How to Calculate the Cost of Capital for Your Business
Companies and investment funds are currently sitting on a lot of money. But before they start putting this capital into new use, it is important to understand more about the cost of financing different investments offer to their business. In order to do so, businesses must calculate the cost of capital.
But what is the cost of capital and how can companies calculate it? This guide will answer these important questions and help you understand why cost of capital is among the most important business formulas you’ll need to learn about. You’ll also be able to understand the common pitfalls and limitations of calculating this important figure for your business.
WHAT DOES ‘COST OF CAPITAL’ MEAN?
The definition of cost of capital simply means the cost of funds the company uses to fund and finance its operations. The cost of capital is often divided into two separate modes of financing: debt and equity.
Cost of capital tells the company its hurdle rate. The hurdle rate refers to the minimum rate of return the company must achieve to be profitable or to generate value.
Each company has its own cost of capital. Different factors influence the cost of capital and these include things such as the operating history of the business, its profitability and credit worthiness.
The figure is one of the most essential parts of a business’ financing strategy, as it can help the company to make better funding and investment decisions and thus boost its overall financial health.
In case the company is solely financed through equity, the cost of capital would refer to the cost of equity. On the other hand, companies funded by debt alone have cost of capital refer to the cost of debt.
As most companies rely on a combination of debt and equity, their overall cost of capital is derived from a weighted average of all capital sources. This refers to the average cost of capital (WACC).
The difference between cost of equity and cost of debt
If the company’s only source has been equity put in by the company’s owners or shareholders, then you can simply calculate the cost of capital by analyzing the cost of equity. The cost of equity then represents the compensation the market demands in exchange for the company’s assets.
On the other hand, the cost of debt refers to situations where the company has funded itself through debt alone. This would mean the company has financed all of its operations simply by lending from creditors. By calculating the cost of debt, you’ll receive the cost of capital.
The cost of debt reveals the effective rate the company should pay its current debt. Since interest is also added into the calculation, the cost of debt can either be measured before-tax or after-tax.
The reason companies are aiming for a balanced mixture of debt and equity financing is to descrease the overall cost of capital in both cases and what it means for the business’ finances. For example, while debt financing is more tax-efficient to equity financing, high levels of debt can result in higher leverage, which means higher interest rates due to increased risk. Therefore, a mixture of both financing sources often provides the lowest cost of capital.
The definition of weighted average cost of capital (WACC)
As we mentioned above, company financing hardly ever relies on a single source. Therefore, the cost of capital is often calculated by using the weighted average cost of capital (WACC). Since it analyses both equity and debt financing, it provides a more accurate picture of how much interest the company owes for each operational currency it finances (per each US dollar, British pound and so on).
It gives a proportional weight to the different costs of capital, such as equity and debt, to derive a weighted average cost. Each capital component will be multiplied by its proportional weight and the sums will be added together.
When companies refer to the cost capital, they often would have calculated it based of the WACC method. The following sections will look at the calculations methods in more detail, but here’s a quick example of what WACC means.
Consider that a business has a lender, which requires a 10% return on its money. Furthermore, the shareholders of the business require a further minimum of a 20% on their investments. On average then, the company’s capital must have a return of 15% to satisfy both the debt and equity holders, meaning the WACC or cost of capital is 15%.
This means the company would need to invest in projects that would provide an annual return of 15% in order to continue paying back to both their shareholders and creditors.
WHY SHOULD A BUSINESS CALCULATE THE COST OF CAPITAL?
Before we look at the formulas to calculate the cost of capital in more detail, it is important to understand why it is essential to do the maths. As mentioned briefly above, the cost of capital can be an essential part of a business’ financial decision-making.
Since cost of capital provides the business with the minimum rate of return it needs on its investments, it is an essential part of budgeting decisions. By knowing the cost of capital, the business can make better decisions on its future investments and other such financing options.
For example, it can help the business to find projects that will generate appropriate gains for the business. On the other hand, it can prevent the business from making an investment, which wouldn’t provide quick enough returns for the company.
Therefore, a cost of capital reveals the business plenty about the type and value of its past and future investments. If a business doesn’t know the rate of return or the cost of financing its operations, it can’t expect much business success.
In addition, it’ll help better attract new investors for the business, as they are able to understand the kind of rate of return they will receive. It also ensures the business doesn’t go after creditors or investors it cannot repay at the current time.
Overall, understanding the cost of capital will boost the business’ financial decision-making. Because the cost of capital is used to design the market fluctuations, it can help build better financial structures.
In some instances, businesses even use it to better understand financial performance and to evaluate whether the management is performing well enough.
CALCULATING THE COST OF CAPITAL
Now that you understand the definition of cost of capital and the importance of calculating it, it’s time to look at the calculating methods.
First, we’ll go through the formulas for calculating both the cost of equity and debt, as they’ll be used in the final calculations of WACC. Naturally, if the business only uses either debt or equity alone, you can also use the formulas as the basis for calculating the cost of capital.
Calculating the cost of debt
First, lets look at how you can calculate the cost of debt. Debt in this formula includes all forms of debt the company uses in order to finance its operations. These could be various bonds, loans and other such forms of debt.
As mentioned earlier, there are two formulas for calculating the cost of debt. This is because it deals with interest, which can be deducted from tax payments. Thus, the alternatives are to calculate the cost of debt either before- or after-tax. Generally, the after-tax cost is more widely used.
The before-tax rate can be calculated by two different methods. First, you can calculate it by multiplying the interest rate of the company’s debt by the principal. For instance, a $100,000 debt bond with 5% pre-tax interest rate, the calculation would be: $100,000 x 0.05 = $5,000.
