The cost of capital is the cost of funds for the Company i.e. the rate at which the Company has gathered the finance required to run the business or a particular project. The Source of finance may vary in each case. Some projects may be financed by shareholder equity other may be fully financed through debts or it may be a mix of both. So the cost of capital would depend on the sources of capital and at what rates that capital has been obtained.
Cost of Equity
It is the minimum rate of return expected by the shareholders. The cost of equity is not a fixed rate of return and the company is not bound to pay a specific return to its shareholders in each period but is definitely more than the cost of debt due to the fact that equity providers take more risk than the debt providers.
There are many methods of calculating the cost of equity including dividend growth model, price earning model, and capital asset pricing model (CAPM). All are based on the fact that the market value of a company’s share is dependent on the risks and earnings potential of the company so we can say that cost of equity is the rate of return which the company must earn to maintain its market value.
Cost of Debt
Cost of debt is the return expected by debt providers which are usually a fixed percentage or based on an industry benchmark e.g. KIBOR, LIBOR, etc. Depending upon the type of debt finance, company legal structure, and tax regulations, a company may get a tax credit on its cost of debt. If the company is able to claim the tax credit on its interest cost then the cost of debt would be taken net of that rebate for all purposes.
Weighted Average Cost of Capital:
If a company is using a mix of both equity and debt as a source of finance then it uses the Weighted Average Cost of Capital (WACC) which is simply a weighted average of both. The formula for WACC is as follows:
= (Amount of equity capital x Cost of Equity) + (Amount of debt capital x Cost of Debt)
Total capital (Equity + Debt)