What is the cost of capital?
Cost of capital refers to the minimum return that a business must earn before it can generate value. Prior to turning a profit, the business is expected to at least generate sufficient income that meets the cost of capital used in funding operations. Such costs comprise of cost of equity and the cost of debt, which finances the business.
The cost of capital of a company has stronger links to the type of financing it uses. In other words, its capital structure. Some companies rely on debt, equity, or a combination of both.
Some companies rely on a combination of equity and debt to fund their expansion efforts. In such a case, the cost of capital is calculated from the weighted average cost of all capital sources – the weighted average cost of capital (WACC).
A company must closely evaluate its choice of financing because that has a direct impact on its capital structure. It is ideal to go for a funding approach that keeps the cost of capital to a minimum.
The cost of capital plays a central role when making investment decisions. Investors will typically evaluate it to gauge the suitability of investing in a particular company. The information is used to assess the return expected from buying stock shares in the company. The volatility of the company’s financial performance will inform an investor whether the potential return justifies the stock costs.
At the same time, business leaders normally use the cost of capital to understand the amount of money that new undertakings must yield to offset upfront costs and realize a profit. It is also a tool for determining the potential risks of certain business decisions.
The whole rationale for the cost of capital is that it gives information needed for understanding a project’s hurdle rate. It is important that a company knows the amount of money a particular endeavor has to generate in order to meet the cost of undertaking it and start creating profit.
How to calculate the cost of capital?
To calculate the cost of capital, one must determine these three components:
Cost of debt
Cost of equity
The weighted average cost of capital (WACC)
1. Cost of debt
Debt often has a bitter-sweet relationship with the business. Whereas it can derail the success of a business, debt is an essential part of business capital structure.
Debt falls under two broad categories: consumer debt and business debt. Consumer debt is any debt that an individual owes. It can be in the form of car loans, student loans, mortgages, and credit cards. Since this debt is accrued for personal reasons and not the company, it falls under the category of consumer debt.
Business debt, also called non-consumer debt, is debt taken to reinforce the capital structures of a business. There is often a gray area when it comes to this type of debt. For instance, using a personal computer for work falls under the category of consumer debt. At the same time, credit card debt from the business expense card is considered business debt. Understanding the type of debt in question is important as it helps with situations like filing for bankruptcy.
All debts can be good or bad, depending on how you handle them. Good debt is associated with a clear plan that justifies its usefulness. Bad debt is money spent without understanding its impact on the business.
Cost of debt entails the pre-tax interest rates applicable on a company’s debts like credit cards, loans, and invoice financing. Keeping this debt within manageable levels helps the company to keep its profits through tax savings.
Calculating the cost of debt is helpful in understanding the cost of capital. The information obtained from such computations helps investors know whether or not it is too risky to invest in the business. Furthermore, the cost of debt reveals the rate paid for using funds sourced through financial strategies like debt financing. Debt financing refers to selling a company’s debt to institutions or individuals to make them creditors of the debt in question.
Various approaches exist for calculating the cost of debt. The most common approach entails adding the total interest expense for each debt in a specific year and then dividing that by the total amount of debt.
Alternatively, the cost of debt can be calculated as follows:
(Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)
The above formula has some key components further broken down as follows:
- Risk-free return – Theoretical return of an investment that ascertains a return without any risks. It is obtained from the return on US government security.
- Credit spread – The difference between two debt securities with the same maturity but different credit quality.
- Tax rate – The percentage of tax imposed on the business
The ability of a company to use debt in its operations depends on how long it has been around. A company in its early stages of formation cannot make the most of debt in the same way that long-standing corporations can. When a company has limited assets and operating history, it may have to look for other means of funding, such as equity financing.
2. Cost of equity
Equity financing is an alternative to debt where the business raises capital by selling shares to stakeholders or new investors. Going the equity way does not mean you let go of control in your business. On the contrary, you can have investors take a minority stake so that you retain controlling interest.
There are various types of equity financing products, including private equity, venture equity, and angel investment.
Angel investment is when someone (an entrepreneur) invests their own money into your business to grow it. That often happens in exchange for a minority stake, such as 10% or 25%. Besides just providing financing, an angel investor takes a close interest in the future of your business.
Venture equity entails individuals (venture capitalists) who finance the business in its early stages with the intention of growing it. VCs do not use their own money. Instead, they use money from large corporations such as pension funds when investing in your business. Even though VCs are not involved in the day-to-day running of your business, they often get involved in other ways, such as determining overall business strategy and direction.