The second method uses the after-tax adjusted interest rate and the company’s tax rate.
Even if you use the after-tax rate, you’ll still need the above before-tax rate. The formula for calculating the after-rate tax is:
Cost of debt (after-tax rate) = before-tax rate * (1 – marginal tax rate)
Keep in mind the before-tax rate is also often referred to as the yield-to-maturity on long-term debt.
Calculating the cost of equity
There are also two ways of calculating the cost of equity: the more traditional dividend capitalization model and the more modern capital asset pricing model (CAPM).
The dividend capitalization model uses the following formula:
Cost of equity = (dividends per share [for next year] / current market value of stock) + growth rate of dividends
More recently, many companies have started to the use the CAPM method. Under this method, the idea is that investors need a minimum rate of return, which is equal to return from a risk-free investment, as well as a return for bearing extra risk.
The formula is as follows:
Cost of equity = risk free rate + beta [i.e. risk measure] * (expected market return – risk free rate)
If the company has used different methods of financing, then the cost of capital is calculated by the weighted average cost of capital. The above formulas are also needed in this method.
The method for calculating WACC is often expressed in the following formula:
WACC = percentage of financing that is equity * cost of equity + percentage of financing that is debt * cost of debt * (1 – corporate tax rate)
In order to calculate the percentage of financing that is equity, you need the following formula:
Percentage of financing that is equity = market value of the firm’s equity / total market value of the firm’s financing (equity and debt)
To calculate the percentage of financing that is debt, you can use the following formula:
Percentage of financing that is debt= market value of the firm’s debt / total market value of the firm’s financing (equity and debt)
The WACC will increase if the beta (risk measure) and the rate of return on equity increase. This is because a growing WACC denotes a drop in valuation and a growth in risk.
You can also find out the above information from this informative YouTube video:
AN EXAMPLE CALCULATION
To make the above formulas a bit less daunting, here’s an example calculation of WACC. The below calculation is a rather simplified version of the different factors that might influence the rates used in the calculation. To ensure you come up with the most accurate figure for the cost of capital, you also need to check out the common problems in calculating it in the following section.
In our example, the crucial figures in WACC are as follows:
The company’s total equity = $10,000
The company’s total debt = $3,000
The cost of equity = 12.5%
The cost of debt = 6%
The tax rate = 28%
Therefore, the WACC will be calculated by solving the formula:
10,000/13,000 * 12.5% + 3,000/13,000 * 6%*(1-28%) = 10.84%
Therefore, the cost of capital for the business is 10.84%.
In reality, calculating the different aspects isn’t quite as quick and straightforward. Therefore, most companies use different online and offline tools as a helpful guide for calculating the figures.
For example, you can find Excel-files, which allow you to simply add the different figures into the file and receive the final rate in an instant.
COMMON PROBLEMS WITH CALCULATING THE COST OF CAPITAL
While it is essential to calculate the cost of capital for your business, you need to be aware of some of the pitfalls as well as limitations behind this method. A survey by the Association for Financial Professionals recently found that many companies don’t use universal methods for calculating the cost of capital and the assumptions many make can lead to distorted estimations of the real cost of capital. Naturally, this can have devastating consequences, as it might mean the company makes investment decisions based on incorrect information.
In order to avoid these issues with your calculation, here are some of the most common problems you should try to avoid.
Using the wrong investment time horizon
The first issue often comes when companies select their forecast periods for variables such as cash flow. The survey, mentioned above, found that companies’ estimates could range from five years to 15-year horizon!
Naturally, different companies can expect investments will live a different time span. But the crucial thing to remember is how the chosen time horizon should reflect the kind of project in question, instead of simply being a standard time period.
If you are calculating the cost of capital for a specific investment project, remember to keep this in mind. Evaluating the nature of the project is a crucial part of success.
Trouble selecting the right risk-free rate
As you remember, the cost of equity formula dealt with risk-free rates. The differences in calculations come from the fact that there aren’t any universal risk-free rates available.
In the US, many use the US Treasury’s rates as the benchmark, but since these also come in different time horizons, the final calculations can change a lot depending on which time ratio you choose to use. For example, the 90-day Treasury note could yield 0.05%, with the 10-year note yielding 2.25%.
This could mean two similar types of businesses have very different cost of equity, solely because they used a different risk-free rate.
While it isn’t necessarily easy to overcome this issue, it is good to keep in mind, especially if you are an investor. Furthermore, you should consider mentioning the risk-free rate in the footnotes to ensure you always know what rate has been chosen and why.
Projecting risk adjustments
Companies should also try to adjust the risk in the above calculations based on the specific project they are about to invest in. Unfortunately, the survey also found that many companies don’t currently include risk adjustments in their cost of capital analysis, but rather just use a percentage point or more to the rate.
But this sort of standardization of cost of capital analysis can leave companies open to issues of overinvesting, for example. If you are calculating the cost of capital for a new investment project, it is essential to also adjust the risks according to the project in question. This is especially important if the risk profile of the project varies greatly from the company’s own risk profile.
Limitations of WACC
Finally, you also need to keep in mind the limitations of WACC. It is crucial to remember the elements used in the formula are not consistent. These subtle differences can be apparent in the basic calculations of how the company calculates its debt as well as its equity.
The final ratio you receive with WACC should therefore not be taken as the ultimate truth. Instead, you want to use the cost of capital as an important indicator, but also add other financial metrics to your analysis and decision-making process. This is also an important point to remember if you are considering investing in a company.
The more you know about the financial status of the company to better. While the cost of capital needs to be taken with a pinch of salt and tough analysis, it is nonetheless an essential metric to learn about.
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