Cost of capital represents the minimum rate of return that a company or business must earn from its investments to make a profit on it. Usually, the cost of capital of a company consists of its cost of debt and cost of equity. Therefore, the company’s capital structure plays a vital role in the determination of its cost of capital.
The cost of capital is a crucial concept used in capital budgeting and investment appraisal process of a company. It is a requirement when using investment appraisal tools based on the time value of money. Unless a company only has equity or debt capital, it must calculate its cost of capital. Both investors and companies can use the cost of capital for different decision-making purposes.
How to calculate the Cost of Capital?
The calculation of the cost of capital usually comes in the form of the Weighted Average Cost of Capital (WACC). It considers the cost of both the equity and debt finance of a company weighted proportionately according to their value. The resulting figure presents the average cost of capital that the company must meet in its investments.
The formula for WACC is as below.
WACC = Ke x [Ve / (Ve + Vd)] + Kd x [Vd / (Ve + Vd)] x (1 – T)
In the above formula, ‘Ke’ and ‘Kd‘ represent the cost of equity and debt of the company, respectively. On the other hand, ‘Ve’ and ‘Vd’ represent the value of equity and debt of the company. Finally, ‘T’ represents the corporation tax percentage of the company.
Example
A company, Sam Co., has total equity of $100,000 and a debt of $25,000. Its cost of equity and debt is 10% and 8% respectively. The corporation tax percentage for Sam Co. is 10%. To calculate its cost of capital, Sam Co. must use the Weighted Average Cost of Capital formula given above.
WACC = Ke x [Ve / (Ve + Vd)] + Kd x [Vd / (Ve + Vd)] x (1 – T)
WACC = 10% x [$100,000 / ($100,000 + $25,000)] + 8% x [$25,000 / ($100,000 + $25,000)] x (1 – 10%)
WACC = 8% + 1.8%
WACC = 9.8%
Sam Co.’s cost of capital is close to its cost of equity. It is because a majority of the company’s capital structure consists of equity. Similarly, the company’s cost of debt is also close to its cost of equity. However, the post-tax cost of debt is only 7.2% (8% x [1 – 10%]), which further increases its cost of capital.
For more examples, see
Weighted Average Cost of Capital (WACC)-Business Valuation Calculator in Excel
Why is the cost of capital important?
Cost of capital is widely used for financial and accounting purposes. First of all, the cost of capital helps businesses and investors to make decisions regarding their investments. Similarly, the cost of capital plays a critical role in resource allocation within the company. Furthermore, it helps businesses determine and establish an optimal capital structure to reduce costs. Similarly, it can also serve as a performance appraisal tool for projects.
Conclusion
Cost of capital is the minimum rate of return that a company must require from its investments to make profits. It often comes in the form of the Weighted Average Cost of Capital. WACC bases the calculation of the cost of capital by proportionately weighing a company’s cost of equity and debt.
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