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.