Cost of Capital and Capital Structure Decisions
THE COST OF CAPITAL is defined as the rate of return that is necessary to maintain the market value of the firm (or price of the firm’s stock). CFOs must know the cost of capital (the minimum required rate of return) when making capital budgeting decisions, helping to establish the optimal capital structure, and making decisions about issues such as leasing, bond refunding, and working capital management. The cost of capital is used either as a discount rate under the net present value (NPV) method or as a hurdle rate under the internal rate of return (IRR) method. The cost of capital is computed as a weighted average of the various capital components, which are items on the right-hand side of the balance sheet such as debt, preferred stock, common stock, and retained earnings.
INDIVIDUAL COSTS OF CAPITAL
The elements of capital have component costs, identified as follows:
ki = before-tax cost of debt
kd = ki (1 – t) = after-tax cost of debt, where t = tax rate
kp = cost of preferred stock
ks = cost of retained earnings (or internal equity)
ke = cost of external equity, or cost of issuing new common stock
ko = firm’s overall cost of capital, or a weighted average cost of capital
Cost of Debt
The before-tax cost of debt can be found by determining the IRR (or yield to maturity; YTM) on the bond cash flows.
However, the following shortcut formula can be used for approximating the YTM on a bond:
I = annual ...