The cost of capital is the rate of return that a firm pays to bondholders and equity holders. Cost of capital is an important measure while making investment decisions, as any one making an investment would expect a higher return from his investment in a company compared to what he could earn from an alternative investment with equivalent risk.
A company raises capital in many forms such as common equity, preferred equity, debt and other instruments. The cost of each of these components of funding is called component cost of capital.
The cost of capital for the entire company averages out the cost of capital from all these components.
To calculate the required rate of return from an investment, we first calculate the marginal cost of capital for each source of capital, and then calculate a weighted average of these costs. This is called the Weighted Average Cost of Capital (WACC). It is also called the Marginal Cost of Capital (MCC) since this is the cost incurred by a company to get additional capital.
WACC is calculated using the following formula:
Where,
w represents the weights of debt, preferred equity, and equity.
d represents the marginal cost of each of these sources of capital, and
t represents the marginal cost of capital.
Example
Let’s assume that a company has the following capital structure:
Weight | Cost | |
Equity | 50% | 20% |
Preferred Stock | 20% | 12% |
Debt | 30% | 8%* |
*Before-tax cost of debt
Weighted Average Cost of Capital Will be calculated as follows:
WACC = 0.30*0.08 (1-30%) + 0.20*0.12 + 0.50*0.20
= 14.08%
There are certain nuances of calculating WACC, which an analyst must be aware of. We will discuss these in the next article.