Cost of Capital Explained

The cost of doing one thing over another is known as the opportunity cost, and it’s an important metric for any business. In our example above, Company A would be looking at a 20% return on their investment (10 million is 20% of 50 million). So, even though the 12% annual return that Company B can receive is impressive, they may have better options for investing their capital.

The cost of capital is the topic of this article. As you read further, we’ll define what the cost of capital is, how it is calculated, and why it’s significant for investors.

What is cost of capital?

The cost of capital is the amount of money needed to make a capital budgeting project worthwhile. In our example above, Company A will do a careful analysis of their cost of capital before undertaking a plant renovation or building a new factory. Cost of capital is sometimes referred to as an opportunity cost. Companies have many projects that compete for their resources. Cost of capital is a key metric for helping them choose one project over another. It’s also important to investors who use cost of capital as a way of determining whether a company’s project will offer a return that’s worth the risk.

Companies fund projects through equity, debt, or – in many cases - a combination of both. If a project is financed solely through equity, then cost of capital is calculated based on the cost of equity. If the project is sold completely by debt, then cost of capital is calculated based on the cost of debt. When the project uses both debt and equity, then the cost of capital is calculated using a weighted average of each source. This is called the weighted average cost of capital (WACC).  Before we break down the calculation for cost of capital, it’s a good time to review the benefits and risks of a company setting up their capital structure.

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Equity financing– There are a couple of benefits for a company to use equity financing. To begin with, it’s a way to quickly raise a large amount of capital. This can be particularly important for companies who don’t have a proven credit history with creditors. Another benefit of equity financing is that there is no default risk. While companies make responsible efforts to repay their shareholder equity through dividends or other vehicles such as a stock buyback program, they do not have a default risk as they would with income received by taking on debt. The risks to equity financing include the higher cost because it commands a higher risk premium from investors. Some companies may also find that equity financing is undesirable because it will weaken the control that current shareholders have over the business.

When a company uses equity alone to finance a given project, the rate of return that equity investors will demand is not as clearly defined as it would be from the interest rate charged on a loan. For this reason, calculating the cost of capital is more of an approximation. Financial professionals typically use the capital asset pricing model.

CAPM = risk-free rate + (company’s beta x risk premium)

• In this formula, the risk-free rate will typically be equal to the yield on a 10-year U.S. Government bond. The 10-year bond is the go-to benchmark because it’s the most heavily quoted and has the highest liquidity. However, the benchmark for the risk-free rate may be different depending on the country where the investment will take place and ensuring that the bond’s maturity date aligns with the time horizon of the investment.
• Beta is a measurement of the volatility of a stock's price changes in relation to the overall market. A beta of 1 means that an investor can expect a security to have a return that is equal to the average market return. A beta of 1.5, therefore, indicates a 150% volatility to the market average. A beta of -1 means the security has a perfect negative correlation meaning that as the market goes down, this security will tend to go up.
• Risk premium – this is a measurement of the return above and beyond the risk-free rate that investors expect from an investment. To calculate the risk premium use the formula:
  Expected return of the market – risk-free rate
  
  So if a company expects a 10% rate of return and the 10-year bond is at 5%, the risk premium would be 5.

Debt financing– Companies often choose to use debt to finance projects because it’s less expensive than equity financing. Debt also has tax advantages since the interest a company pays on their debt is typically tax deductible. These tax shields increase the cash flow and total return a company can report on their balance sheet. However, debt can create its own problems. Specifically, if a company takes on too much debt, it can start to become more expensive than issuing new shares. Additionally, if a company has a lot of debt, it can reach a tipping point where the interest payments begin to increase a company's risk of default. As their default risk increases, it will cost a company more to finance additional debt. In addition, if equity investors see that the company is paying more for debt financing, they may accept an even higher premium for their assumption of risk.

