Cost of capital

3 Key Takeaways

• Cost of capital is the minimum return a company must earn on its investments to satisfy its investors.
• It is calculated as a weighted average of the cost of debt and the cost of equity.
• A company’s cost of capital is influenced by various factors, including its capital structure, risk profile, and prevailing market conditions.

What is Cost of Capital?

Cost of capital is a comprehensive term that encompasses the cost of all the different types of capital a company uses to finance its operations and growth. This includes both debt and equity financing. Debt financing refers to borrowing money from lenders, while equity financing involves raising funds by selling ownership stakes in the company.

The cost of debt is the interest rate the company pays on its borrowings, while the cost of equity is the return demanded by shareholders for their investment. Since companies often use a combination of debt and equity, the overall cost of capital is determined by calculating the weighted average cost of capital (WACC), which takes into account the proportion of debt and equity in the company’s capital structure.

Importance of Cost of Capital

• Investment Decision-Making: Companies use the cost of capital as a benchmark to evaluate the potential return on investment (ROI) of new projects. A project is only considered viable if its expected return exceeds the company’s cost of capital.
• Capital Structure Decisions: The cost of capital helps companies decide on the optimal mix of debt and equity financing to minimize their overall cost of funding.
• Valuation: Cost of capital is a key input in discounted cash flow (DCF) analysis, a common method used to value companies.
• Performance Evaluation: The cost of capital can be used to assess a company’s performance by comparing its return on invested capital (ROIC) to its WACC.

How Cost of Capital Works

The cost of capital is calculated using the following formula for WACC:

WACC = (E/V * Re) + ((D/V * Rd) * (1 - Tc))

Where:

• E = Market value of the company’s equity
• D = Market value of the company’s debt
• V = Total market value of the company’s financing (E + D)
• Re = Cost of equity
• Rd = Cost of debt
• Tc = Corporate tax rate

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM), while the cost of debt is typically the yield to maturity on the company’s outstanding debt.

Examples of Cost of Capital

• A company with a WACC of 8% needs to earn at least an 8% return on its investments to maintain its market value.
• If a project’s expected return is 10%, and the company’s WACC is 8%, the project would be considered financially viable.
• A company with a high debt-to-equity ratio will generally have a lower WACC than a company with a low debt-to-equity ratio, due to the tax deductibility of interest payments.

Real-World Application

Cost of capital is a critical concept for any company that seeks to grow and create value for its shareholders. By understanding their cost of capital, companies can make informed decisions about which projects to invest in, how to finance their operations, and how to maximize their overall financial performance.