The cost of capital is the weighted average cost of the funds a company uses to finance its operations. It represents the minimum return that a company must earn on its investments to satisfy its investors, whether they are equity shareholders or debt holders. There are several components to consider when computing the cost of capital, including the cost of debt, cost of equity, and the cost of preferred stock. Here’s a step-by-step guide on how to compute the cost of capital:

1. Cost of Debt:

Formula:

$\text{Cost of Debt}=\frac{\text{Annual Interest Expense}\times (1-\text{Tax Rate})}{\text{Net Debt}}$

Cost of Debt=Net DebtAnnual Interest Expense×(1−Tax Rate)​

• Annual Interest Expense: The total interest paid on outstanding debt.
• Tax Rate: The corporate tax rate.
• Net Debt: The difference between total debt and cash or cash equivalents.

2. Cost of Equity:

a. Dividend Discount Model (for Dividend-Paying Stocks):

Formula:

$\text{Cost of Equity}=\frac{\text{Dividends per Share}}{\text{Current Stock Price}}+\text{Dividend Growth Rate}$

Cost of Equity=Current Stock PriceDividends per Share​+Dividend Growth Rate

• Dividends per Share: The annual dividends paid per share.
• Current Stock Price: The current market price per share.
• Dividend Growth Rate: The expected annual growth rate of dividends.

b. Capital Asset Pricing Model (CAPM) (for Non-Dividend-Paying Stocks):

Formula:

$\text{Cost of Equity}=\text{Risk-Free Rate}+(\text{Beta}\times \text{Market Risk Premium})$

Cost of Equity=Risk-Free Rate+(Beta×Market Risk Premium)

• Risk-Free Rate: The rate of return on a risk-free investment (e.g., government bonds).
• Beta: A measure of a stock’s volatility compared to the market.
• Market Risk Premium: The expected return of the market minus the risk-free rate.

3. Cost of Preferred Stock:

Formula:

$\text{Cost of Preferred Stock}=\frac{\text{Dividends per Share}}{\text{Net Preferred Stock Price}}$

Cost of Preferred Stock=Net Preferred Stock PriceDividends per Share​

• Dividends per Share: The annual dividends paid per preferred share.
• Net Preferred Stock Price: The current market price per preferred share.

4. Weighted Average Cost of Capital (WACC):

Formula:

$\text{WACC}=\frac{E}{V}\times \text{Cost of Equity}+\frac{D}{V}\times \text{Cost of Debt}\times (1-\text{T})+\frac{P}{V}\times \text{Cost of Preferred Stock}$

WACC=VE​×Cost of Equity+VD​×Cost of Debt×(1−T)+VP​×Cost of Preferred Stock

• E: Market value of equity.
• D: Market value of debt.
• P: Market value of preferred stock.
• V: Total market value of equity, debt, and preferred stock.
• T: Corporate tax rate.

Important Points:

• Ensure that all values used are consistent in terms of time (e.g., annual rates, market values).
• Market values are preferable to book values for accuracy.
• WACC represents the overall cost of funds used by a company and is often used as a discount rate for evaluating investment projects.

Remember that these formulas provide estimates, and the actual cost of capital may vary based on market conditions and company-specific factors. It’s essential to regularly reassess and adjust these estimates as circumstances change.