Cost Of Capital

Calculation, Components & Measurement

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Prepared By-

Savita Mahendru

Asst Lecturer in Commerce�HRMMV

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What Is Cost of Capital?

• Cost of capital is a company's calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory.
• The term cost of capital is used by analysts and investors, but it is always an evaluation of whether a projected decision can be justified by its cost. Investors may also use the term to refer to an evaluation of an investment's potential return in relation to its cost and its risks.
• Many companies use a combination of debt and equity to finance business expansion. For such companies, the overall cost of capital is derived from the weighted average cost of all capital sources. This is known as the weighted average cost of capital (WACC).

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• Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building.
• Cost of capital encompasses the cost of both equity and debt, weighted according to the company's preferred or existing capital structure. This is known as the weighted average cost of capital (WACC).
• A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the capital used to finance the project. Otherwise, the project will not generate a return for investors.

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Understanding Cost of Capital

• The concept of the cost of capital is key information used to determine a project's hurdle rate. A company embarking on a major project must know how much money the project will have to generate in order to offset the cost of undertaking it and then continue to generate profits for the company.
• Cost of capital, from the perspective of an investor, is an assessment of the return that can be expected from the acquisition of stock shares or any other investment. This is an estimate and might include best- and worst-case scenarios. An investor might look at the volatility (beta) of a company's financial results to determine whether a stock's cost is justified by its potential return.

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Weighted Average Cost of Capital (WACC)

• A firm's cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and equity capital.
• Each category of the firm's capital is weighted proportionately to arrive at a blended rate, and the formula considers every type of debt and equity on the company's balance sheet, including common and preferred stock, bonds, and other forms of debt.

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Finding the Cost of Debt

• The cost of capital becomes a factor in deciding which financing track to follow: debt, equity, or a combination of the two.
• Early-stage companies rarely have sizable assets to pledge as collateral for loans, so equity financing becomes the default mode of funding. Less-established companies with limited operating histories will pay a higher cost for capital than older companies with solid track records since lenders and investors will demand a higher risk premium for the former.

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• The cost of debt is merely the interest rate paid by the company on its debt. However, since interest expense is tax-deductible, the debt is calculated on an after-tax basis as follows:

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Finding the Cost of Equity

• The cost of equity is more complicated since the rate of return demanded by equity investors is not as clearly defined as it is by lenders. The cost of equity is approximated by the capital asset pricing model as follows:

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• Beta is used in the CAPM formula to estimate risk, and the formula would require a public company's own stock beta. For private companies, a beta is estimated based on the average beta among a group of similar public companies. Analysts may refine this beta by calculating it on an after-tax basis. The assumption is that a private firm's beta will become the same as the industry average beta.
• The firm’s overall cost of capital is based on the weighted average of these costs.

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• For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.
• Therefore, its WACC would be:

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• 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 ability to generate value.
• Companies strive to attain the optimal financing mix based on the cost of capital for various funding sources. Debt financing is more tax-efficient than equity financing since interest expenses are tax-deductible and dividends on common shares are paid with after-tax dollars. However, too much debt can result in dangerously high leverage levels, forcing the company to pay higher interest rates to offset the higher default risk

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Cost of Capital and Capital Structure

• Cost of capital is an important factor in determining the company’s capital structure. Determining a company’s optimal capital structure can be a tricky endeavor because both debt financing and equity financing carry respective advantages and disadvantages.

• Debt is a cheaper source of financing, as compared to equity. Companies can benefit from their debt instruments by expensing the interest payments made on existing debt and thereby reducing the company’s taxable income. These reductions in tax liability are known as tax shields. Tax shields are crucial to companies because they help to preserve the company’s cash flows and the total value of the company.
• However, at some point, the cost of issuing additional debt will exceed the cost of issuing new equity. For a company with a lot of debt, adding new debt will increase its risk of default and the inability to meet its financial obligations. A higher default risk will increase the cost of debt, as new lenders will ask for a premium to be paid for the higher default risk.

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• In addition, a high default risk may also drive the cost of equity up because shareholders will likely expect a premium over and above the rate of return for the company’s debt instruments for taking on the additional risk associated with equity investing.
• Despite its higher cost (equity investors demand a higher risk premium than lenders), equity financing is attractive because it does not create a default risk to the company. Also, equity financing may offer an easier way to raise a large amount of capital, especially if the company does not have extensive credit established with lenders. However, for some companies, equity financing may not be a good option, as it will reduce the control of current shareholders over the business.

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Cost of Capital vs. Discount Rate

• The cost of capital and discount rate are somewhat similar and the terms are often used interchangeably. Cost of capital is often calculated by a company's finance department and used by management to set a discount rate (or hurdle rate) that must be beaten to justify an investment.
• That said, a company's management should challenge its internally generated cost of capital numbers, as they may be so conservative as to deter investment.
• Cost of capital may also differ based on the type of project or initiative; a highly innovative but risky initiative should carry a higher cost of capital than a project to update essential equipment or software with proven performance.

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Importance of Cost of Capital

• Businesses and financial analysts use the cost of capital to determine if funds are being invested effectively. If the return on an investment is greater than the cost of capital, that investment will end up being a net benefit to the company's balance sheets. Conversely, an investment whose returns are equal to or lower than the cost of capital indicate that the money is not being spent wisely.
• The cost of capital can also determine a company's valuation. Since a company with a high cost of capital can expect lower proceeds in the long run, investors are likely to see less value in owning a share of that company's equity.

