What Is The Cost Of Capital And Why Is It Important?

What Is The Cost Of Capital?

The cost of capital is the company’s calculation of the minimum return that would be necessary to justify undertaking a capital budgeting project such as building a new plant.

Analysts and investors use the term cost of capital, but it is always a measure of whether a potential decision can be justified at its cost. Investors may also use this term to evaluate the potential return of an investment in relation to its cost and risk.

Many companies use a combination of debt and equity to expand the business. For these firms, the total cost of capital is derived from the weighted average cost of all sources of capital.

KEY TAKEAWAYS

The cost of capital represents the return a company needs to earn to justify the cost of an investment project, such as the purchase of new equipment or the construction of a new building.

The cost of capital includes the cost of both equity and debt, weighted according to the company’s preferred or current capital structure.

The company’s investment decisions for new projects must always result in a return that exceeds the cost of the company’s capital used to finance the project. Otherwise, the project will not generate returns for investors.

Understand the Cost of Capital

The concept of cost of capital is the basic information used to determine the break-even rate for a project. A company working on a large project must know how much money the project will need to make to cover the cost of starting the project and then making a profit for the company.

Cost of capital, from an investor’s point of view, is an estimate of the return that can be expected from a share of stock or other investment. This is an estimate and may include best and worst case scenarios. An investor can look at the volatility (beta) of a company’s financial results to determine whether the cost of a share is justified by its potential return.

Weighted Average Cost of Capital (WACC)

A company’s cost of capital is usually calculated using a weighted average cost of capital formula that takes into account the cost of both debt and equity capital.

Each class of a company’s capital is weighted proportionately to arrive at the blended rate, and the formula takes into account all types of debt and equity on a company’s balance sheet, including common and preferred stock, bonds, and debt. other types of

Determine the Loan Amount

The cost of capital becomes a factor in determining which financing path to take: debt, equity, or a combination of the two.

Early-stage companies rarely have large assets that can be pledged as collateral for loans, so equity financing becomes the default financing mode. Less established companies with limited operating history will pay a higher cost of capital than older companies with a strong track record because lenders and investors will demand a higher risk premium for the former.

Cost of debt is simply the interest rate a company pays on its debt. However, since the interest expense is tax deductible, the loan is calculated on an after-tax basis:

The cost of debt can also be estimated by adding the 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 complex because the rate of return required by equity investors is not as clearly defined as it is set by lenders. The cost of equity is estimated using the capital asset pricing model as follows:

The beta in the CAPM formula is used to estimate risk, and the formula will require the company’s public stock beta. For private companies, beta is estimated based on the average beta among a group of similar public companies. Analysts can refine this beta by calculating it on a post-tax basis. The assumption is that the beta of a private company will be the same as the average beta in the industry.

The company’s total cost of capital is based on the weighted average of these costs.

For example, consider a project with a capital structure of 70% equity and 30% debt. The cost of equity is 10%, and the cost of debt, after taxes, is 7%.

It is the cost of capital that will be used to discount future cash flows from potential projects and to estimate their net present value (NPV) and other value-creating opportunities.

Companies try to get the best financing mix based on the cost of capital of different funding sources. Debt financing is more tax efficient than equity financing because interest expense is tax deductible and dividends on common stock are paid in after-tax dollars. However, too much debt can lead to dangerously high levels of leverage, forcing the company to pay higher interest rates to cover the higher default risk.

Cost of Capital versus the Discount Rate

Cost of capital and discount rate are somewhat similar and the terms are often used interchangeably. The cost of capital is often calculated by a company’s financial department and used by management to set the discount rate (or hurdle rate) that must be hit to justify the investment.

However, company management must challenge internally generated investment numbers, as they may be too conservative to curb investment.

The cost of capital may also vary based on the type of project or initiative. A highly innovative but risky initiative must cost more capital than a project to upgrade basic equipment or software with proven performance.

The Importance of the Cost of Capital

Companies and financial analysts use the cost of capital to determine whether money is being invested efficiently. If the return on investment exceeds the cost of capital, that investment will end up as a net gain on the company’s balance sheets. On the contrary, an investment whose return is equal to or less than the cost of capital indicates that the money is not spent wisely.

The cost of capital can also determine the value of a company. Because a company with a higher cost of capital can expect lower earnings in the long run, investors are likely to see less value in participating in that company’s stock.

Examples from the Real World

Each industry has its own prevailing average cost of capital.

The numbers vary greatly. According to a compilation from New York University’s Stern School of Business, the cost of building homes is relatively high, $6.35. Grocery retail sales volume is relatively low, at 1.98 percent.

Biotechnology and pharmaceuticals, steel manufacturers, Internet software companies, and integrated oil and gas companies also have high capital costs. These industries require significant investments in research and development, equipment and plants.

Industries with low capital costs include money center banks, energy companies, real estate investment trusts (REITs), and utilities (public and water). These companies may require less equipment or benefit from very stable cash flows.

Why Is The Cost Of Capital Important?

Most companies seek to grow and expand. There are many options: expanding a factory, buying a competitor, building a new, larger factory. Before a company decides on any of these options, it determines the cost of capital for each proposed project. It indicates how long it will take to pay back the cost of the project , and how much will be paid in the future. Of course, these estimates are always estimates. But the company must follow a reasonable process for choosing between its options.

What Is The Difference Between Cost Of Capital And Discount Rate?

The two terms are often used interchangeably, but there is a difference. In a business, the cost of capital is usually determined by the accounting department. This is a relatively straightforward calculation of the project’s break-even point. The management team uses this calculation to determine the project’s discount rate, or hurdle rate. That is, they decide whether the project can generate enough profit not only to pay for its costs, but also to reward the company’s shareholders.

How Do You Calculate The Weighted Average Cost Of Capital?

Weighted average cost of capital is a company’s average cost of capital, weighted by the type of capital and its share on the company’s balance sheet. It is determined by multiplying the cost of each type of capital by the percentage of that type of capital on the company’s balance sheet and adding the products together.

Bottom Line

Cost of capital measures the cost a company incurs to finance its operations. It measures the cost of borrowing money from lenders, or raising it from investors through equity financing, against the expected return on investment. This metric is important in determining whether capital is being deployed effectively.