Cost of Capital: What It Is, Why It Matters, Formula, and Example | Financial Management & Strategic Management for CA Intermediate PDF Download

What is Cost of Capital?

The cost of capital refers to the minimum return required to validate a capital budgeting project, like constructing a new factory. It assesses if the anticipated decision is justifiable based on its expenses.

Numerous companies opt for a mix of debt and equity to fund their business growth. In such cases, the total cost of capital is determined by the weighted average of all funding sources, termed as the Weighted Average Cost of Capital (WACC).

Key Takeaways

• The cost of capital signifies the required return for a company to rationalize the expense of a capital project, like acquiring new equipment or building a new structure.
• It includes both equity and debt costs, adjusted based on the company's chosen or current capital makeup. This is termed as the weighted average cost of capital (WACC).
• Every new project a company undertakes must yield a return surpassing the firm's capital cost invested in the project. Otherwise, investors won't see a return on their investment.

Understanding Cost of Capital

• The cost of capital plays a crucial role in establishing a project's hurdle rate. When a company embarks on a significant project, it needs to understand how much revenue the project must generate to cover its expenses and then continue to generate profits.
• The company can assess the capital cost with debt, known as levered cost of capital, or without debt, known as unlevered cost.
• From an investor's perspective, the cost of capital is an evaluation of the expected return from investing in stock shares or other investments. This evaluation involves estimating potential returns under various scenarios, including best and worst cases.
• Investors may analyze the volatility (beta) of a company's financial performance to determine if a stock's cost aligns with its potential return.

Weighted Average Cost of Capital

• The cost of capital for a firm is usually determined through the weighted average cost of capital (WACC) formula, which takes into account both debt and equity capital costs.
• This formula assigns proportional weights to each capital category, creating a combined rate. It encompasses various types of debt and equity found on the company's balance sheet, such as common and preferred stock, bonds, and other debt instruments.

The Cost of Debt

When determining the financing strategy to pursue—be it debt, equity, or a blend of both—the cost of capital plays a pivotal role.

Startups often lack substantial assets for loan collateral, leading them to rely on equity financing as the primary funding avenue. Comparatively, less-established companies with shorter operating histories incur higher capital costs than well-established counterparts.

The cost of debt refers to the interest rate paid by a company on its borrowed funds. Notably, because interest expenses are tax-deductible, the cost of debt is calculated on an after-tax basis:
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) = R_f + β(R_m - R_f)
Where:
R_f = risk-free rate of return
R_m = market rate of return

Beta plays a crucial role in the Capital Asset Pricing Model (CAPM) by assessing risk. In the CAPM formula, a public company's specific stock beta is needed. However, for private companies, beta estimation is based on the average beta of comparable public companies. Analysts may adjust this beta after considering tax implications. The underlying assumption is that a private firm's beta will converge with the industry's 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:
(0.7 × 10%) + (0.3 × 7%) = 9.1%

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.

Note: 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 often seen as similar, leading to their interchangeable use. Companies typically calculate the cost of capital, which then informs the management's decision on setting a discount rate, also known as a hurdle rate. This rate acts as a benchmark that an investment must surpass to be deemed worthwhile.
However, it's important for a company's management to question the accuracy of internally generated cost of capital figures. These numbers can sometimes be overly cautious, potentially discouraging investments.
Additionally, the cost of capital can vary depending on the nature of the project or initiative. For instance, a highly innovative yet risky project should carry a higher cost of capital compared to a project aimed at updating established equipment or software with a track record of success.

Importance of Cost of Capital

• Businesses and financial analysts utilize the cost of capital to assess the effectiveness of investments. When the return on investment surpasses the cost of capital, it contributes positively to the company's financial position.
• Conversely, if returns are equal to or fall below the cost of capital, it suggests that the investment may not be prudent.
• The cost of capital also influences a company's valuation. A company with a high cost of capital can anticipate lower future earnings, potentially reducing investor interest in its equity.

Cost of Capital by Industry

• Each industry maintains its own average cost of capital, with figures varying significantly. For instance, data compiled by New York University's Stern School of Business indicates that homebuilding commands a relatively high cost of capital at 9.28%, whereas the retail grocery sector operates at a much lower rate of 5.31%.
• The Stern School of Business further notes that software Internet companies, paper/forest companies, building supply retailers, and semiconductor companies generally face the highest cost of capital due to their substantial capital investment requirements.
• On the other hand, industries such as rubber and tire companies, power companies, real estate developers, and financial services companies (excluding banks and insurance) tend to have lower capital costs. These sectors may require less equipment or benefit from stable cash flows, contributing to their lower cost of capital.

Why Is the Cost of Capital Important?

Businesses often aim for growth and expansion, considering options like expanding facilities, acquiring competitors, or building new infrastructure. Before committing to any of these ventures, they assess the cost of capital for each project. This analysis indicates the time it will take for a project to recover its costs and the potential future returns. While these projections are estimates, a company must use a rational approach to decide among its options.

What's the Difference Between the Cost of Capital and the Discount Rate?

Although these terms are sometimes used interchangeably, there's a distinction. In business, the cost of capital is typically calculated by the accounting department. It represents the breakeven point for a project. Management then uses this calculation to establish the discount rate, also known as the hurdle rate, for the project. Essentially, they assess whether the project can generate sufficient returns not only to cover its costs but also to benefit the company's shareholders.

How Is the Weighted Average Cost of Capital Calculated?

The weighted average cost of capital (WACC) reflects the average cost of a company's capital, factoring in the types of capital and their proportions on the company's balance sheet. This calculation involves multiplying the cost of each type of capital by its percentage on the balance sheet and then adding these products together.

The Bottom Line

The cost of capital gauges the expenses a business bears to fund its operations. It assesses the cost of obtaining funds from creditors or investors through equity financing, comparing these costs to the expected investment returns. This metric plays a crucial role in evaluating the effective deployment of capital.