Types of Cost of Capital You Should Know Have you ever asked your business if the profit will be worth the price? This is a really important question to be asked. The cost of capital , which is one of the main concepts in finance, is the main factor that helps you answer all these questions. The cost of capital is essentially the price of the funds that you need to keep your business running. You "pay" for the money (capital) that is the main driver of your business in the same manner that you pay for employee wages or staff. Such a "payment" can be represented by the interest on a loan or the dividends that you are required to give to the investors who have risked their money.
Big businesses that have a lot of experience in finance are not the only ones that need to know this cost. It is the most important number when it comes to making the right financial decisions. Why? Because it determines your "risk rate". A new project or investment is not really making you money if it cannot assure a return higher than your cost of capital; in fact, it is lowering your value. This cost is not just one single figure. It represents a combination of several sources. Let's take a look at the main categories of cost of capital that you need to know.
1. The Debt Cost (Kd) There is, however, an important (and extremely beneficial) twist: the tax shield.
Interest paid on corporate debt is a tax-deductible expense in most countries, including India. That is, it decreases your taxable income, which in turn decreases your tax liability. Consequently, the interest rate on your loan is much higher than the real cost of debt.
We always calculate the cost of debt after taxes.
Easy Formula:
Interest Rate × (1 - Your Corporate Tax Rate) = After-Tax Cost of Debt
Easy Example:
Business loan of Rupees Ten Lakhs at 10% interest.
The corporate tax rate is 25%.
10% is your expense before tax.
10% × (1 – 0.25) = 10% × 0.75 = 7.5% is your expense after tax.
With the 2.5% that you "saved" on taxes, the interest on the ₹1,000,000 loan is actually costing you only 7.5% per year.
Debt is usually the least expensive source of a company's capital because it is tax-deductible and generally less risky for the lender (they will be paid first). When a debt is taken, you naturally are required to make certain payments. This is the phase where money management becomes very important. Controlling the cash flow for these loan payments is a totally different issue than that of the expense. In order to be sure that the money is available, it is absolutely necessary to have a very strict billing and spending management.
2. The Equity Cost (Ke) This is quite challenging since it is not an obvious, direct expense. There is no monthly charge for "cost of equity ".
What it is: The cost of equity is one of the opportunity costs. As a result of taking the risk of investing in your business, your shareholders (equity investors) expect to get this return.
Imagine this: Why would someone invest ₹1,00,000 in your business instead of a "safe" investment like a 7% government bond ? Risk is the answer. They put money in your company because they expect a significantly higher return to compensate for the risk of your company going under.
In case you do not (or cannot) provide results which would make them happy, they are going to sell their shares that will decrease the value of your business.
Why is it always above the debt cost? The payment to the debt holders is the very first one. They are the first to be paid back their money if the business goes bankrupt. Last are the equity holders. They may lose the entirety of their money. Hence, the greater the risk, the greater the reward should be.
Dividends distributed among the shareholders cannot be tax-deductible. Therefore, it is more expensive for the business than paying loan interest.
How to figure it out? There isn't one easy straightforward formula, but the Capital Asset Pricing Model (CAPM) is the primary method used. The name shouldn't scare you. The concept is uncomplicated:
Cost of equity is one of the capitals used in the business, and it can be calculated through risk-free rate plus beta × (market return minus risk-free rate).
The formula in detail:
Risk-free rate: The interest rate on a government bond is a common example.
Market Return: The stock market 's overall average return.
(Market Return – Risk-Free Rate): This is the "premium" or "bonus" that investors receive for taking the typical risk of making market investments.
Beta is the most important factor. It measures the specific risk (volatility) of your company relative to the market as a whole.
If your beta is 1, you are just as risky as the market.
If your beta is 1.5, you are 50% more risky (more volatile) than the market.
If your beta is 0.8, you are 20% less risky than the market.
For an instance, consider a company with a beta of 1.2 (just a bit more risky than average), the expected market return is 12%, and the risk-free rate is 7%:
Equity Cost = 7% + 1.2 × (12% – 7%)
Equity Cost = 7% + 1.2 x (5%)
Equity Cost = 7% + 6% = 13%
The required minimal return for your company to be able to satisfy the equity investors is 13%. It is much higher than the 7.5% cost of debt in our previous example, as you can tell.
3. The "Other" Components: Retained Earnings and Preferred Stock Besides the two main ones that are debt and common equity, there are two more that we can talk about.
Preferred Stock Price (Kp) Some businesses offer what is called "preferred stock." This is a hybrid that combines elements of both stock and debt. It makes a regular, fixed payment that is expressed as a percentage, much like a dividend.
How it works: The preferred stockholder's fixed dividend is the only cost.
