Cost of Capital Components, Formula and Risks

Cost of Capital Definition

Before a company accepts money from investors or shareholders it must first determine if their future projected returns are large enough to pay back their investors as well as turn a profit for the company.  In order for companies to secure additional capital they must first prove that the return on capital is greater than the cost of capital.

Cost of Capital Key Components

The cost of capital can be calculated in a number of ways, but for the purpose of this article we will be using the weighted average cost of capital (WACC).  This method is comprised of 3 key components: (1) dollar cost of debt, (2) dollar cost of preferred stock, and (3) dollar cost of common stock.

Cost of Capital Formula

The below formula details how to calculate the cost of capital for a company.

Risks Associated with the Cost of Capital

The cost of capital is comprised of three key risk components: (1) risk free rate of return, (2) business risk premium, and (3) financial risk premium.

Risk Free Rate of Return

The risk free rate of return is an investment completely free of risk (i.e. Treasury Note)

Business Risk Premium

A business risk premium is a reason to increase the rate of return due to the uncertainty of the future.  For example, potential investors would heavily factor in the business risk premium with the major U.S. automakers since the auto industry as a whole is influx. 

Financial Risk Premium

The financial risk premium is another factor into the cost of capital since a company's current debt levels and interest payment to debt holders will play a role in their attempts at profitability.