Private equity entails firms raising capital from institutional investors like insurance companies and pension funds. The money obtained alongside their own forms a private equity fund and invest in businesses. The goal of private equity investment is to make businesses more valuable than selling them.
Cost of equity refers to the rate of return that a company is obligated to pay equity investors. It is the compensation set in the market for owning an asset alongside the risks of such ownership.
Financial leaders can use the cost of equity to determine the attractiveness of an investment. However, pinpointing the cost of equity can sometimes be challenging since it relies on stakeholders and is based on cash flow, historical information, the company’s estimates, and how similar firms compare to it.
The Capital Asset Pricing Model (CAPM) is used to calculate the cost of equity. This model puts into consideration the riskiness of an investment in comparison to the current market.
The cost of equity is calculated as follows:
Risk-Free Rate of Return + Beta × (Market Rate of Return - Risk-Free Rate of Return)
The formula is explained below:
- Risk-Free Rate of Return - Theoretical rate of return of an investment with zero risks
- The average rate of return – The average annual amount expected from an investment
- Return risk – The risk of a particular investment. This is calculated and published by investment services for publicly traded companies
Some companies offer dividends in return for investing in them. Such corporations calculate the cost of equity using the Dividends Capitalization Model.
The formula used for the cost of equity in this case is:
(Dividends per Share / Current Market Value of Stocks) + (Dividend Growth Rate)
The components of the above formula are as explained:
- Dividends – Regular payments made by the company to shareholders
- Market value stocks – The value of stocks as determined by financial markets
- Dividend growth rate – The yearly percentage of growth for dividends issued by the company
The cost of equity is affected by current market conditions. For instance, in cases where treasuries have relatively high returns, equity returns must be higher for competitiveness with the risk-free rate. Additionally, the dividend value and dividend rate often come into play when determining the value of a company’s equity.
3. Weighted Average Cost of Capital (WACC)
Most financial experts and business leaders calculate the cost of capital using the weighted average cost of capital. The method is particularly helpful when the business’ capital structure comprises a combination of debt and equity. With WACC, the cost of capital is computed as an average of all these sources.
WACC typically helps with calculating the rate of return, which reveals the return demanded by shareholders to provide capital. Investors can also use this number to determine the risk of cash flows and the desirability of company projects, shares, and potential acquisitions. Furthermore, the computation can reveal discount rates for future cash flows that would create value for the business.
The formula for calculating WACC is as follows:
(E/V x Re) + ((D/V x Rd) x (1 – T)), where:
E – Firm’s equity market value
D – Firm’s debt market value
V - Equity + debt
E/V – % of the capital that’s equity
D/V - % of the capital that’s debt
Re - Required rate of return
Rd - Cost of debt
T - Tax rate
Investors often seek to get a low WACC for them to proceed with their investment in the company. The high figure implies that the company’s stocks are highly volatile or the debt is too risky. In this case, investors would demand greater returns.
Cost of capital vs. Discount Rate
Discount rate and the cost of capital are somewhat interrelated terms and are normally used interchangeably. The company’s finance department will typically calculate the cost of capital. The management then uses information from such computations to determine the discount rate (hurdle rate), which needs to be beaten to make an investment sensible.
Even as the business computes the cost of capital internally, the management needs to challenge these numbers. That’s because the numbers can be so conservative to the point that they push away potential investors.
More importantly, note that the cost of capital does not remain constant across projects or initiatives. Some undertakings that are very innovative but risky carry a higher cost of capital as opposed to software or equipment that has proven performance.
Why care about the cost of capital?
The cost of capital has significant implication in the business world as far as investments, and capital structure is concerned. Financial analysts and businesses use the cost of capital to rate the way funds are being invested.
A company that has a higher return on investment than the cost of capital means such a company would get net benefits from the investment. On the other hand, businesses can sense danger when the return is equal to or less than the cost of capital. In such a case, it implies the funds are not being invested wisely.
It is possible to get the valuation of a company from the cost of capital. This is more of a conceptual value. Given that a lower cost of capital implies higher proceeds, investors will attach high value to owning shares in such a company.
Businesses have different reasons for growing and expanding. Some may want to open a new factory, buy out a competitor, expand the factory, or build new offices. Prior to engaging in any of these undertakings, the business must first determine the cost of capital for initiating the proposed project. That will indicate how long the project would take to start repaying the cost and the expected future return. As the cost of capital reveals the cost of borrowing money from investors, it also shows whether or not the same is being used effectively.