Cost Of Capital

Cost of capital is the cost of resources employed in the business. This cost will include the cost of equity and debt in the business.

This combined cost of capital is also known as the weighted average cost of capital (WACC). WACC includes computation of the cost of preference capital and cost of reserves if any based on the weights assigned to different sources of capital. The calculation of the cost of capital is crucial to understand the returns that need to be generated from the business or an investment to cover the costs.

Formula to calculate the cost of capital

The cost of capital is broadly calculated as the cost of equity and the cost of debt in the business. These costs are then combined to calculate the overall cost of capital.

Cost of Equity – The cost of equity is calculated using the CAPM model. The formula for the same is given below.

Cost of equity (CAPM) – Rf + Beta (Rm – Rf)

Where, Rf = Risk free return
Rm = Market rate of return
Beta = Risk

Cost of debt = Interest Rate * (1- Tax Rate).

Weighted Average Cost of Capital is the average cost of capital of a business which includes different types of capital employed in the business. The formula to calculate the same is given below.

WACC = ( E / V * Re) + (D / V * Rd * (1-Tax Rate)

Where –
E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = E+D (Market Value of the company’s equity and debt together)
Re = Rate of Cost of equity
Rd = Rate of Cost of debt