Lecture Notes 33 - - Cost of Capital


The cost of capital is part of the discount rate.  The discount rate is made up of two parts 1.) the cost of capital and 2.) the risk premium.


The cost of capital is what money/funds cost.  There are four different sources, which are called the Four Components of the Cost of Capital.


1.)  Debt (Bonds)

            2.)  Preferred Stock

            3.)  Common Stock

            4.)  Retained Earnings


These four components are also called the Capital Structure of the Firm.


The cost of capital is expressed in a percentage form and can be looked at either historically (actuals) or future (expected).


Future (Expected) Cost of Capital


There are three questions that a firm must ask itself 1.) Where do you get money  2.)  What are you going to do with the money and 3.)  How do you distribute the money.


To determine the future cost of capital you have to draw an IOS/MCC Graph.  IOS is the investment opportunity schedule and MCC is the marginal cost of capital.


To get further explanation on the IOS/MCC Graph please see Prof. Harding.


Historical (Actual) Cost of Capital


To determine the historical cost of capital you must determine the weighted average cost of capital (WACC).


Calculate the WACC given the following component costs- -


            DEBT             10%

            PREF              11%

            COMM            13%

            RE                   12%


The first step is to calculate the tax rate.  To calculate the tax rate you have to look at the actuals on the income statement and take the Taxes divided by the Before Tax Income.  So using the actuals form the previous class handout titled “A Quick and Dirty Financial Planning Model” we can determine the tax rate …


            Taxes - - 27300                                               27300/91000=30%

            Income B/T - - 91000


It is VERY IMPORTANT that you know who to calculate the tax rate.


The next step after you have determined the tax rate is to calculate the after tax cost of debt.  NOTE:  The cost of debt (10%) is a before tax cost of debt


            After Tax Cost of Debt = Before Tax Cost of Debt (1-Tax Rate)

                                                =         .10(1-.30)

                                                =         .10 * .70

                                                =         .07 or 7%

The After Tax Cost of Debt is 7%.


Now you can solve for WACC…


                                    B/T Cost         A/T Cost                     Dollars *

            DEBT             .10                   .07                   X         513000                        =         35910

            PREF              .11                   .11                   X         234000                        =         25740

            COMM            .13                   .13                   X         122000                        =         15860

            RE                   .12                   .12                   X         600000                        =         72000

                                                                                                1469000                      149510           

* Taken from the balance sheet “Quick and Dirty Financial Planning Model”


149510/1469000 = .1018  or 10.18%

The WACC is 10.18%


End Of Lecture Notes 33


Copyright  Kelley Dahlquist  2000