Cost of Capital

What Is the Cost of Capital?

Read this chapter on capital, flotation, debt, preferred stock, and common stock costs. Can you list the reasons why WACC is so important? Pay attention to the section on how to calculate the WACC.

Investors expect a profit. Very few investors would be willing to hand over money if they did not expect to receive more back! Therefore, each dollar of capital a company raises has a cost associated with it.

The cost of capital is the rate of return that a firm must supply to its investors. If a corporation doesn't provide enough return, market forces will decrease the prices of their stock and bonds to restore the balance. The cost of capital acts as a link between a firm's long-run and short-run financial decisions because it ties long-run returns with current costs. We should undertake only projects where the return is greater than the associated cost.

Flotation Costs

Flotation costs are the costs of issuing and selling a security. Typical costs include both underwriting and administrative costs.

Administrative costs are any expenses incurred by the security issuer, including legal, accounting, etc.

Underwriting costs are payments to investment bankers for selling the security. When we discuss the cost of capital, we are discussing the net proceeds from the sale of any security (bond, stock, or any other security). So, net proceeds are the total amount received minus any above-described flotation costs.

Components of WACC

There are several components to the cost of capital for a firm. These are:

Cost of debt
Cost of preferred stock
Cost of common stock

Together, these three components are then "weighted" based on the percentages they use in the company.

Key Takeaways

The cost of capital is the return a company must earn on its investment projects to maintain its market value.
Flotation costs are the costs of issuing a security.
The components of the cost of capital are 1. debt, 2. preferred stock, and 3. common stock.

Exercises

What are flotation costs?
What are administrative costs?
What are underwriting costs?

Source: Finance for Managers.

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