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).
- 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.
Cost Of Capital
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:
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:
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:
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.
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.
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.
What Is the Difference Between the Cost of Capital and the Discount Rate?
The two terms are often used interchangeably, but there is a difference. In business, cost of capital is generally determined by the accounting department. It is a relatively straightforward calculation of the breakeven point for the project. The management team uses that calculation to determine the discount rate, or hurdle rate, of the project. That is, they decide whether the project can deliver enough of a return to not only repay its costs but reward the company's shareholders.
How Do You Calculate the Weighted Average Cost of Capital?
The weighted average cost of capital represents the average cost of the company's capital, weighted according to the type of capital and its share on the company balance sheet. This is determined by multiplying the cost of each type of capital by the percentage of that type of capital on the company's balance sheet and adding the products together.
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.
For example, if the company paid an average yield of 5% on its outstanding bonds, its cost of debt would be 5%. This is also its cost of capital.What is a simple example of cost of capital? ›
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%.How to calculate the cost of capital? ›
In this formula:
- E = the market value of the firm's equity.
- D = the market value of the firm's debt.
- V = the sum of E and D.
- Re = the cost of equity.
- Rd = the cost of debt.
- Tc = the income tax rate.
- Determine the equity and debt market values. Find the market values for both your company's capital debt and equity. ...
- Calculate the actual costs of the debt and equity. ...
- Combine the debt and equity market values. ...
- Find the current corporate tax rate. ...
- Apply the formula.
Essentially, capital costs are one-time expenses paid for things used in the production of goods or service. A good example of a capital costs is the purchase of fixed assets, like new buildings or business tools. It could also include the costs of intangible assets, like patents and other forms of technology.What is the answer of cost of capital? ›
Gitman, "The cost of capital is the rate of return a firm must earn on its investments for the market value of the firm to remain unchanged. It can also be thought of as the rate of return required by the market suppliers of capital in order to attract needed financing at a reasonable price".What is a good example of capital? ›
Here are a few examples of capital: Company cars. Machinery. Patents.What is cost of working capital example? ›
Working capital is calculated by taking a company's current assets and deducting current liabilities. For instance, if a company has current assets of $100,000 and current liabilities of $80,000, then its working capital would be $20,000.Are there examples in using the cost of capital in personal life? ›
For most people your personal cost of capital will first be: The interest rates on any debt that you hold (car loans, credit cards, student loans, mortgages, etc). If you don't have debt, it would be the interest rate on any CD's or savings accounts.What is the math of cost of capital? ›
Calculation of Cost of Capital (Step by Step)
The weight of the debt component is computed by dividing the outstanding debt by the total capital invested in the business, i.e., the sum of outstanding debt, preferred stock, and common equity.
Capital = Assets – Liabilities
Capital can be defined as being the residual interest in the assets of a business after deducting all of its liabilities (ie what would be left if the business sold all of its assets and settled all of its liabilities).
The weighted average cost of capital (WACC) is the average rate that a business pays to finance its assets. It is calculated by averaging the rate of all of the company's sources of capital (both debt and equity), weighted by the proportion of each component.What are the two ways to calculate WACC? ›
- The first determines how much of the company's capital structure is equity and then multiplies that by the cost of equity.
- The second part of the formula shows how much of the capital structure is debt and multiplies that proportion by the cost of debt.
Under this model, Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return).Why is cost of capital important? ›
The cost of capital can thus be thought of as the “hurdle” rate of return required on new investment projects. That is, the minimum rate of return a new project must yield to be undertaken profitably.What is the difference between cost of capital and capital cost? ›
Cost of Capital: An Overview. A company's cost of capital refers to the cost that it must pay in order to raise new capital funds, while its cost of equity measures the returns demanded by investors who are part of the company's ownership structure.What is a capital cost summary? ›
Capital costs are fixed, one-time expenses incurred on the purchase of land, buildings, construction, and equipment used in the production of goods or in the rendering of services. In other words, it is the total cost needed to bring a project to a commercially operable status.How is WACC cost of debt calculated? ›
Take the weighted average current yield to maturity of all outstanding debt then multiply it one minus the tax rate and you have the after-tax cost of debt to be used in the WACC formula.What is the cost capital quizlet? ›
The cost of capital is the minimum rate of return that a firm must earn on its investments to grow firm value. A weighted average cost of capital should be used to find the expected average future cost of funds over the long run.What are 3 examples of capital items? ›
Capital goods include buildings, machinery, equipment, vehicles, and tools.
