What is the “cost of capital”?
The cost of capital is the required return required to make the capital budgeting project, like building a new plant, worth it. When analysts and investors discuss the cost of capital, they usually mean the weighted average cost of a company’s debt and the cost of equity combined.
The cost of capital measure is used by internal companies to judge whether an investment project is worth the expenditure of resources and by the investors who use it to determine whether an investment is worth the risk compared to the return. The cost of capital depends on the financing method used. It refers to the cost of equity if the business is funded solely by equity, or to the cost of debt if it is funded solely by debt.
Many companies use a combination of debt and equity to finance their operations, and for these companies the overall cost of capital is derived from the weighted average cost of all sources of capital, widely known as the weighted average cost of capital (WACC).
Cost of capital
What does the cost of capital tell you?
The cost of capital represents a hurdle rate that a business must overcome before it can generate value, and it is widely used in the investment budgeting process to determine whether a business should pursue a project.
The concept of cost of capital is also widely used in economics and accounting. Another way to describe the cost of capital is the opportunity cost of investing in a business. Wise corporate management will only invest in initiatives and projects that will produce returns greater than the cost of their capital.
From an investor’s perspective, the cost of capital is the return expected by the one providing the capital for a business. In other words, it is an assessment of a company’s equity risk. In doing so, an investor can examine the volatility (beta) of a company’s financial results to determine if a certain security is too risky or would make a good investment.
Key points to remember
- The cost of capital represents the return a business needs to undertake a capital project, such as purchasing new equipment or constructing a new building.
- The cost of capital generally includes the cost of equity and debt, weighted according to the preferred or existing capital structure of the business, known as the weighted average cost of capital (WACC).
- A company’s investment decisions for new projects should always generate a return higher than the company’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
The cost of capital for a business is generally calculated using the weighted average cost of capital formula which takes into account the cost of debt and equity. Each category of corporate capital is weighted proportionally to arrive at a mixed rate, and the formula takes into account each type of debt and equity on the corporate balance sheet, including common and preferred shares, bonds and other forms of debt.
Find the cost of debt
Each company must define its financing strategy at an early stage. The cost of capital becomes an essential factor in deciding which financing path to follow: debt, equity or a combination of the two.
Businesses in the start-up phase rarely have significant assets to pledge debt financing, so equity financing becomes the default mode of financing for most of them. Less established companies with a limited track record will pay a higher cost of capital than older companies with a strong track record, as lenders and investors will charge a higher risk premium for the former.
The cost of debt is only the rate of interest paid by the business on its debt. However, since interest expense is tax deductible, the debt is calculated after tax as follows:
TheThe cost of debt=Total debtInterest chargesThe×(1–T)or:Interest charges=Int. paid on the company’s current debtT=The marginal corporate tax rateTheThe
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).
Find the cost of equity
The cost of equity is more complicated because the rate of return required by equity investors is not as clearly defined as by lenders. The cost of equity is approximated by the fixed asset pricing model as follows:
TheVSAPM(Cost of equity)=RFThe+β(RmThe–RFThe)or:RFThe=risk-free rate of returnRmThe=market rate of returnTheThe
Beta is used in the CAPM formula to estimate risk, and the formula would require the beta of the actions of a public company. For private companies, a beta is estimated based on the average beta of a group of similar public companies. Analysts can refine this beta version by calculating it on an after-tax basis without leverage. The assumption is that the beta of a private company will become the same as the average beta of the industry.
The overall cost of capital for the business is based on the weighted average of these costs. For example, consider a business with a capital structure of 70% equity and 30% debt; its cost of equity is 10% and the cost of debt after tax is 7%.
Therefore, his 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 the ability to generate value.
Companies strive to achieve the optimal funding mix based on the cost of capital for various sources of funding. Debt financing has the advantage of being more tax efficient than equity financing, because interest expense is tax deductible and dividends on common shares are paid in after-tax dollars. However, excessive debt can lead to dangerously high leverage, resulting in higher interest rates sought by lenders to offset the higher risk of default.
Cost of capital and tax considerations
One element to consider when deciding to finance capital projects via equity or debt is the possibility of making tax savings on the debt, because interest expense can reduce the taxable income of a business, and therefore his income tax.
However, the Modigliani-Miller theorem (M&M) declares that the market value of a company is independent of the way it finances itself and shows that, according to certain hypotheses, the value of leveraged companies compared to companies leverage is equal, in part because the other costs offset the tax savings that arise from increased debt financing.
Example of the cost of capital used
Each industry has its own cost of capital. For some companies, the cost of capital is lower than their discount rate. Some financial services may lower their discount rates to attract capital or increase them gradually to provide a cushion depending on the level of risk they are comfortable with.
In January 2019, diversified chemical companies had the highest cost of capital, at 10.72%. The lowest cost of capital can be claimed by non-bank financial services and insurance companies at 3.44%. The cost of capital is also high among biotechnology and pharmaceutical companies, steel manufacturers, food wholesalers, Internet (software) companies, and integrated oil and gas companies.
These industries generally require large capital investments in research, development, equipment and factories. Some of the industries with lower capital costs include money banks, hospitals and healthcare facilities, power companies, real estate investment trusts (REITs), reinsurers, grocery stores and food businesses retail, and utilities (general and water). These companies may require less equipment or benefit from very stable cash flows.
The difference between the cost of capital and the discount rate
The cost of capital and the discount rate are somewhat similar and are often used interchangeably. The cost of capital is often calculated by a company’s financial department and used by management to set a discount rate (or hedge rate) that must be exceeded to justify an investment.
That said, the management of a business should challenge its cost of internally generated capital, as it can be so conservative that it discourages investment. The cost of capital can also differ depending on the type of project or initiative; a very innovative but risky initiative should entail a higher cost of capital than a project to update equipment or software essential to proven performance.