Following are the main components of cost of capital:
• Cost of debt.
• Cost of equity.
• Cost of preferred capital.
• Retained earnings.
• Number of stocks sold.
• Tax rate.
From the company investor point, debt carriers least risk and lower risk implies lower return. Thus, it is the lowest cost of capital which a firm can raise. This followed by the preferred share capital which is riskier than debt but less riskier than the equity capital. Finally is the equity which carries more risk, but the equity from the retained earnings results in lesser cost when compared to the new equity issue.
In case of before tax, preferred capital is lower when compared to debt because of higher after tax return on this capital as the investors will accept for the lesser pre-tax yield on the dividends of preferred stocks than on bonds. This is followed by debt and finally the equity.
One important point to be noted in case of debt is the interest factor which is actually tax deductible and this results in future reduction of cost of debt. Thus after tax the cost of debt is lower which is followed by preferred stock and the equity.