Classification of the cost of capital are as under:

## Cost of debt:

The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will increase as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after-tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate) (1-T), where T is the corporate tax rate and Rf is the risk-free rate.

The yield to maturity can be used as an approximation of the cost of debt.

## Cost of equity

Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta= sensitivity to movements in the relevant market

Where:

Es The expected return for a security

Rf The expected risk-free return in that market (government bond yield)

Î²s The sensitivity to market risk for the security

RM The historical return of the stock market/ equity market

(RM-Rf) The risk premium of market assets over risk free assets.

The risk-free rate is taken from the lowest yielding bonds in the market, such as government bonds.

## Expected return

The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model".

## Cost of retained earnings/cost of internal equity

Note that retained earnings are a component of equity, and so the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.

## Weighted average cost of capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.

The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is similar as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes because of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet. To calculate the firmâ€™s weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt, Cost of Preference Capital and Cost of Equity Capital.

Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.

May 24, 2017