The cost of capital is composed of the costs of debt, preferred stock, and common stock. The formula for the cost of capital is composed of separate calculations for all three of these items, which must then be combined to derive the total cost of capital on a weighted average basis. To derive the cost of debt, multiply the interest expense associated with the debt by the inverse of the tax rate percentage, and divide the result by the amount of debt outstanding. The amount of debt outstanding that is used in the denominator should include any transactional fees associated with the acquisition of the debt as well as any premiums or discounts on sale of the debt. These fees, premiums, or discounts should be gradually amortized over the life of the debt, so that the amount included in the denominator will decrease over time. The formula for the cost of debt is:

Advertisement

 

Interest expense x [1 – Tax rate] [devided by] Amount of debt – Debt acquisition fees + Premium on debt – Discount on debt

 

The cost of preferred stock is a simpler calculation since interest payments made on this form of funding are not tax-deductible. The formula is:

 

Interest expense / Amount of preferred stock

 

The calculation of the cost of common stock requires a different type of calculation. It is composed of three types of return: a risk-free return, an average rate of return to be expected from a typical broad-based group of stocks, and a differential return based on the risk of the specific stock in comparison to the larger group of stocks. The risk-free rate of return is derived from the return on a U.S. government security. The average rate of return can be derived from any large cluster of stocks, such as Standard & Poor’s 500 or the Dow Jones Industrials. The return related to risk is called a stock’s beta; it is regularly calculated and published by several investment services for publicly held companies, such as Value Line. A beta value of less than one indicates a level of rate-of-return risk that is lower than average, while a beta greater than one would indicate an increasing degree of risk in the rate of return. Given these components, the formula for the cost of common stock is:

Risk-free return + [Beta x (Average stock return – Risk-free return)]

Once all of these calculations have been made, they must be combined on a weighted average basis to derive the blended cost of capital for a company. This is accomplished by multiplying the cost of each item by the amount of outstanding funding associated with it:

= Total debt funding x Percentage cost

= Dollar cost of debt

= Total preferred stock funding x Percentage cost

= Dollar cost of preferred stock

Therefore:

= Total common funding x Percentage cost

= Dollar cost of common stock

= Total cost of capital

Case Example:

An investment analyst wants to determine the cost of capital of the Volto Electric Company to see if it is generating returns that exceed its cost of capital. The return it reported for its last fiscal year was 11.8%. The company’s bonds are currently priced on the open market at a total price of $50,800,000, its preferred stock at $12,875,000, and its common stock at $72,375,000. Its incremental tax rate is 34%. It pays $4,625,000 in interest on its bonds, and there is an unamortized debt premium of $1,750,000 currently on the company’s books. The preferred stock pays interest of $1,030,000. The risk-free rate of return is 5%, the return on the Dow Jones Industrials is 12%, and Jolt’s beta is 1.5. To calculate Volto’s cost of capital, first determine its cost of debt, which is:

$4,625,000 Interest expense × [1 – 0.34 Tax rate]
—————————————————————————– = 5.8%
$50,800,000 Debt + $1,750,000 Unamortized premium

 

The investment analyst then proceeds to the cost of preferred stock, which is calculated as:

$1,030,000 Interest expense
—————————————- = 8.0%
$12,875,000 Preferred stock

Finally, the analyst calculates the cost of common stock, which is:

5% Risk-free return + [1.5 Beta x (12% Average return – 5% Risk-free return] = 15.5%

 

The analyst then creates the weighted-average table shown in the following table to determine the combined cost of capital for Volto:

Type of Funding         Amount of                Percentage     Dollar Cost
                                    Funding                    Cost            

Debt                           $50,800,000                5.8%         $2,946,400
Preferred stock           $12,875,000                8.0%         $1,030,000
Common stock           $72,375,000               15.5%        $11,218,125
Totals                         $136,050,000             11.2%        $15,194,525

 

Conclusion: based on these calculations, Volto’s return of 11.8% is a marginal improvement over its cost of capital of 11.2%.

 

The dollar value of the preferred stock and common stock used in this calculation is based on the current market price of these items, rather than the price at which they were originally sold. The market rate, can help to accurately determine the assumed rate of return that investors are expecting at the moment; this is much preferable to using the book rate for either item, since this fixes the rate of return at the time when the shares were originally sold and gives no indication of current market expectations.