Tools, machinery, buildings, vehicles, computers, and construction equipment are types of capital goods. Capital goods are one of the four leading economic factors.What are the three examples of capital? ›
- Financial (Economic) Capital. Financial capital is necessary in order to get a business off the ground. ...
- Human Capital. Human capital is a much less tangible concept, but its contribution to a company's success is no less important. ...
- Social Capital.
Cash, including money in bank accounts and undeposited checks from customers. Marketable securities, such as U.S. Treasury bills and money market funds. Short-term investments a company intends to sell within one year. Accounts receivable, minus any allowances for accounts that are unlikely to be paid.What is the formula and example of working capital? ›
Working Capital = Current Assets - Current Liabilities
For example, if a company's balance sheet has 300,000 total current assets and 200,000 total current liabilities, the company's working capital is 100,000 (assets - liabilities).
In business, capital means the money a company needs to function and to expand. Typical examples of capital include cash at hand and accounts receivable, near cash, equity and capital assets. Capital assets are significant, long-term assets not intended to be sold as part of your regular business.What does a 12% WACC mean? ›
Weighted Average Cost of Capital (WACC) is expressed in a percentage form like interest rate. If a company works with a 12% WACC, all investments should give a higher return than the 12% of WACC. A company should pay an amount to its bondholders for financing debt.What does a 6% WACC mean? ›
Example of a High Weighted Average Cost of Capital (WACC)
The company issues and sells 60,000 shares of stock at $100 each to raise the first $6,000,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.
The WACC can be hard to calculate, especially if you're not familiar with all the inputs. Higher debt levels usually mean a higher WACC will be required. Complex balance sheets with varying types of debt and interest rates will find it more complicated to calculate their WACC.What are 3 methods used to calculate the cost of equity capital? ›
There are three formulas for calculating the cost of equity: capital asset pricing model (CAPM), dividend capitalization, and weighted average cost of equity (WACE).What mistakes are made when calculating WACC? ›
- using the wrong tax rate.
- using the book value of debt and equity instead of the correct valuation.
- assuming a capital structure that is neither the current nor forecasted structure.
- failure to satisfy the “time consistency formulae” (see the paper)
- E / (D + E) = Equity Weight %
- D / (D + E) = Debt Weight %
- Ke = Cost of Equity.
- Kd = After-Tax Cost of Debt.
The Fairness Finance simplified Wacc calculator can be used to estimate the cost of capital applicable for discounting operating cash flow. The result is obtained by entering, in the fields below, the necessary assumptions (in percentages except for the levered beta).What does a WACC of 10% mean? ›
It represents the expense of raising money—so the higher it is, the lower a company's net profit. For instance, a WACC of 10% means that a business will have to pay its investors an average of $0.10 in return for every $1 in extra funding.How do you calculate cost of capital using CAPM? ›
Using the capital asset pricing model (CAPM) to determine its cost of equity financing, you would apply Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return) to reach 1 + 1.1 × (10-1) = 10.9%.What is the formula for the cost of equity in WACC? ›
Cost of equity = Risk free rate of return + Beta * (market rate of return - risk free rate of return).How do you calculate opportunity cost of capital for a project? ›
- The opportunity cost of capital =
- = Rate of Return on Most Profitable Investment −
- − Rate of Return on Investment Chosen to Pursue.
Logically, the working capital requirement calculation can be done via the following formula: WCR = Inventory + Accounts Receivable – Accounts Payable.