All companies must make decisions about how they will finance their current and future operations. Firms can elect to borrow funds or they can sell stakes in the company to shareholders. For companies to make these decisions, they need to consider the capital structure, or mix of debt and equity, of the firm. They must also determine the cost of their debt, the cost of their equity, and the cost to acquire new capital.
Generally, a firm’s cost of capital is what it costs the firm to acquire money. It may also be thought of as the rate required by investors (lenders or shareholders) for the use of their money. The cost of capital could be the cost of the financing the firm already has or it could be the cost of new financing, which is referred to as the marginal cost of capital. When evaluating projects, the internal rate of return on the project, or how much money the project will generate, can be compared to the cost of capital, which is the cost of financing such a project. If the rate of return exceeds the cost of capital, the project is probably a good one (in terms of cost only). The cost of capital takes into account the cost of debt and the cost of equity.
The cost of debt could be the effective interest or coupon rate a firm currently pays on its debt. It could also be the rate of return required by a firm’s creditors. The cost of debt is often calculated net of taxes, since firms can deduct interest expense from their income for tax purposes. The after-tax cost of debt is equal to the pretax cost of debt times one minus the firm’s marginal tax rate. Common types of debt are loans and bonds.
A firm’s cost of equity is the return its stockholders require. It is the rate investors require accounting for the time their money is tied up in a firm and the risk they encounter in doing so. It can be calculated in two main ways, although there are many possible