What Is Cost of Capital?
Cost of capital is a calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory. It is an evaluation of whether a projected decision can be justified by its cost.
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.
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.
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 with solid track records.
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:
Cost of debt=Total debtInterest expense×(1−T)where:Interest expense=Int. paid on the firm’s current debtT=The company’s marginal tax rate
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).
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:
CAPM(Cost of equity)=Rf+β(Rm−Rf)where:Rf=risk-free rate of returnRm=market rate of return
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.
Cost of Debt + Cost of Equity = Overall 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%.
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 mix based 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.
An increase or decrease in the federal funds rate affects a company’s WACC because it changes the cost of debt or borrowing money.
Cost of Capital vs. Discount Rate
The cost of capital and discount rate are somewhat similar and the terms are often used 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 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.
Cost of Capital by Industry
Every industry has its own prevailing average cost of capital.
The numbers vary widely. For example, according to a compilation from New York University’s Stern School of Business, homebuilding has a relatively high cost of capital of 10.68%, while the retail grocery business is much lower, at 6.37%.
WACCs are higher than before as interest rates have been rising.
According to the Stern School of Business, the cost of capital is highest among electrical equipment manufacturers, building supply retailers, and tobacco and semiconductor companies. Those industries tend to require significant capital investment.
Industries with lower capital costs include general utility companies, regional banks, and money center banks. 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, the 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.