Cost of Capital - Coursework Example

Cost of Capital s Cost of Capital The cost of capital is described by Rosenbaum and Pearl (2009) as the cost of a firm’s funds, both equity and debt. In other words, the cost of capital is the cost of utilizing owners’ or creditors’ funds. The cost of capital relies on the mode of financing that has been used. The cost of capital is often used to evaluate a company’s new projects. This implies that it is the minimum return expected by the investors for offering capital to the firm. The direct sources of capital are capital cost of debt, cost of preferred stock, cost of common stock, and cost of retained earnings.

First, the cost of debt is a component of the weighted average cost of capital, and it refers to the interest paid on a certain amount if a company borrows funds from outside or it is obliged to take a debt from financial institutions. It is usually expressed as a percentage rate. Besides that, it is computed either as an after tax rate or before tax rate. Second, the cost of preferred stock is the rate of return needed by the preferred stock holders in a company. It is usually computed by dividing the yearly dividend payment on the preferred stock by the current market price of the preferred stock.

Third, the cost of common stock is also known as cost of equity and is the minimum rate of return that a firm is supposed to generate so as to persuade the investors to invest in the common stock of the company at its current market price. Lastly, the cost of retained earnings is a component of the cost of equity. However, it excludes the taxes as well as the transaction costs associated with dividends making it slightly less than the common stock (Brigham & Houston, 2015). The cost of retained earnings should be at least equal to the shareholders’ rate of return on the re-investment of the company’s dividends.

ReferencesBrigham, E., & Houston, J. (2015). Fundamentals of Financial Management. Boston: Cengage Learning.Rosenbaum, J, & Pearl, J. (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John Wiley & Sons.