The cost of capital is the expected return that is required on investments to compensate you for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average basis (WACC).

• It is alternatively referred to as the opportunity cost of capital or the required rate of return.
• It is calculated based on the expected average rate of return of investors in a firm.

Calculating Cost of Capital

Numerical Example :

Bonds:
• Annual interest rate 6%
• Years to maturity is 9 years

Common shares:
• Shares held 100,000
• Current share price $5
• Market return over next year 12%
• Beta (somewhat risky) 1.15
• Treasury bills currently yield 4%

• Tax rate 25%

Calculation of Cost of Capital:
First, determine market values

Bonds:
FV = $200,000
Interest per year = $200,000 x 0.06 = $12,000
N (number of years) = 9
i (interest rate) = 6%
PV (present value of the bonds)

             S
P = ———-
         (1+rt)

     $ 200,000
P = ————-
   [1 + (0.06)^9]

       $ 200,000
P = ————–
              1.54

P = $129,870.12

Let’s check it out:
Interest per year = $129,870.12 x 0.06 = $7,792.21
Interest for nine years = $ 7,792.21 x 9 = $ 70,129.88

Amount to be paid at maturity =
$ 129,870.12 + $ 70,129.88 = $ 200,000 (this is the face value).

• Common Shares:
100,000 shares x $ 5 = $ 500,000

Second, determine weightings based on market values:

Third, determine costs:
• Common shares:
Rate of return = Risk-free rate (treasury bills rate) + [market return over next year – risk free rate]Beta
= 0.04 +(0.12 -0.04)1.15
= 0.04 + 0.092
= 0.132

• Bonds:
PV = $ 129,870
FV = $ 200,000
i (after tax) = $ 12,000 (1 – 0.25)
= $ 12,000 x 0.75
= $ 9,000
Effective rate = $ 9,000/$ 200,000 = 0.045 or 4.5%

Finally, determine cost of capital:

Cost of Capital = 11.41%