What Is Cost of Capital?

What Is Cost of Capital?

Let me explain what cost of capital means. Many companies finance their business expansions using a mix of debt and equity. You calculate the cost of capital to figure out if a project will deliver positive returns for the company and its investors.

Key Takeaways

You should ensure new projects generate returns that beat the cost of capital for that initiative. I use the cost of capital to establish a hurdle rate, which is the minimum return you expect from an investment or project. Remember, a risky, innovative project demands a higher cost of capital than something straightforward like updating equipment.

Understanding Cost of Capital

The cost of capital is essential for setting a project's hurdle rate. If you're starting a major project, you need to know how much revenue it must produce to cover its costs and then keep generating profits. You might look at it with debt involved—the levered cost—or without, the unlevered version.

From an investor's viewpoint, cost of capital assesses the expected return from buying stock or other investments. This is an estimate, covering best- and worst-case outcomes. You could check a company's beta, or volatility, to see if the stock's cost matches its potential return.

Weighted Average Cost of Capital (WACC)

You typically calculate a firm's cost of capital with the weighted average cost of capital formula, factoring in both debt and equity costs. Each capital type gets weighted by its proportion, blending rates from common stock, preferred stock, bonds, and other debts on the balance sheet.

The Cost of Debt

Cost of capital influences whether you choose debt, equity, or both for financing. Early-stage companies often lack assets for loan collateral, so they rely on equity, facing higher costs due to limited history. Established firms with strong records get lower costs.

The cost of debt is simply the interest rate on the debt, but since interest is tax-deductible, you calculate it after-tax: Cost of debt = (Interest expense / Total debt) × (1 - T), where Interest expense is interest paid on current debt, and T is the marginal tax rate.

You can also estimate it by adding a credit spread to the risk-free rate and multiplying by (1 - T).

The Cost of Equity

Cost of equity is trickier because equity investors' required returns aren't as clear as lenders'. You approximate it with the capital asset pricing model (CAPM): CAPM (Cost of equity) = Rf + β (Rm - Rf), where Rf is the risk-free rate, Rm is the market return, and β measures risk.

For public companies, use their stock beta. For private ones, estimate based on averages from similar public firms, possibly adjusting after-tax.

Cost of Debt + Cost of Equity = Overall Cost of Capital

The overall cost of capital comes from the weighted average of these costs. For instance, if a company has 70% equity at 10% cost and 30% debt at 7% after-tax, WACC is (0.7 × 10%) + (0.3 × 7%) = 9.1%.

You use this to discount future cash flows for NPV and value generation. Companies aim for the best financing mix. Debt is tax-efficient due to deductible interest, but excessive debt raises leverage risks and interest rates.

Cost of Capital vs. Discount Rate

Cost of capital and discount rate are similar and often swapped in talk, but they're not identical. Your finance team calculates cost of capital for management to set a discount rate or hurdle rate that investments must exceed.

Management should question these numbers if they're too conservative and block good investments. Costs vary by project—higher for risky innovations than for routine updates.

Importance of Cost of Capital

You use cost of capital to check if funds are invested well. If returns beat it, the investment boosts the balance sheet. If not, it's a poor use of money. High cost of capital can lower long-term proceeds, reducing equity value for investors.

Cost of Capital by Industry

Costs differ by industry. Homebuilding has high costs, groceries low. Highest are in software, paper/forest, building supplies, and semiconductors due to heavy investments. Lower in rubber/tires, power, real estate, and financial services, which need less equipment or have steady cash flows.

Why Is Cost of Capital Important?

Businesses grow by options like expanding factories or acquisitions. Before choosing, calculate each project's cost of capital to see repayment time and future returns. These are estimates, but you need a solid method to pick wisely.

What Is the Difference Between the Cost of Capital and the Discount Rate?

Cost of capital is usually from accounting, a breakeven calculation. Management uses it to set the discount rate, deciding if the project repays costs and rewards shareholders.

How Do You Calculate the Weighted Average Cost of Capital?

WACC is the average cost weighted by capital type's share on the balance sheet. Multiply each cost by its percentage and sum them up.

The Bottom Line

Cost of capital measures what it costs a business to finance operations, comparing borrowing or equity raising to expected investment returns. This helps decide if capital is used effectively.