Let’s say you’ve got a new, hot idea; the next best thing since sliced bread. You’ve got one problem: you need lots of money to launch your idea. In a perfect world, you have all the money at your fingertips. Sadly, this is not reality. You need to go knocking and prove to those who hold the purse strings that it’s worth their investment. You’ll likely be asked to show that their return on the investment will be better than their cost of capital. They want to know “what’s in it for me.” But are you sure you know what that is? To correctly answer that question, you need to understand how to calculate the cost of capital.
Cost of Capital Introduction
The cost of capital is the rate at which you can borrow money. It’s important to understand because it affects how much money you’ll have to repay when borrowing from lenders.
In other words, the cost of capital is what it costs you to use someone else’s money. Furthermore, the cost of capital also helps companies determine how much investors should be paid for investing in their business (i.e., stockholders).
We have two groups of people who may put up the capital needed to run a business: investors and debt holders. Firstly, investors are those who purchase stock, and debt holders are those who buy bonds or issue loans to the company.
Cost of Capital Calculation
Calculating the cost of capital involves many factors:
- debt capacity,
- the riskiness of the investment,
- time remaining until maturity and
- tax rates—
These factors all play a role in determining exactly how much interest you’ll have to pay on any given loan or line of credit before repayment begins (if ever).
Key Take Aways
- The cost of capital is simply the return expected by those who provide money for the business.
- Debt financing is more tax-efficient than equity financing.
Cost of Capital Importance
It’s important because it affects the decision to invest in new projects, which can significantly impact a company’s long-term growth and profitability.
Remember, the cost of capital is not the same as the discount rate or interest rate on debt, though they may be related (more on this later).
How You Calculate Cost of Capital
As mentioned above, the cost of capital is the weighted average of the debt cost and the expected return rate investors want.
To calculate it, you need to know two things:
- Interest Rate. The interest rate paid on your company’s debt financing. Where can this be found? Well, look only as far as your company’s annual report or other financial statements.
- Rate of Return. The expected rate of return that investors expect from investing in your business (or “equity” financing). This number will vary depending on your industry and how risky investors perceive it, but don’t worry too much about finding an exact figure right now! For now, we must ensure that whatever number we come up with doesn’t exceed our current cost-of-debt figure, but if worse comes to worse, Our calculations show us getting close enough for comfort…well… we’ll cross that bridge when we get there!
Calculate the Cost of Debt
The cost of debt is the interest rate you pay your creditors. The most common way to calculate the cost of debt is by using a discount rate, which is another way of saying “interest rate.” The first step is straightforward: calculate the company’s debt cost. To do so, you add up all the money the company has borrowed and look at the interest rates they’re paying.
Here is a snapshot of our variables:
- 7% interest rate on an open line of credit,
- 5% long-term loan,
- and bonds that it uses to make acquisitions at 3%.
Calculate the average:
At this point, we add it all up and calculate the average of 6%. Moreover, since in on debt is a tax deduction, you multiply it by the corporate tax rate (in the US, this tends to be around 30%).
The Cost of Debt Formula
Cost of debt = average interest cost of debt x (1 – tax rate)
To calculate the cost of debt, multiply 6% by (1.00-.30). Your result is a cost of debt equal to 4.3%
Set this number aside.
Calculate the Equity Equation
The cost of equity is the expected return on equity, and it’s a part of the cost of capital. It’s calculated using the capital asset pricing model (CAPM), which uses a riskless rate, the market premium, and a beta to find an appropriate discount rate for your company.
The equity equation isn’t black and white- we need to consider risk (beta) and the current interest rates. As a refresher, beta measures the volatility of the company’s stock as it relates to the market as a whole. A general rule of thumb is that the higher the beta, the riskier the stock is.
A stock with a beta close to 1 typically rises and falls at the same rate as the market. Alternatively, a stock rising and falling more frequently than the market may have a beta closer to 1.5. Finally, a stock that doesn’t fluctuate as much as the market – think a utility, the beta might be closer to 0.75.
The formula is as follows:
Cost of equity = risk-free interest rate + beta (market rate – risk-free rate)
Cost of Capital Rates
Regarding the cost of capital, there are two affecting rates: market and risk-free. The market rate is what you expect to get from the stock on the market right now. Not surprisingly, we see a lot of debate regarding this number, but it generally falls between 10-12%.
The risk-free rate is the return on a risk-free investment like a treasury bill can fall somewhere between 1 and 3%). Once again, this figure is debatable.
Let’s assume, in our scenario, the company’s beta is 1, with a risk-free rate of 2% and a market rate of 11%; then you’d get the following calculation:
2% + 1 (11% – 2%) = 11%
Beta is extremely important in cost-of-capital calculations. You’d be remiss not to note how vital the beta is. A simple beta change from 1 to 2 would double the cost of equity from 11% to 20%. That’s quite a significant difference.
Weighted Cost of Capital (WACC)
Now, the next step is to take the cost of debt (4.3%) and the cost of equity (11%) and weigh them. To do so, compare these percentages to the percentage of debt and equity the company uses to fund its activities.
In our scenario, let’s assume the company uses 30% debt and 70% equity to run its operations. Next, you plug in the 30% (0.3) and multiply it by the cost of debt (4.3%) calculated above:
(0.3 x 4.3%) + (0.7 x 11%) = 8.99%
Finally, you’re left with 8.99%, the company’s weighted cost of capital (WACC).
Remember that this number evaluates future investments, so you have a fair amount of projecting.
Cost of Capital Mistakes
The biggest mistake many people make is taking the number at face value. You must look at all the metrics inputted into the equation and ensure they’re accurate.
Equally important, challenge the number crunchers. Ask them how they came up with the cost of debt or equity. Or better yet, why was 12% used as the market rate?
Undoubtedly, the cost of capital has a significant influence on what you’re able to do. Furthermore, you’ll miss out on many opportunities if you have to hit a higher standard. Ask the tough questions and see if the rate is negotiable.
Conversely, some pad the number and bump it up to be “safe.” Let’s say you crunched the corporate cost of capital, and it came out to 12%. But, to be safe, it’s bumped up to 15%. However, the 12% likely already included a cushion. Unfortunately, that extra 3% bump might make things unnecessarily hard on yourself.
Keeping Cost of Capital in Check
Keeping your cost of capital in check is vital as it helps you make sound business decisions. If you’re paying more than necessary for borrowed money, or if the cost of equity needs to be lowered, then making decisions consistent with your long-term goals and objectives will be challenging.
For example, it will be harder to grow if you want to grow quickly but have a high debt cost. You’ll have less money available for reinvestment into the business. Similarly, more debt will impact your company’s value per share (VPS) growth rate.
The cost of capital is an important metric for any business, but it cannot be easy to calculate. The good news is that plenty of online resources will help you figure out your company’s cost of capital and keep it in check.
