Cost of Capital

Recently updated on April 13th, 2023 at 06:40 pm

Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm’s cost of debt and cost of equity blended together.

As it is evident from the name, cost of capital refers to the weighted average cost of various capital components, i.e. sources of finance, employed by the firm such as equity, preference or debt. In finer terms, it is the rate of return that must be received by the firm on its investment projects, to attract investors for investing capital in the firm and to maintain its market value.

The factors which determine the cost of capital are:

  • Source of finance
  • Corresponding payment for using finance

On raising funds from the market, from various sources, the firm has to pay some additional amount, apart from the principal itself. The additional amount is nothing but the cost of using the capital, i.e. cost of capital which is either paid in lump sum or at periodic intervals.

The cost of capital metric is used by companies internally to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return. The cost of capital depends on the mode of financing used. It refers to the cost of equity if the business is financed solely through equity or to the cost of debt if it is financed solely through debt.

Many companies use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the weighted average cost of capital (WACC).

Classification of Cost of Capital

Explicit cost of capital

It is the cost of capital in which firm’s cash outflow is oriented towards utilization of capital which is evident, such as payment of dividend to the shareholders, interest to the debenture holders, etc.

Implicit cost of capital

It does not involve any cash outflow, but it denotes the opportunity foregone while opting for another alternative opportunity.

To cover the cost of raising funds from the market, cost of capital must be obtained. It helps in assessing firm’s new projects because it is the minimum return expected by the shareholders, lenders and debtholders for supplying capital to the business, as a consideration for their share in the total capital. Hence, it establishes a benchmark, which must be met out by the project.

However, if a firm is incapable of reaping the expected rate of return, the value of shares in the market will tend to decline, which will lead to the reduction in the wealth of the shareholders as a whole.

Importance of Cost of Capital

  • It helps in evaluating the investment options, by converting the future cash flows of the investment avenues into present value by discounting it.
  • It is helpful in capital budgeting decisions regarding the sources of finance used by the company.
  • It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is maximum, and the cost of capital is minimum.
  • It can also be used to appraise the performance of specific projects by comparing the performance against the cost of capital.
  • It is useful in framing optimum credit policy, i.e. at the time of deciding credit period to be allowed to the customers or debtors, it should be compared with the cost of allowing credit period.

Cost of capital is also termed as cut-off rate, the minimum rate of return, or hurdle rate.

Cost of capital represents a hurdle rate that a company must overcome before it can generate value, and it is used extensively in the capital budgeting process to determine whether a company should proceed with a project.

The cost of capital concept is also widely used in economics and accounting. Another way to describe the cost of capital is the opportunity cost of making an investment in a business. Wise company management will only invest in initiatives and projects that will provide returns that exceed the cost of their capital.

Cost of capital, from the perspective on an investor, is the return expected by whoever is providing the capital for a business. In other words, it is an assessment of the risk of a company’s equity. In doing this an investor may look at the volatility (beta) of a company’s financial results to determine whether a certain stock is too risky or would make a good investment.

  • Cost of capital represents the return a company needs in order to take on a capital project, such as purchasing new equipment or constructing a new building.
  • Cost of capital typically encompasses the cost of both equity and debt, weighted according to the company’s preferred or existing capital structure, 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.

Weighted average cost of capital

Weighted average cost of capital is determined by multiplying the cost of each source of capital with its respective proportion in the total capital. Let us understand the concept of weighted average cost of capital with the help of an example. Suppose an organization raises capital by issuing debentures and equity shares.

It pays interest on debt capital and dividend on equity capital. When the organization adds the total interest paid on debt capital to the total dividend paid on equity capital, it obtains weighted average cost of capital. An organization requires generating the profit on its various investments equal to the weighted average cost of capital.

Weighted average cost of capital can be calculated mathematically by using the following formula

Weighted Average Cost of Capital = (KE * E) + (KP * P) + (KD * D) + (KR* R)

Where,

E = Proportion of equity capital in capital structure

P = Proportion of preference capital in capital structure

D = Proportion of debt capital in capital structure

KR = Cost of proportion of retained earnings in capital structure

R = Proportion of retained earnings in capital structure

Let us understand the weighted average cost of capital with the help of some examples.

