % of capital structure Total
Retained Earnings 10% X 25% 2.50%
Common Stocks 11% X 10% 1.10%
Preferred Stocks 9% X 15% 1.35%
Bonds 6% X 50% 3.00%
TOTAL       7.95%

So the WACC of this company is 7.95%.

Financial Terms: A B C D E F G H I J K L M N O P Q R S T U V W Y Z

About the author

Mark McCracken

Author: Mark McCracken is a corporate trainer and author living in Higashi Osaka, Japan. He is the author of thousands of online articles as well as the Business English textbook, "25 Business Skills in English".

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