Cost of Capital including Cost of common stock, Cost of preferred stock, Cost of debt By Raja Kumar Singh Designated as Senior Software Engineer at Infosys Ltd. Bangalore


Introduction

The Liability (right) side of a company’s balance sheet represents common stock, preferred stock and debt. These are called capital component of a company. Any increase in a company’s total assets will have to be financed through an increase in at least one of these capital components. The cost of these components is called cost of capital for a company. In simple words, capital is the money borrowed by company for running; such as buying raw material, payment of wages, rent, operating expenses, etc. The cost incurred while borrowing capital is known as Cost of Capital.

Components and weighted average cost of capital (WACC)

Following are the components of cost of capital for a company.
  • ke= The cost of common stock. For e.g.: dividend paid, floatation cost incurred in case of IPO and FPO
  • kps= The cost of preferred stock. For e.g.: dividend paid by Infosys to its shareholders
  • kd = The cost/rate at which company can issue debt. For e.g.: company issues bond at a fix coupon rate
Thus, a company can raise capital with portions of common stock, preferred stock and debt. However, the cost of raising funds differs as per the component used. For e.g., a company can have 100% capital raised with 40% common stock where cost of common stock(ke) is 12%, 20% preferred stock where cost of preferred stock (kps) is 9%, and 40% debt where cost of debt (kd) is 11%(after-tax). When one multiples weights of capital structure with cost of each component, it is known as the weighted average cost of capital (WACC). It is determined by addition of cost of all capital components as per capital structure. It is calculated as follows:

     WACC= (we)(ke) + (wd)[kd(1-t)] + (wps)(kps), where
  • wd = percentage of debt in company’s capital (in this case is 0.4)
  • wps = percentage of preferred stock in company’s capital (in this case is 0.2)
  • we = percentage of common stock in company’s capital (in this case is 0.4)
In this case, WACC will be calculated as follows:

     WACC = (0.4)*12+(0.2)*9+(0.4)*11 = 11%

Cost of common stock (ke)

Common stock is a unit in company’s ownership. Whenever a company offers shares to general public, it incurs various costs such as IPO & FPO cost, floatation cost (amount paid to merchant banks) and dividends. These costs are called cost of common stock (ke). There are three approaches for calculating cost of common stock for a company:
  1. Capital asset pricing model (CAPM): An investor has two options to invest, can either invest at a risk free rate in U.S treasury notes or take risk by investing in common stock. Cost of common stock is derived by adding risk free rate (RF) and excess return on risk (risk premium). This approach is called capital asset pricing. It can be summarized through the following equation:
ke=Rf + β(Rm-Rf), where 
  • Rf= It is the risk free rate of return. It is the yield on default risk-free debt such as U.S. treasury note. For e.g.: 6%
  • β = It refers to the systematic or market risk that a company is exposed to. For e.g.: a beta of 1.5 means the price of share would move by 1.5 times in relation to market index
  • Rm = It is expected rate of return in the market. Generally returns of indexes such as S&P500, SENSEX, NIFTY are used to ascertain market return. For e.g.: 10%
Thus, cost of common stock in this case would be, Ke= 6 + 1.5(10-6) = 12%
  1. The dividend discount model approach: When a company has a forecasted constant growth (‘g’) in dividends we use dividend discount model approach. Thus, this approach is used to calculate ke by dividing next year’s dividend with current market value of share, plus constant growth ‘g’:
ke= D1 /p0 + g, where
  • p0 = current value of stock
  • D1 = dividend of next year
  • g = company’s growth in dividend
For e.g. : Alpha company declares dividend of $1 for next year and stock today sells for $21 in the market and the company is expected to grow at 7.2%. Then, ke=(1/21)+0.072 = 0.12 or 12%
  1. Bond yield plus risk premium: Many times a company is not listed with stock exchanges so information related to declaration of dividends, financial statements is difficult to obtain. For such companies, this approach is used to calculate ke when input values for the other two approaches are difficult to ascertain. It is calculated by adding a risk premium to the market yield.
ke= bond yield + risk premium
  • Bond yield refers to market return on bonds in similar industry
  • Risk premium refers to excess returns on taking risk
For e.g.: Acme Inc’s interest rate on long term debt is 8%. Risk premium is estimated to be 5%. Then, ke = 8% + 5% = 13%

Cost of preferred stock (kps)

A preferred stock is similar to common stock of a company, only difference being preferred stock holders have preference over dividend over common stock holders and generally lack voting rights. There are several costs incurred during issue of preferred stock such as floatation cost and dividends to stock holders, which is called cost of preferred stock(kps)

kps = Dps/P, where
Dps = Preferred dividends       P=Market price of preferred stock
For e.g.: Dexter Inc’s preferred stock pays dividend of $8 per share and sells at $100. Then, kps= 8/100 = 0.08 = 8%

Cost of debt (kd)

Another way of raising funds is via debt capital. When the company borrows money by issuing bonds or commercial paper on which it pays a fix coupon payment (interest), it is called debt capital. This fix coupon payment which company pays is known as cost of debt (kd). A company’s cost of debt is determined by combination of factors such as credit rating, portion of debt to be issued in comparison to capital structure, purpose for issuing debt etc. Based on all these factors company issues bonds on which it pays a fix coupon payment (kd).

For e.g.: Spencer inc. is planning to issue new debt at an interest rate (Fix coupon rate) of 8%. Spencer has a 40% marginal federal-plus-state tax rate. What is Spencer’s cost of debt capital?
kd = kd(1-t)= 8% ( 1 – 0.4) = 4.8%

Note: Companies enjoy tax benefit on issuing debt due to which while ascertaining WACC, after tax cost of debt is used. (calculated as above).

Author
Raja Kumar Singh
Senior Software Engineer
Infosys Limited, Bangalore

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