What is the Cost of Capital?
Cost of capital represents the minimum return required to justify taking on a capital budgeting project such as building a new factory. It calculates whether a planned investment can be justified in terms of its cost.
Companies often finance their expansion using a mix of debt and equity. The overall cost of capital for such organizations is derived from the weighted average of these sources, commonly known as the weighted average cost of capital (WACC).
Key Takeaways
- Essential Return: Cost of capital is the return that needs to be achieved to justify the expenditure on any significant capital project.
- Combined Financing: It includes the costs of equity and debt, weighted according to the company’s financial structure.
- Strategic Decisions: Companies need their investments to yield returns greater than the cost of capital to ensure profitability.
Unpacking the Cost of Capital
Understanding the cost of capital is crucial for setting a project’s hurdle rate – the minimum rate of return needed. It helps a business figure out how much a project needs to generate in revenues to cover its costs and deliver profits. Companies may analyze these costs as levered (considering debt) or unlevered (excluding debt).
From an investor’s perspective, the cost of capital assesses the expected returns from investments like stocks. Investors gauge this by reviewing the financial volatility or ‘beta’.
Weighted Average Cost of Capital (WACC)
The formula of WACC accounts for the costs of both equity and debt in a company’s capital structure. Each component is weighted proportionately: common and preferred stock, bonds, and other debt forms are included.
The Cost of Debt
For an early-stage company lacking assets for loan collateral, equity financing is typical. Less established firms with limited histories incur higher capital costs than established firms.
The cost of debt is the interest paid on loans, calculated after tax:
Cost of Debt = (Interest Expense / Total Debt) * (1 - Tax Rate)
Additionally, it can be estimated by adding a credit spread to the risk-free rate then multiplying by (1 - Tax Rate).
The Cost of Equity
Calculating equity cost is complex since it relies on investors’ return expectations, roughly estimated using the Capital Asset Pricing Model (CAPM):
Cost of Equity (CAPM) = Risk-Free Rate + Beta(Market Rate - Risk-Free Rate)
Here, ‘Beta’ gauges risk, assumed from the average of comparable public companies for private enterprises.
Combined Capital Costs
A company’s total cost of capital merges these components:
Consider a firm with 70% equity at a 10% cost and 30% debt at a 7% after-tax cost.
WACC = (0.7 * 10%) + (0.3 * 7%) = 9.1%
This WACC assesses the return required from prospective projects to ensure they add value.
Equity vs. Debt Financing Considerations
- Tax Efficiency: Debt financing is more tax-efficient as interest is tax-deductible compared to equity financing’s after-tax dividends.
- Leverage Impact: High debt levels raise leverage and interest rates due to default risks, influencing overall capital cost.
Differentiating Cost of Capital and Discount Rate
Though often used interchangeably, they are distinct: businesses calculate cost of capital to set appropriate return expectations (hurdle rates) for investments. Management uses it to decide if the returns justify the costs and reward shareholders.
Importance of Cost of Capital
Determining cost of capital helps ensure funds are deployed effectively, projecting a company’s investment value and propensity for long-term gains. Differences in industries largely affect these costs, influenced by necessity for equipment and steady capital returns.
- High Cost Examples: Electrical equipment, building supplies, and semiconductors.
- Low Cost Examples: Utility companies and regional banks.
Strategic Growth Considerations
Businesses exploring expansion options like acquisitions or infrastructure investment determine the project-specific costs of capital to make the best choice based on ROI projections.
How to Calculate WACC?
The WACC averages and weights each capital type, reflecting its proportional cost multiplied by its balance sheet share.
Conclusion
Understanding and calculating the cost of capital is essential for assessing investment value and ensuring strategic financing choices are made to benefit a company’s operations and enhance shareholder value.
Related Terms: capital budgeting, WACC, hurdle rate, beta, NPV, discount rate.
References
- Internal Revenue Service. “Publication 535 (2021), Business Expenses”.
- New York University Stern School of Business. “Industry Survey”.