WACC is used in financial modeling as the discount rate to calculate the net present value of a business.

WACC Formula

As shown below, the WACC formula is:

WACC = (E/V x Re)  +  ((D/V x Rd)  x  (1 – T))

Where:

E = market value of the firm’s equity (Market cap)

D = market value of the firm’s debt

V = total value of capital (equity plus debt)

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Re = cost of equity (required rate of return)

Rd = cost of debt (yield to maturity on existing debt)

T = tax rate

An extended version of the WACC formula is shown below, which includes the cost of Preferred Stock (for companies that have it).

(KE * E) + (KP * P) + (KD * D) + (KR* R)

The purpose of WACC is to determine the cost of each part of the company’s capital structure based on the proportion of equity, debt, and preferred stock it has. Each component has a cost to the company. The company pays a fixed rate of interest on its debt and a fixed yield on its preferred stock. Even though a firm does not pay a fixed rate of return on common equity, it does often pay dividends in the form of cash to equity holders.

The weighted average cost of capital is an integral part of a DCF valuation model and, thus, it is an important concept to understand for finance professionals, especially for investment banking and corporate development roles. This article will go through each component of the WACC calculation.

WACC Part 1: Cost of Equity

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which equates rates of return to volatility (risk vs reward).  Below is the formula for the cost of equity:

Re  =  Rf  +  β  ×  (Rm − Rf)

Where:

Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield)

β = equity beta (levered)

Rm = annual return of the market

The cost of equity is an implied cost or an opportunity cost of capital. It is the rate of return shareholders require, in theory, in order to compensate them for the risk of investing in the stock.  The Beta is a measure of a stock’s volatility of returns relative to the overall market (such as the S&P 500).  It can be calculated by downloading historical return data from Bloomberg or using the WACC and BETA functions.

Risk-free Rate

The risk-free rate is the return that can be earned by investing in a risk-free security, e.g., U.S. Treasury bonds. Typically, the yield of the 10-year U.S. Treasury is used for the risk-free rate.

Equity Risk Premium (ERP)

Equity Risk Premium (ERP) is defined as the extra yield that can be earned over the risk-free rate by investing in the stock market. One simple way to estimate ERP is to subtract the risk-free return from the market return. This information will normally be enough for most basic financial analysis. However, in reality, estimating ERP can be a much more detailed task. Generally, banks take ERP from a publication called Ibbotson’s.

Levered Beta

Beta refers to the volatility or riskiness of a stock relative to all other stocks in the market. There are a couple of ways to estimate the beta of a stock. The first and simplest way is to calculate the company’s historical beta (using regression analysis) or just pick up the company’s regression beta from Bloomberg. The second and more thorough approach is to make a new estimate for beta using public company comparables. To use this approach, the beta of comparable companies is taken from Bloomberg and the unlevered beta for each company is calculated.

Unlevered Beta = Levered Beta / ((1 + (1 – Tax Rate) * (Debt / Equity))

Levered beta includes both business risk and the risk that comes from taking on debt. However, since different firms have different capital structures, unlevered beta (Asset beta) are calculated to remove additional risk from debt in order to view pure business risk. The average of the unlevered betas is then calculated and re-levered based on the capital structure of the company that is being valued.

Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt / Equity))

In most cases, the firm’s current capital structure is used when beta is re-levered. However, if there is information that the firm’s capital structure might change in the future, then beta would be re-levered using the firm’s target capital structure.

After calculating the risk-free rate, equity risk premium, and levered beta.

The cost of equity = risk-free rate + equity risk premium * levered beta. 

WACC Part 2: Cost of Debt and Preferred Stock

Determining the cost of debt and preferred stock is probably the easiest part of the WACC calculation. The cost of debt is the yield to maturity on the firm’s debt and similarly, the cost of preferred stock is the yield on the company’s preferred stock. Simply multiply the cost of debt and the yield on preferred stock with the proportion of debt and preferred stock in a company’s capital structure, respectively.

Since interest payments are tax-deductible, the cost of debt needs to be multiplied by (1 – tax rate), which is referred to as the value of the tax shield. This is not done for preferred stock because preferred dividends are paid with after-tax profits.

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.

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