Cost Of Capital

Section: Cost of Capital Estimated study time: 45 minutes Content: The cost of capital is the minimum required return that a company must earn on its investments to satisfy its capital providers — both debt holders and equity holders. It is the hurdle rate for capital budgeting: projects earning returns above the cost of capital create value; those earning below destroy value. The Weighted Average Cost of Capital (WACC) is the most important version: WACC = (E/V) × Re + (D/V) × Rd × (1 – T), where E = market value of equity, D = market value of debt, V = E + D (total firm value), Re = cost of equity, Rd = pre-tax cost of debt, and T = marginal tax rate. The (1 – T) factor reflects the tax deductibility of interest payments — debt financing provides a tax shield that reduces its effective cost. WACC uses market value weights (not book value weights) because it represents the opportunity cost to current investors. The cost of debt (Rd) is the yield to maturity (YTM) on new debt issuances — the market rate at which the company can currently borrow. It is not the coupon rate on existing debt (which reflects past market conditions). For investment-grade companies, Rd can be approximated using the YTM of the company's traded bonds. The pre-tax cost of debt is then adjusted by (1 – T) for the interest tax shield. The cost of preferred stock is the preferred dividend divided by the current market price: Rp = Dp / P0. Preferred stock is not tax-deductible (dividends are paid from after-tax income), so no tax adjustment is needed. The cost of…