Course Level: Beginner to Intermediate - No prior knowledge of capital management is required although some understanding of capital management will be helpful. Recommended for 2.0 hours of CPE. Course Method: Inter-active self study with audio clips, self-grading exam, and certificate of completion.

Calculating the Cost of Capital

In order to evaluate projects of average risk, we must knowThe cost of capital, management courses online overall cost of capital. Cost of Capital is calculated asThe cost of capital, management courses online weighted average of each component of capital - debt, common stock, preferred stock, and retained earnings. Each component is calculated as follows:

Cost of Debt (Cd): Calculate the after tax cost of debt based onThe cost of capital, management courses online effective interest rate. the management of capital, evaluating of projectsfollowing formula is used to calculate the cost of debt:

Cd = I ( 1 - TR) where I is Interest Rate on Debt and TR isThe cost of capital, management courses online Tax Rate.

Example 5 - Calculate the Cost of Debt

Cantor Corporation borrowed $ 100,000 at 8% interest.
the management of capital, evaluating of projectsamount ofThe cost of capital, management courses online loan proceeds was $ 96,000 and the tax rate is 35%.

Cost of Debt = ($ 100,000 x .08) / $ 96,000 x ( 1 - .35) = 8.3% x .65 = 5.4%.


Cost of Common Stock (Ccs): Three different methods can be used to calculateThe cost of capital, management courses online Cost of Common Stock. the management of capital, evaluating of projectsthree methods are:

1. Dividend Growth - Dividends paid to common shareholders along withThe cost of capital, management courses online overall expected growth rate is used to calculate a cost for the common stock. the management of capital, evaluating of projectsformula for calculating the cost of common stock is: (Dividends in Year 1 / Market Value of Stock) + Overall Growth Rate.

Example 6 - CalculateThe cost of capital, management courses online Cost of Common Stock based on Dividend Growth

Cantor Corporation expects to pay a $ 6.00 dividend this year to common shareholders. Historically, dividends have grown by 2% each year. Cantor's common stock is currently selling for $ 45.00 per share.

Cost of Common Stock = ($ 6.00 / $ 45.00) + .02 = 15.3%.


2. Capital Asset Pricing Model (CAPM) - the management of capital, evaluating of projectsCAPM isThe cost of capital, management courses online most widely used approach to calculating the cost of common stock. the management of capital, evaluating of projectsCAPM uses three components to calculate the cost of common stock - (1) rf isThe cost of capital, management courses online risk free rate earned by investors (such as U.S. Treasury Bonds; (2) b is the beta coefficient which expresses the risk of the common stock in relation to the market; and (3) rm is the rate earned inThe cost of capital, management courses online market (such as the Standard & Poor’s 500 Composite Index). the management of capital, evaluating of projectsCAPM formula is Ccs = rf + b ( rm - rf ).

Example 7 - CalculateThe cost of capital, management courses online Cost of Common Stock based on CAPM

Cantor Corporation has common stock with a listed beta of 1.35.
the management of capital, evaluating of projects estimated market return is 12% andThe cost of capital, management courses online risk free rate based on Treasury Bonds is 6.5%.

Ccs = 6.5% + 1.35 ( 12% - 6.5% ) = 13.9%


3. Bond Plus - A simple approach to calculating the cost of common stock is to add a risk premium toThe cost of capital, management courses online cost of debt. the management of capital, evaluating of projectsformula is Ccs = Cd + risk premium. the management of capital, evaluating of projectsrisk premium is the additional rate that must be paid to common shareholders above what is paid to bond holders.

Example 8 - CalculateThe cost of capital, management courses online Cost of Common Stock based on Bond Plus

Referring back to Example 5, we calculated a cost of debt of 5.4%. We have estimated a market risk premium on common stock of 4%.

Ccs = 5.4% + 4.0% = 9.4%


Cost of Preferred Stock (Cps): If your capital structure includes preferred stock, the cost of preferred stock is calculated byThe cost of capital, management courses online amount of dividends in relation to the market price of the preferred stock. the management of capital, evaluating of projects formula is Cps = Dividends / Market Price of Stock.

Example 9 - CalculateThe cost of capital, management courses online Cost of Preferred Stock

Assume we have preferred stock selling for $ 80 per share and dividends per share are $ 10.
the management of capital, evaluating of projects cost of preferred stock is:

Cps = $ 10 / $ 80 = 12.5%


Cost of Retained Earnings: the management of capital, evaluating of projects cost of retained earnings (internal funds) within a capital structure is similar toThe cost of capital, management courses online cost of common stock. We can think of the cost of retained earnings in relation to the opportunity cost of how we can use these funds. Generally, the cost of retained earnings is slightly less thanThe cost of capital, management courses online cost of common stock since no issuance costs is incurred.

After we have calculated each component cost of capital, we will calculate a weighted average based onThe cost of capital, management courses online relative market values of each component. the management of capital, evaluating of projectsfollowing example will illustrate how weighted average cost of capital is calculated.



Our overall cost of capital is calculated as a weighted average based onThe cost of capital, management courses online relative market values of each component of capital. If market values are not available, use %’s derived from The cost of capital, management courses online targeted or forecasted capital structure. If worse comes to worse, you can fall back on book values. In any event, the weighted average cost of capital isThe cost of capital, management courses online overall cost of capital that will be used to evaluate capital investments.

Cost of Equity and Risk

the management of capital, evaluating of projectsCost of Equity isThe cost of capital, management courses online rate of return required by those who invest in equity securities. the management of capital, evaluating of projects expected return can be broken down into two components - Risk Free Rate and Risk Premium. A good benchmark for establishingThe cost of capital, management courses online Risk Free Rate is the rate paid on 30 year U.S. Treasury Bonds since the risk of default is virtually non-existent. the management of capital, evaluating of projectsRisk Premium can be established by understanding two forms of risk - Business Risk and Financial Risk. InThe cost of capital, management courses online absence of debt, shareholders are confronted with one form of risk, business risk. Business Risk isThe cost of capital, management courses online risk of changes to operating income from numerous factors that influence business. When we introduce debt, we have to include financial risk. Financial Risk is the risk of changes to earnings fromThe cost of capital, management courses online use of increased debt. More debt results in higher interest payments, which impacts earnings. Consequently, The cost of capital, management courses online Risk Premium consists of Business Risk + Financial Risk. the management of capital, evaluating of projectsfollowing graph summarizes these relationships:



In the above graph, we have a total risk free rate of 5%. the management of capital, evaluating of projectsaddition of business risk increases The cost of capital, management courses online required rate on stock to 10%. When we introduce debt, this adds financial risk and increases the required return on stock. the management of capital, evaluating of projects final total rate of return on stock with all forms of risk climbs from 12% to 16% over a range of Debt to Equity Ratios. SinceThe cost of capital, management courses online cost of capital represents the rate that must be paid to investors for the use of long-term funds, higher risk to investors will increaseThe cost of capital, management courses online cost of capital.

1 comment:

rlabey said...

Thanks for information as a manager i know how informations are helpful thanks again.
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