Appendix A 201Cost of CapitalAFTERTAX =
Cost of CapitalBEFORETAX * (1 TaxRate
where the tax rate is determined by applicable tax law.The second broad source of funding is equity financing. Under
equity financing the lender acquires an ownership (or equity) position
within the borrower’s organization. As a result of this ownership posi-
tion, the lender has the right to participate in the financial success of the
organization as a whole. The two primary sources of equity financing are
stocks and retained earnings. The cost of capital associated with shares
of stock is much debated within the financial community. A detailed pre-
sentation of the issues and approaches is beyond the scope of this appen-
dix. Additional reference material can be found in Park and Sharp-Bette
[1990]. One issue about which there is general agreement is that the cost
of capital for stocks is higher than the cost of capital for debt financing.
This is at least partially attributable to the fact that interest payments are
tax deductible, while stock dividend payments are not.
If any subject is more widely debated in the financial community
than the cost of capital for stocks, it is the cost of capital for retained earn-
ings. Retained earnings are the accumulation of annual earnings surpluses
that a company retains within the company’s coffers rather than pays out
to the stockholders as dividends. Although these earnings are held by the
company, they truly belong to the stockholders. In essence the company
is establishing the position that by retaining the earnings and investing
them in capital projects, stockholders will achieve at least as high a return
through future financial successes as they would have earned if the earn-
ings had been paid out as dividends. Hence, one common approach to
valuing the cost of capital for retained earnings is to apply the same cost
of capital as for stock. This, therefore, leads to the same generally agreed
result. The cost of capital for financing through retained earnings gener-
ally exceeds the cost of capital for debt financing.
In many cases the financing for a set of capital investments is ob-
tained by packaging a combination of the above sources to achieve a
desired level of available funds. When this approach is taken, the over-
all cost of capital is generally taken to be the weighted average cost of
capital across all sources. The cost of each individual source’s funds is
weighted by the source’s fraction of the total dollar amount available.
By summing across all sources, a weighted average cost of capital is
calculated, as shown in the following example: