Dykstra: Calculating the Cost of Capital

Days like Monday -- when markets dropped nearly 4% -- don't bring wins in my deep-in-the-money options-trading system, which has a record of 99-1. But plunging prices help us fill our positions.

And that's exactly what happened yesterday. We landed our position in my pick Archer-Daniels-Midland(ADM Quote), which on Friday had looked possibly beyond our reach, at the price I specified.

My subscribers often take wins on open positions on the market's up days. Some big-movement days last week brought quick wins of $1,000 apiece on Microsoft(MSFT Quote) and Hewlett-Packard(HPQ Quote) -- proving that good tech companies at value prices can pay off for us.

We also scored a $3,900 payoff on our position in Cisco(CSCO Quote) on March 23, after 103 days in play.

Over recent weeks, we've laid the groundwork for comparing a company's return on capital to its cost. When picking stocks, I want to know if the company puts its capital to good use. I determine this by comparing its ROC to its cost of capital.

On March 17, I reviewed how to determine a company's cost of its debt -- one of two components in the cost of capital. We did that by seeing how much the company pays its bondholders. In this case, I determined that Halliburton(HAL Quote) had an estimated after-tax cost of 2.6% on its $2.6 billion in long-term debt at the end of 2008. I also showed that long-term debt made up 13.8% of total capital.

Our next step is to multiply these two percentages, giving us a weighted cost of debt of .00359. But that number is meaningful only in the context of Halliburton's total capital. Equity made up the other 86.2%.