Published by: Nuru
Published date: 28 Feb 2022
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.
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)
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
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 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:
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