Component of Cost of capital

Component of cost of capital contains the cost of debt, cost of preferred stock, cost of common stock. WACC is also discussed in this topic.

1. Cost of debt:

a. Cost of Perpetual debt: 

The debt which does not have any specified maturity period is called perpetual debt. It is permanent borrowed capital and irredeemable debt. 

Before-tax cost of debt (Kd) = Coupon Interest / Net proceed = I / NP

where,

NP = Selling price - Flotation cost 

Selling price = Par Value + Premium (or - Discount)

After-tax cost of debt (Kdt) = Before-tax cost of debt (Kd) - Tax saving = Kd - Kd * T = Kd (1 - T)

So, After-tax cost of debt (Kdt) = Kd (1 - T)

b. Cost of Redeemable Debt:

The debt which does have a specified maturity period is called redeemable debt. 

Before-tax cost of debt (Kd) = [ I + ( M-NP) / n] / [ ( M + 2NP ) / 3 ]

where, 

I = coupon interest in Rs
M= Matutiry value = face value
NP= Net Proceed
n= maturity period 

After-tax cost of debt (Kdt) = Kd (1 - T)

2. Cost of Preferred stock:

a. Cost of Preferred stock with no maturity value:

Cost of preferred stock (Kps) = Preferred stock dividend / NP = Dps / NP

where, NP = Selling price - floatation cost = P₀ - FC

b. Cost of Preferred stock with maturity value:

Cost of preferred stock (Kps) = [Dps + ( M - NP ) / n ] / [ ( M +2NP) / 3]

where,

Dps = Preferred stock dividend

M = Par value or face value

NP = Net proceed = SP - FC

n = maturity period

3. Cost of Common Stock

a. Cost of Internal equity:

Cost of internal equity or retained earning (Ks) = D₁ / P₀ + g = D₀(1+g) / P₀ + g

where,

D₁= expected dividend per share

D₀= current dividend per share

P₀ = Market price per share

g = growth rate

b. Cost of External equity:

Cost of external equity or new common equity (Ke) = D₁ / NP + g = D₀(1+g) / NP + g

where, 

D₁= expected dividend per share

D₀= current dividend per share

g = growth rate

NP =Net Proceed = P₀ - Flotation cost

P₀ = Market price per share

WACC (Weighted Average Cost of Capital):

WACC is the weighted average of the after-tax cost of debt, preferred stock, and common equity. In other words, it is worked out by weighing the cost of each component of capital by its proportion in the capital structure.

Steps to calculate WACC:

1. Calculate the after-tax component cost
2. Find the weights of each source of financing
3. Multiply the after-tax cost of each source by its weight (proportion) in the capital structure
4. Add the weighted component costs to get the firms of WACC

WACC = Kdt * Wd + Kps * Wps + Ks * Ws + Ke * We 

where, 

 Kdt = After-tax cost of debt 

 Wd = Weights of debt

Kps = After-tax cost of preferred stock

Wps = Weights of preferred stock

Ks =  After-tax cost of internal equity or retained earnings

Ws = Weights of internal equity or retained earnings

Ke =  After-tax cost of external equity or new common stock

We = Weights of external equity or new common stock