HOW TO CALCULATE THE COST OF CAPITAL

Companies such as Tesla and Gamestop carry higher costs of debt, too; for example, Tesla currently carries a cost of debt of 4.21%, which reflects the poor credit rating the company currently carries. Likewise, Gamestop carries a cost of debt of 4.13%, which also indicates a poor credit rating, leading to higher lending costs. Our company pays a tax rate of 30%, and it saves $1,500 in taxes by expensing the interest. We calculate that by taking $5,000 in interest expense by 30% tax rate, giving us a $1,500 write-off.

Specific forms of alternative financing are preferred stock, retained earnings, and new common stock. If your company is perceived as having a higher chance of defaulting on its debt, the lender will assign a higher interest rate to the loan, and thus the total cost of the debt will be higher. Most firms in emerging markets are not rated; to determine which home-country interest rate to select, it is necessary to assign a credit rating to the local firm.

After-Tax Cost of Debt Formula

Because interest payments are deductible and can affect your tax situation, most people pay more attention to the after-tax cost of debt than the pre-tax one. The effective pre-tax interest rate your business is paying to service all its debts is 5.3%. Therefore, the final step is to tax-affect the YTM, which comes out to an estimated 4.2% cost of debt once again, as shown by our completed model output. The current market price of the bond, $1,025, is then input into the Year 8 cell. For the next section of our modeling exercise, we’ll calculate the cost of debt but in a more visually illustrative format.

The first determines how much of the company’s capital structure is equity and then multiplies that by the cost of equity. Beyond cost of capital’s role in capital structure, it indicates an organization’s financial health and informs business decisions. When determining an opportunity’s potential expense, cost of capital helps companies evaluate the progress of ongoing projects by comparing their statuses against their costs. Companies current cost of debt in the early stages of operation may not be able to leverage debt in the same way that well-established corporations can. Limited operating histories and assets often force smaller companies to take a different approach, such as equity financing, which is the process of raising capital through selling company shares. Evaluating the cost of borrowed money allows a business to make informed decisions about financing its operations.

Internal Rate of Return

Once the costs of capital are optimized, a business can apply this cost of capital to various asset and project assessments. Note that retained earnings are a component of equity, and, therefore, the cost of retained earnings is equal to the cost of equity as explained above. Dividends are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.

He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution License .