What is ‘Cost of Capital’
Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. Another way to describe cost of capital is the cost of funds used for financing a business. Cost of capital depends on the mode of financing used — it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.
BREAKING DOWN ‘Cost of Capital’
Sources of funding for capital budgeting vary from company to company and depend on factors such as operating history, profitability, creditworthiness, etc. In general, newer enterprises with limited operating histories will have higher costs of capital than established companies with solid track records, since lenders and investors will demand a higher risk premium for the former.
Every company has to chart out its game plan for financing the business at an early stage. The cost of capital thus becomes a critical factor in deciding which financing track to follow — debt, equity or a combination of the two. Early-stage companies seldom have sizable assets to pledge as collateral for debt financing, so equity financing becomes the default mode of funding for most of them.
The cost of debt is merely the interest rate paid by the company on such debt. However, since interest expense is tax-deductible, the after-tax cost of debt is calculated as: Yield to maturity of debt x (1 – T) where T is the company’s marginal tax rate.
Cost of Capital and Equity Financing
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. Theoretically, the cost of equity is approximated by the capital asset pricing model (CAPM) = risk-free rate + (company’s beta x risk premium).
The firm’s overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and after-tax cost of debt is 7%. Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%. 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 has the advantage of being 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, resulting in higher interest rates sought by lenders to offset the higher default risk.
Cost of Capital and Tax
One element to consider in deciding to finance capital projects via equity or debt is the fact that there are tax advantages of issuing debt. The Modigliani-Miller Theorem (M&M), which states that the market value of a company is calculated using its earning power and the risk of its underlying assets and is independent of the way it finances investments or distributes dividends, shows that under certain assumptions, the value of leveraged vs. non-leveraged firms should be equal.