What Does a Company's Cost of Capital Represent?

What does a company's cost of capital represent? The cost of capital represents the funds that are raised for a company to use. (Gallagher and Andrew, 2003, pg 238) To raise or borrow funds costs money. It costs money because leaders of the funds demand compensation for the funds provided. (Gallagher and Andrew, 2003, pg 238) The best way to explain this is to use the example of purchasing a home. A bank or mortgage company will loan you funds to purchase a home, however they require you to pay them interest to borrow these funds, in addition, if you don't pay back the loan with interest, they can come and take your home, your asset.

We need to look at how each type of cost of capital in order to understand how to calculate the cost. (Lawrence, 2005) The cost of debt is the interest rate after taxes. The reason we look at this as after taxes is we must calculate the savings to the company on taxes. The reason a company doesn't use all their cost of capital in the form of debt is because of the risk analysis that is performed on a company. (Lawrence, 2005) It would make the company look bad. We calculate the cost of debt by the before-tax cost of debt multiplied by one minus the firms marginal tax rate. (Gallagher and Andrew, 2003, pg 240) The next type of cost of capital is the cost of preferred and common stock. This is not taxable. We find the cost of preferred stock by the amount of the expected preferred stock dividend divided by the current price of the preferred stock minus the flotation cost per share. (Gallagher and Andrew, 2003, pg 241) The flotation cost is the cost of issuing the new securities. (Gallagher and Andrew, 2003, pg 241) The last type of cost of capital is the cost of common equity. "This is the required rate of return on funds supplies by existing common stockholders." (Gallagher and Andrew, 2003, pg 242) We find this figure by taking the dollar amount of common dividend expected one period divided by the required rate of return per period on this common stock investment minus the expected growth rate per period. (Gallagher and Andrew, 2003, pg 242)