If you’re an economics enthusiast or an aspiring entrepreneur, understanding the concept of cost of capital is crucial for your business ventures and management skills. Let’s delve into this economic indicator and explore its significance.
1 What is the Cost of Capital?
What is the Cost of Capital?
Cost of capital refers to the percentage cost of various sources of capital required to fund capital expenditures, such as purchases of investments.
All sources of capital come with a cost, whether direct, as in the case of debt, or opportunity cost, in the case of retained earnings.
The cost of raising new capital is known as the marginal cost of capital.
The cost of equity is typically associated with the required rate of return that common stockholders demand before investing in a company. When capitalized, this expected rate of return should be higher than the current market price. Commonly, the cost of common equity is reported as the dividend per share/market price per share + the growth rate of dividends.
The cost of preferred stock is a fixed dividend rate. Dividends paid on both common and preferred stocks are generally paid out of after-tax income, making them an after-tax cost.
The cost of retained earnings is an opportunity cost, which some argue should be equal to the rate of return that shareholders could earn if it were distributed to them. Others suggest that in the absence of these retained earnings, the company would have to issue new equity. Thus, they believe the cost of capital should be equal to the cost of common equity.
The interest rate is the allowable deductible cost, so the after-tax interest rate paid may be appropriate in this case. Companies can choose to structure their capital to minimize the overall cost of capital when making financial decisions. The cost of capital is used as the discount rate in calculating the net present value obtained from new projects and comparing it with the internal rate of return of the project.
2 The Significance of the Cost of Capital
The Significance of the Cost of Capital
The cost of capital represents the hurdle a company needs to overcome to generate surplus value. It is often used by companies to assess the feasibility of a project before embarking on it.
In economics and accounting, the cost of capital is widely used to describe the opportunity cost of investing in a business.
From an investor’s perspective, the cost of capital is the expected profit for those providing capital to a business.
The cost of capital is used as a metric to evaluate businesses, serving as a discount rate to calculate the value of an investor’s cash flow stream.
The cost of capital is independent of the method and location of capital raising; it depends on the use of the funds, not the source.
3 Methods for Determining the Cost of Capital
The Cost of Capital Represents the Profit a Company Must Generate
The cost of capital represents the profit a company must generate to undertake a project. It comprises owner’s equity and debt. When the profit generated surpasses the cost of capital, the project is considered feasible. Here’s how to determine the cost of capital:
Cost of Debt
When a business raises capital by borrowing, the interest paid on the loan is referred to as the cost of debt. It is calculated by taking the rate on a risk-free bond with a maturity matching the term structure of the company’s debt and adding a default risk premium.
Cost of Equity Capital
The cost of equity capital is determined by valuing the company’s capital assets as follows:
Cost of Equity Capital = Risk-free Rate of Return + Expected Risk Premium
Or
Cost of Equity Capital = Risk-free Rate of Return + Beta x (Market Rate of Return – Risk-free Rate of Return)
Where: Beta represents the sensitivity to movements in the related market
Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC) is an index used to measure a company’s cost of capital. It represents the minimum profit a company must generate based on its current assets to meet its debt obligations.
When calculating WACC, it is necessary to estimate the reasonable market value of equity capital if other companies are not listed. To calculate the WACC, you first need to determine the individual financial sources, including the cost of debt, preferred stock cost, and cost of equity.
4 Factors Influencing the Cost of Capital
Factors Influencing the Cost of Capital
A company’s cost of capital is influenced by factors such as:
- Current dividend policy
- Interest rates
- Financial and investment decisions
- Capital structure
- Current income tax rates
- Marginal cost of capital breakpoint
- Accounting information
5 Cost of Capital Formula
Cost of Capital Formula
You can calculate a company’s cost of capital by taking the weighted average of the cost of each type of security. The weights here are the proportion of each security’s market value to the total market value of the company’s issued securities.
WACC = (E/V) * Re + (D/V) * Rd * (1 – Tc)
Where:
Re: Cost of Equity
Rd: Cost of Debt
E: Market Value of Total Equity
D: Market Value of Total Debt
V: Total Long-term Capital of the Enterprise
Tc: Corporate Income Tax Rate
In conclusion, we have explored the concept of cost of capital, a vital economic indicator. We hope this article has provided you with valuable insights into this topic.
