A Brief Guide to Engineering Financial Calculations: Cost of Capital

Our investment analyses typically ignore the cost of capital. That is, there is no explicit financing cost, because the company operates from its own cash flow. In reality, the company may have to borrow money to finance the investment. In that case, the cost of capital needs to be included, whether financed by debt or equity. Simple forms of calculating these costs are shown below.

Cost of Retained Earnings:

k_r= D₁ / P₀ + g

Cost of New Common Stock:

k_e= D₁ / [P₀(1-f_c)] +g

Cost of New Preferred Stock:

k_p= D* / [P* (1-f_c)]

Cost of Equity:

i_e= (c_r/c_e)k_r + (c_c/c_e)k_e + (c_p/c_e)k_p

After-Tax Cost of Debt:

i_d= (c_s/c_d)k_s (1- t_m) + (c_b/c_d)k_b (1- t_m)

Cost of Total Capital:

k = i_dc_d/V + i_ec_e/V