Cost of Capital: What It Is, Why It Matters, Formula, and Example (2023)

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, theoverall 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).

Understanding Cost of Capital

The concept of the cost of capital is key information used to determine a project's hurdle rate. A company embarking on a major project must know how much money the project will have to generate in order to offset the cost of undertaking it and then continue to generate profits for the company.

Cost of capital, from the perspective of an investor, is an assessment of the return that can be expected from the acquisition of stock shares or any other investment. This is an estimate and might include best- and worst-case scenarios. An investor might look at the volatility (beta) of a company's financial results to determine whether a stock's cost is justified by its potential return.

Weighted Average Cost of Capital (WACC)

A firm's cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and equity capital.

Each category of the firm's capital is weighted proportionately to arrive at a blended rate, and the formula considers every type of debt and equity on the company's balance sheet, including common and preferred stock, bonds, and other forms of debt.

Finding the Cost of Debt

The cost of capital becomes a factor in deciding which financing track to follow: debt, equity, or a combination of the two.

Early-stage companies rarely have sizable assets to pledge as collateral for loans, so equity financing becomes the default mode of funding. Less-established companies with limited operating histories will pay a higher cost for capital than older companies withsolid track records since lenders and investors will demand a higher risk premium for the former.

The cost of debt is merely the interest rate paid by the company on its debt. However, since interest expense is tax-deductible, the debt is calculated on an after-tax basis as follows:

$\begin{aligned} &\text{Cost of debt}=\frac{\text{Interest expense}}{\text{Total debt}} \times (1 - T) \\ &\textbf{where:}\\ &\text{Interest expense}=\text{Int. paid on the firm's current debt}\\ &T=\text{The company’s marginal tax rate}\\ \end{aligned}$​Costofdebt=TotaldebtInterestexpense​×(1−T)where:Interestexpense=Int.paidonthefirm’scurrentdebtT=Thecompany’smarginaltaxrate​

The cost of debt can also be estimated by adding a credit spread to the risk-free rate and multiplying the result by (1 - T).

Finding the Cost of Equity

The cost of equity is more complicated since the rate of return demanded by equity investors is not as clearly defined as it is by lenders. The cost of equity is approximated by the capital asset pricing model as follows:

$\begin{aligned} &CAPM(\text{Cost of equity})= R_f + \beta(R_m - R_f) \\ &\textbf{where:}\\ &R_f=\text{risk-free rate of return}\\ &R_m=\text{market rate of return}\\ \end{aligned}$​CAPM(Costofequity)=Rf​+β(Rm​−Rf​)where:Rf​=risk-freerateofreturnRm​=marketrateofreturn​

Beta is used in the CAPM formula to estimate risk, and the formula would require a public company's own stock beta. For private companies, a beta is estimated based on the average beta among a group of similar public companies. Analysts may refine this beta by calculating it on an after-tax basis. The assumption is that a private firm's beta will become the same as the industry average beta.

The firm’s overall cost of capital is based on the weighted average of these costs.

For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.

Therefore, its WACC would be:

$(0.7 \times 10\%) + (0.3 \times 7\%) = 9.1\%$(0.7×10%)+(0.3×7%)=9.1%

This is the cost of capital that would be used to discount future cash flows from potential projects and other opportunities to estimate their net present value (NPV) and ability to generate value.

Companies strive to attain the optimal financing mixbased on the cost of capital for various funding sources. Debt financing is more tax-efficient than equity financing since interest expenses are tax-deductible and dividends on common shares are paid with after-tax dollars. However, too much debt can result in dangerously high leverage levels, forcing the company to pay higher interest rates to offset the higher default risk

Cost of Capital vs. Discount Rate

The cost of capital and discount rate are somewhat similarand the terms are oftenused interchangeably. Cost of capital is often calculated by a company's finance department and used by management to set a discount rate (or hurdle rate) that must be beaten to justify an investment.

That said, a company's management should challenge its internally generated cost of capital numbers, as they may be so conservative as to deter investment.

Cost of capital may also differ based on the type of project or initiative; a highly innovative but risky initiative should carry a higher cost of capital than a project to update essential equipment or software with proven performance.

Importance of Cost of Capital

Businesses and financial analysts use the cost of capital to determine if funds are being invested effectively. If the return on an investment is greater than the cost of capital, that investment will end up being a net benefit to the company's balance sheets. Conversely, an investment whose returns are equal to or lower than the cost of capital indicate that the money is not being spent wisely.

The cost of capital can also determine a company's valuation. Since a company with a high cost of capital can expect lower proceeds in the long run, investors are likely to see less value in owning a share of that company's equity.

Real-World Examples

Every industry has its own prevailing average cost of capital.

The numbers vary widely. Homebuilding has a relatively high cost of capital, at 6.35, according to a compilation from New York University's Stern School of Business. The retail grocery business is relatively low, at 1.98%.

The cost of capital is also high among both biotech and pharmaceutical drug companies, steel manufacturers, internet software companies,and integrated oil and gas companies. Those industries tend to requiresignificant capital investment in research, development, equipment, and factories.

Among the industries with lower capital costs are money center banks, power companies, real estate investment trusts (REITs), and utilities (both general and water). Such companies may require less equipment or may benefit from very steady cash flows.

The Bottom Line

The cost of capital measures the cost that a business incurs to finance its operations. It measures the cost of borrowing money from creditors, or raising it from investors through equity financing, compared to the expected returns on an investment. This metric is important in determining if capital is being deployed effectively.