Cost of Capital: What It Is & How to Calculate

"Is it in the budget?" This question is familiar to nearly every business leader and stakeholder.

While reviewing balance sheets and other financial statements can help answer this question, a firm grasp of financial concepts—such as cost of capital—is critical.

Stakeholders who want to articulate a return on investment, whether a systems revamp or a new warehouse, must understand cost of capital. Here’s an overview of cost of capital, how it’s calculated, and how it impacts business and investment decisions.

What Is Cost of Capital?

Cost of capital is the minimum rate of return or profit a company must earn before generating value. It’s calculated by a business’s accounting department to determine financial risk and whether an investment is justified.

Company leaders use cost of capital to gauge how much money new endeavors must generate to offset upfront costs and achieve profit. They also use it to analyze the potential risk of future business decisions.

Cost of capital is extremely important to investors and analysts. These groups use it to determine stock prices and potential returns from acquired shares. For example, if a company’s financial statements or cost of capital are volatile, cost of shares may plummet; as a result, investors may not provide financial backing.

How to Calculate Cost of Capital

To determine cost of capital, business leaders, accounting departments, and investors must consider three factors: cost of debt, cost of equity, and weighted average cost of capital (WACC).

1. Cost of Debt

While debt can be detrimental to a business’s success, it’s essential to its capital structure. Cost of debt refers to the pre-tax interest rate a company pays on its debts, such as loans, credit cards, or invoice financing. When this kind of debt is kept at a manageable level, a company can retain more of its profits through additional tax savings.

Companies typically calculate cost of debt to better understand cost of capital. This information is crucial in helping investors determine if a business is too risky. Cost of debt also helps identify the overall rate being paid to use funds acquired from financial strategies, such as debt financing, which is selling a company’s debt to individuals or institutions who, in turn, become creditors of that debt.

There are many ways to calculate cost of debt. One common method is adding your company’s total interest expense for each debt for the year and dividing it by the total amount of debt.

Another formula that businesses and investors can use to calculate cost of debt is:

Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)

Here’s a breakdown of this formula’s components:

• Risk-free return: Determined from the return on US government security
• Credit spread: Difference in yield between US Treasury bonds and other debt securities
• Tax rate: Percentage at which a corporation is taxed

Companies in the early stages of operation may not be able to leverage debt in the same way that well-established corporations can. Limited operating histories and assets often force smaller companies to take a different approach, such as equity financing, which is the process of raising capital by selling company shares.

2. Cost of Equity

Equity is the amount of cash available to shareholders due to asset liquidation and paying off outstanding debts, and it’s crucial to a company’s long-term success.

Cost of equity is the rate of return a company must pay out to equity investors. It represents the compensation the market demands in exchange for owning an asset and bearing the risk associated with it.

This number helps financial leaders assess how attractive investments are internally and externally. It’s difficult to pinpoint the cost of equity, however, because it’s determined by stakeholders and based on a company’s estimates, historical information, cash flow, and comparisons to similar firms.

Cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which considers an investment’s riskiness relative to the current market.

To calculate CAPM, investors use the following formula:

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return - Risk-Free Rate of Return)

Here’s a breakdown of this formula’s components:

• Risk-free return: Determined from the return on US government security
• Average rate of return: Estimated by stocks, such as Dow Jones
• Return risk: Stock’s beta, which is calculated and published by investment services for publicly held companies

Companies that offer dividends calculate the cost of equity using the Dividend Capitalization Model. To determine cost of equity using the Dividend Capitalization Model, use the following formula:

Cost of Equity = (Dividends per Share / Current Market Value of Stocks) + (Dividend Growth Rate)

Here’s a breakdown of this formula’s components:

• Dividends: Amount of money a company pays regularly to its shareholders
• Market value stocks: Fractional ownership of equity in an organization whose value is determined by financial markets
• Dividend growth rate: Annual percentage rate of growth of a dividend over a period

3. Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the most common method for calculating cost of capital. It equally averages a company’s debt and equity from all sources.

Companies use this method to determine rate of return, which indicates the return shareholders demand to provide capital. It also helps investors gauge the risk of cash flows and desirability for company shares, projects, and potential acquisitions. In addition, it establishes the discount rate for future cash flows to obtain business value.

WACC is calculated by multiplying the cost of each capital source (both equity and debt) by its relevant weight by market value, then adding the products together to determine the total. The formula is:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Here’s a breakdown of this formula’s components:

• E: Market value of firm’s equity
• D: Market value of firm’s debt
• V: Total value of capital (equity + debt)
• E/V: Percentage of capital that’s equity
• D/V: Percentage of capital that’s debt
• Re: Required rate of return
• Rd: Cost of debt
• T: Tax rate

A high WACC calculation indicates that a company’s stock is volatile or debt is too risky, meaning investors will demand greater returns.

Why Is the Cost of Capital So Important?

Beyond the cost of capital’s role in capital structure, it indicates an organization's financial health and informs business decisions. When determining an opportunity’s potential expense, cost of capital helps companies evaluate the progress of ongoing projects by comparing their statuses against their costs.

Shareholders and business leaders analyze cost of capital regularly to ensure they make smart, timely financial decisions. In an ideal world, businesses balance financing while limiting cost of capital.

Cost of Capital Examples

Effectively managing cost of capital is essential in business. Here are three examples where cost of capital can play a pivotal role in strategic decision-making.

Mergers and Aquisitions

When a company considers mergers and acquisitions, cost of capital can help managers determine whether a deal makes financial sense.

For example, if a technology firm wants to acquire a startup, it must assess whether the purchase's combined benefits and future cash flows will be higher than the cost of the capital used to fund the acquisition.

This evaluation ensures acquisitions will add to your company’s earnings, not reduce.

Capital Restructuring

Businesses frequently review a combination of debt and equity to improve its capital structure.

For example, a retail chain may want to decrease its dependence on high-interest debt to lower its overall expenses. By recalculating cost of capital using different structures, the company can identify the most cost-efficient balance, which could potentially increase shareholder value by reducing the hurdle rate—the lowest rate of return an initiative must achieve before it's deemed acceptable—for future investments.

Investment in Research and Development

In industries where research and development (R&D) is a crucial element for growth, cost of capital is used to evaluate the viability of investing in new products' development.

For example, a pharmaceutical company often will need to compare the cost of capital with the anticipated returns from successful new drugs and the high-risk, long-development periods that can occur when rolling out new products.

In each of these scenarios, cost of capital serves as a fundamental measure to guide companies in making informed, strategic decisions that align with its goals and objectives.

Cost of Capital in Decision-Making

In business, it’s crucial for leaders to calculate and interpret cost of capital. This financial metric is essential for justifying and securing support for new initiatives and helps managers make financially informed decisions.

Cost of capital enables business leaders to justify and garner support for proposed ideas, decisions, and strategies. Stakeholders only back ideas that add value to their companies, so it’s essential to articulate how yours can help achieve that end. By determining cost of capital, you can make a strong case for your projects, align proposed initiatives with strategic objectives, and show potential to stakeholders.

Want to learn more about how understanding cost of capital can help drive business initiatives? Explore Leading with Finance and our other online finance and accounting courses. To continue building your financial literacy, download our free Financial Terms Cheat Sheet.

This post was updated on June 26, 2024. It was originally published on May 19, 2022.