# Cost of Capital Definition

2021-05-11 14:08:34
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Capital Asset Pricing Model

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k.e = (Rm-Rf)*beta

Rm = Market return

Rf= Risk free return

Cost of Debt

Debts are the source of funds that an organization borrows to enable the operations of the organization. There is usually interest attached to all forms of debts. The cost of debt is the effective rate, which is measured either pre or post tax returns, and that an organization pays on its present debt. It is however important to know that interest expense is deductible; therefore, it would be best to calculate cost of debt after tax. Cost of debt and cost of equity are both part of the organizations capital structure which may provide an insight into how risky an organization may be depending on its debt to equity ratio. This measure is therefore important as it provides more information on the overall rate the organization is paying to use debt financing. However, an organization may be fully financed by either only equity or only debt or a combination of both where WACC is adopted.

The cost of debt is calculated as follows:

After tax cost of debt = (Before tax cost of debt) x (1 Marginal tax rate)

WACC

The weighted average cost of capital is a calculation in which each part of the cost of capital of the organization is proportionally weighted. An organization has several sources of capital. These include long-term debts, short-term debts, preferred stock, or bonds all of which should be included in the calculation of the WACC. A correctly calculated WACC reveals about an organization the rate of return on equity. This means an increase in the rate of return on equity and the beta increases the organizations WACC. This directly refers to a decrease in valuation and consequently increases the organizations risk. To obtain an organizations WACC, the sum of the cost of each component of the capital (equity and debt) is multiplied by its proportional weight. Therefore, WACC is the required rate of return of the investor, which describes the combination of debts and equity as the structure of an organization.

The formula for calculating the Weighted Average Cost of Capital (WACC) is as follows:

WACC= E/V*CE + D/V*CD*(1-T)

Where:

CE = cost of equity

CD = cost of debt

E = the firm's equity market value

D = the firm's debt market value

V = E + D = total market value of the firms financing (includes both equity and debt)

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

T = current corporate tax rate