What is Cost of Capital?

What is Cost of Capital?

Cost of capital is a company’s calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory.

The term cost of capital is used by analysts and investors, but it is always an evaluation of whether a projected decision can be justified by its cost. Investors may also use the term to refer to an evaluation of an investment’s potential return in relation to its cost and its risks.

Many companies use a combination of debt and equity to finance business expansion. For such companies, the overall cost of capital is derived from the weighted average cost of all capital sources. This is known as the weighted average cost of capital (WACC).

Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building.

Cost of capital encompasses the cost of both equity and debt, weighted according to the company’s preferred or existing capital structure. This is known as the weighted average cost of capital (WACC).

A company’s investment decisions for new projects should always generate a return that exceeds the firm’s cost of the capital used to finance the project. Otherwise, the project will not generate a return for investors.

How to calculate cost of capital

1. Cost of Debt

While debt can be detrimental to a business’s success, it’s essential to its capital structure. Cost of debt refers to the pre-tax interest rate a company pays on its debts, such as loans, credit cards, or invoice financing. When this kind of debt is kept at a manageable level, a company can retain more of its profits through additional tax savings.

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Companies typically calculate cost of debt to better understand cost of capital. This information is crucial in helping investors determine if a business is too risky. Cost of debt also helps identify the overall rate being paid to use funds acquired from financial strategies, such as debt financing, which is selling a company’s debt to individuals or institutions who, in turn, become creditors of that debt.

There are many ways to calculate cost of debt. One common method is adding your company’s total interest expense for each debt for the year, then dividing it by the total amount of debt.

Another formula that businesses and investors can use to calculate cost of debt is:

Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)

Here’s a breakdown of this formula’s components:

  • Risk-free return: Determined from the return on US government security
  • Credit spread: Difference in yield between US Treasury bonds and other debt securities
  • Tax rate: Percentage at which a corporation is taxed

2. Cost of Equity

Equity is the amount of cash available to shareholders as a result of asset liquidation and paying off outstanding debts, and it’s crucial to a company’s long-term success.

Cost of equity is the rate of return a company must pay out to equity investors. It represents the compensation that the market demands in exchange for owning an asset and bearing the risk associated with owning it.

This number helps financial leaders assess how attractive investments are—both internally and externally. It’s difficult to pinpoint cost of equity, however, because it’s determined by stakeholders and based on a company’s estimates, historical information, cash flow, and comparisons to similar firms.

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Cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which considers an investment’s riskiness relative to the current market.

To calculate CAPM, investors use the following formula:

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)

Here’s a breakdown of this formula’s components:

  • Risk-free return: Determined from the return on US government security
  • Average rate of return: Estimated by stocks, such as Dow Jones
  • Return risk: Stock’s beta, which is calculated and published by investment services for publicly held companies

3. Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the most common method for calculating cost of capital. It equally averages a company’s debt and equity from all sources.

Companies use this method to determine rate of return, which indicates the return that shareholders demand to provide capital. It also helps investors gauge the risk of cash flows and desirability for company shares, projects, and potential acquisitions. In addition, it establishes the discount rate for future cash flows to obtain value for a business.

WACC is calculated by multiplying the cost of each capital source (both equity and debt) by its relevant weight by market value, then adding the products together to determine the total. The formula is:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Here’s a breakdown of this formula’s components:

  • E: Market value of firm’s equity
  • D: Market value of firm’s debt
  • V: Total value of capital (equity + debt)
  • E/V: Percentage of capital that’s equity
  • D/V: Percentage of capital that’s debt
  • Re: Required rate of return
  • Rd: Cost of debt
  • T: Tax rate
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Factors Affecting Cost of Capital

There are various factors that can affect the cost of capital. Some fundamental factors are as follows:

Primarily, the market opportunity available to entrepreneurs is the most contributing factor. If no new profitable businesses are available in the market, a business person would not need money. Therefore the demand for money will fall, resulting in a fall in the cost of capital.

Preferences of capital providers in terms of consumption or savings are other important factors that vary from person to person and country to country. If the capital providers bent towards consumption, the supply of capital would reduce and thereby increase in cost.

We have already discussed the importance of risk. The higher the risk, the higher the required rate of return and vice versa.

In economics, it is said that inflation plays an important role in deciding this cost. The higher the inflation, the higher would be expectations of the capital providers. Else they may opt to consume or invest somewhere else.

Why Is Cost of Capital Important?

Most businesses strive to grow and expand. There may be many options: expand a factory, buy out a rival, build a new, bigger factory. Before the company decides on any of these options, it determines the cost of capital for each proposed project.

This indicates how long it will take for the project to repay what it cost, and how much it will return in the future. Such projections are always estimates, of course. But the company must follow a reasonable methodology to choose between its options.