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Real-World Examples

• Every industry has its own prevailing average cost of capital.
• The numbers vary widely. Homebuilding has a relatively high cost of capital, at 6.35, according to a compilation from New York University's Stern School of Business. The retail grocery business is relatively low, at 1.98%.1
• The cost of capital is also high among both biotech and pharmaceutical drug companies, steel manufacturers, internet software companies, and integrated oil and gas companies.1 Those industries tend to require significant capital investment in research, development, equipment, and factories.
• Among the industries with lower capital costs are money center banks, power companies, real estate investment trusts (REITs), and utilities (both general and water).Such companies may require less equipment or may benefit from very steady cash flows.

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Why Is Cost of Capital Important?

• Most businesses strive to grow and expand. There may be many options: expand a factory, buy out a rival, build a new, bigger factory. Before the company decides on any of these options, it determines the cost of capital for each proposed project. This indicates how long it will take for the project to repay what it cost, and how much it will return in the future. Such projections are always estimates, of course. But the company must follow a reasonable methodology to choose between its options.

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

• The two terms are often used interchangeably, but there is a difference. In business, cost of capital is generally determined by the accounting department. It is a relatively straightforward calculation of the breakeven point for the project. The management team uses that calculation to determine the discount rate, or hurdle rate, of the project. That is, they decide whether the project can deliver enough of a return to not only repay its costs but reward the company's shareholders.

How Do You Calculate the Weighted Average Cost of Capital?

• The weighted average cost of capital represents the average cost of the company's capital, weighted according to the type of capital and its share on the company balance sheet. This 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.

The Bottom Line

• The cost of capital measures the cost that a business incurs to finance its operations. It measures the cost of borrowing money from creditors, or raising it from investors through equity financing, compared to the expected returns on an investment. This metric is important in determining if capital is being deployed effectively.

Factors Affecting the Cost of Capital

• The cost of capital is the minimum expected rate of return of the investors or suppliers of funds to the firm. The expected rate of return depends upon the risk characteristics of the firm, risk perception of the investors and a host of other factors. Following are some of the factors which are relevant for the determination of cost of capital of the firm.
• 1. Risk-free Interest Rate: The risk free interest rate, If, is the interest rate on the risk free and default-free securities. For example, the securities issued by the Government of India are taken as risk free and default free in respect of payment of periodic interest as well as principal repayment on maturity. Theoretically speaking, the risk free interest rate, If, depends upon the supply and demand consideration in financial market for long term funds. The market sources of demand and supply determines the If, which is consisting of two components :

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(a) Real Interest Rate: The real interest rate is the interest rate payable to the lender for supplying the funds or in other words, for surrendering the funds for a particular period.

(b) Purchasing Power Risk Premium: When a lender lends money, he in fact lends his present purchasing power in favour of the other party i.e., borrower. After sometimes, when the lender gets the repayment, he recovers the same face value money. But if the prices have increased during the same period, then he is not getting back the same purchasing power which he lent. Investors, in general, like to maintain their purchasing power and therefore, like to be compensated for the loss in purchasing power over the period of lending or supply of funds. So, over and above the real interest rate, the purchasing power risk premium is added to find out the risk-free interest rate. Higher the expected rate of inflation, greater would be the purchasing power risk premium and consequently higher would be the risk free interest rate, IRF.

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2. Business Risk: Another factor affecting the cost of capital is the risk associated with the firm’s promise to pay interest and dividends to its investors. The business risk is related to the response of the firm’s Earnings Before Interest and Taxes, EBIT, to change in sales revenue. Every project has its effect on the business risk of the firm. If a firm accepts a proposal which is more risky than average present risk, the investor will probably raise the cost of funds so as to be compensated for the increased risk. This premium added for the business risk compensation is also known as business risk premium. There would obviously be a point at which the investor will not like to supply the funds regardless of the return, the firm would be ready to pay.

3. Financial Risk: The financial risk is an other type of risk which can affect the cost of capital of the firm. The particular composition and mixing of different sources of finance, known as the financial plan or the capital structure, can affect the return available to the investors. The financial risk is often defined as the likelihood that the firm would not be able to meet its fixed financial charges. It is related to the response of the firm’s earning per share to a variation in EBIT. The financial risk is affected by the capital structure or the financial plan of the firm. Higher the proportion of fixed cost securities in the overall capital structure, greater would be the financial risk. The investor in such a case require to be compensated for this increased risk. They add financial risk premium over and above the business risk premium.

4. Other Considerations: The investors may also like to add a premium with reference to other factors. One such factor may be the liquidity or marketability of the investment. Higher the liquidity available with an investment, lower would be the premium demanded by the investor. If the investment is not easily marketable, then the investors may add a premium for this also and consequently demand a higher rate of return.

• In view of the above, the cost of capital may be defined as

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• In view of the above, the cost of capital may be defined as

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• If a firm wants to raise funds by the issue of security then it must offer a return in the form of interest or redemption premium or expected dividends to the investors. Now, the investor before making a decision to invest the funds in the firm will compare the returns offered by the firm with the returns he can get elsewhere. In other words, the investor will be ready to supply the funds only if the firm offers a return which is at least equal to the opportunity cost of the investor. The opportunity cost of the investor may be defined as the return foregone by the investor on the alternative investment opportunity of the same or comparable risk. So, the cost of capital of the firm may be defined as the opportunity cost of the suppliers of funds i.e., the investors.

• The opportunity cost of the investors depends upon the nature and type of security being offered by the firm. Every investor has a risk perception regarding the risk inherent in different types of investment. As the risk increases, an investor may be ready to supply the funds only if sufficiently compensated for the risk. That is why the opportunity cost of the investor is not the same for different types of securities. Therefore, the cost of capital of the firm is not same for different types of securities. The firm has to offer different returns to the investors depending upon the risk of the security.