The formula for calculating cost of debt is calculated after taxes (because interest is tax-deductible) and is calculated as:

Yield to maturity of debt x (1- T)

T = the company’s marginal tax rate

Calculating the Weighted Average Cost of Capital (WACC)

In reality, most companies use a combination of both equity and debt to provide financing for capital projects. When this is the case, the cost of equity and after-tax cost of debt are weighted as percentages in the formula which is as follows:

WACC = (weighted multiplier x cost of equity) + (weighted multiplier x after-tax cost of debt)

We started this article with an example of a company that was considering making a $50 million capital expenditure to renovate an existing factory. Let’s say the company’s capital structure dictated a capital structure of 70% equity and 30% debt. To calculate the weighted average cost of capital, you would first have to know what the expected cost of equity and cost of debt would be. To make some assumptions, we’ll say the cost of equity is 10% and the after-tax cost of debt is 7%. This assigns the weighting that is needed for the WACC formula.

WACC = (0.7 x 10%) + (0.3 x 7%) = 9.1%

A closer look at the cost of capital and taxes

When a company is setting its capital structure, debt financing can look appealing because of the ability to write off the interest they pay on the debt. However, according to the Modigliani-Miller Theorem (M&M) a company’s market value can be calculated by knowing its earning power and the risk of its underlying assets. The theorem goes on to assume that a company’s market value is independent of the way it finances investments or distributes dividends. The takeaway is that in some cases, the value of a leveraged firm versus the value of a non-leveraged firm should be equal.

The cost of capital and the discount rate

The cost of capital is closely related to the discount rate. Although the two terms are sometimes used as synonyms, there is a difference. A company's finance department will typically calculate the cost of capital that is then used to set a discount rate. A discount rate is an attempt to project future cash flow based on revenue coming in today. To do that, it first has to be discounted using a rate that takes into account the timeframe being used, the company’s future revenue growth projections and free cash flow estimates.

The concern is that finance departments may set the cost of capital at a conservative level that could make investment prohibitive. In other cases, a company may lower its discount rate to attract capital investment.

Cost of capital varies by industry

Although every company has to come up with its own cost of capital, the nature of certain sectors will create different average costs of capital. As of January 2018, the highest cost of capital was highest in the following industries:

• Diversified chemical companies
• Biotech and pharmaceutical drug companies
• Steel manufacturers
• Food Wholesalers
• Internet (software) companies
• Integrated oil and gas companies

This makes sense because companies in these industries are more likely to be investing in research and development (R&D), equipment, and factories.

Conversely, some companies that generally have lower capital costs would include:

• Banks
• Hospitals and healthcare facilities
• Power companies
• Real estate investment trusts (REITs)
• Retail grocery and food wholesalers
• Utility companies

These businesses generally have less need for capital investment and/or have steady cash flow.

The bottom line on cost of capital

The cost of capital can be thought of as a company’s opportunity cost for a variety of capital projects. By calculating their cost of capital a company determines if a project will generate the kind of return they need to justify investing in the project. But beyond the question of whether or not to invest in the project, companies can use cost of capital as a way of financing their project based on their capital structure.

When a company chooses to finance a project through equity financing (i.e. issuing new shares of stock), the cost of capital is calculated after determining the cost of equity. When a company chooses to finance a project through debt financing, they calculate the cost of capital after determining the after-tax cost of that debt. In reality, most companies choose to use both equity and debt to finance their projects. In this scenario, the percentage to which they use equity and debt are weighted into a formula called the weighted average cost of capital (WACC).

Some companies will choose to use debt financing over equity financing because they can receive tax benefits from the interest rates that they can use as write-downs. However, there is a risk for companies to take on too much debt that can begin to make the debt less affordable.

Companies may use equity financing because it allows them to raise a significant amount of capital that generally cannot be raised through debt financing. Using equity financing also reduces their default risk and places it upon the investors. However, this risk premium makes equity financing more expensive and some companies may not want to weaken the control current shareholders have in the company.