Simple Calculation: Preferred Stock Cost = Fixed Dividend / Stock Price
What makes it different: As the dividend is fixed, it is less risky than common stock; however, since the dividends are not tax-deductible, it is more expensive than debt.
Retained Earnings Cost Here is another "opportunity" or "hidden" expense. Retained earnings are the profits you made but did not distribute as dividends to shareholders. You have "retained" them to reinvest in the company.
What it is: When you take a part of your generated profits and reinvest it back in the business, your shareholders are expecting to get a return out of their investment. If instead, they were given the opportunity to take their money back, the return that they could have received is the cost of these withheld earnings.
Therefore, the Cost of Equity (Ke) and the Cost of Retained Earnings are considered to be equal. If you were not able to make at least your Cost of Equity on those reinvested gains, it would have been better for you to just give that money back to your shareholders.
4. Weighted Average Cost of Capital (WACC), the "Master" figure Well, the cost of debt is 7.5%, but the cost of equity is 13%. So, which number are you supposed to use when deciding on a new project?
Neither of the numbers is the right answer.
You actually combine them all. This important "master number" that results from the combination is called the Weighted Average Cost of Capital (WACC ).
What it is: WACC is the average cost of all the money your firm has raised, be it loan or equity, and is calculated by weighting the percentage of each type of money by its cost.
Think of it as being not that different from trail mix.
Your business capital is one big bag of trail mix.
The "raisins" are the debt (cheap, but you can't have too many).
The "cashew nuts" are the equity (expensive but necessary).
The average cost of a handful of that mixture is known as the WACC. It is the most precise figure for the overall cost of capital for your business.
How the computation is done: The computation may look complex at first glance, but it really is just a straightforward weighted average.
Weight of Equity × Cost of Equity + Weight of Debt × After-Tax Cost of Debt equals WACC.
Simple Example: Let's take our prior numbers: Debt After-Tax Cost (Kd) = 7.5%
Cost of Equity (Ke) is 13%.
What if 40% of the total value of your business is covered by debt and the remaining 60% by equity?
Debt Weight = 0.40
Equity Weight = 0.60
Let's tie them together: WACC is (0.60 × 13%) + (0.40 × 7.5%)
WACC is (7.8%) plus (3.0%).
WACC amounts to 10.8%.
Your magic number is 10.8%. This is your "risk rate."
Why WACC Is Necessary for Making Important Decisions At present, our number is 10.8%. What do we do with it?
This figure is the benchmark for all your major financial decisions.
1. Making "Go or No-Go" decisions on projects You may liken your WACC (e.g., 10.8%) to the "pass mark" of a project.
Project A's return is 15%, which exceeds 10.8%. GO! You create more value than you destroy with this project.
The return on Project B is 9%, which is lower than 10.8%. NO GO! Since the project doesn't even cover the cost of the money used, you lose value.
2. How the WACC Influences the Value of Your Firm This one is pretty straightforward:
The lower the WACC of a company, the more valuable it is.
A low WACC means that you are very efficient at raising and spending money. Investors will value your firm at a higher level because they recognize efficiency. You can lower your WACC and increase the value of your firm by finding the "sweet spot" mixture of cheaper debt and more expensive equity.
3. WACC Is Not Fixed Your WACC is impacted by interest rates and market risk. Besides that, it is different for each company.
Conservative and stable businesses, like utilities, are awarded a low WACC (e.g., 7.0%) because they are less risky.
Industries with high risk and high growth potential, like technology, have a high WACC (e.g., 9.4%+) because that is what investors expect in return for taking such risk.
Conclusion It may look like an intellectual and difficult task, but figuring out your "cost of capital" is actually one of the most handy things a business owner can do.
The truth is:
It's not that money is freely given. There is a price for every rupee that you use in your firm.
This price is a mix of a costly stock with high expectations and a cheap, tax-advantaged debt.
To find that one single number which most accurately reflects your business "money price" you need to work out your Weighted Average Cost of Capital (WACC).
Your WACC should be your "risk rate." You should never, under any circumstances, authorize a huge project or investment unless you are sure it will yield a return higher than your WACC.
Knowing your cost of capital puts you in a position where you are no longer guessing, but rather making decisions that are mathematically correct and which will create real, sustainable value for your company.
FAQs 1. What is cost of capital? Cost of capital is, in very simple terms, the "price of money." It is the minimal amount of return on investment that a business is required to create in order to satisfy its investors. It is used as the "risk rate" for new operations.
2. What is WACC and why is it so important? Weighted Average Cost of Capital is abbreviated as WACC. It is the "blended" average of the costs of all the capital a business has. It is very important as it shows the company's real limit to all its investment decisions.
3. How does the cost of capital affect a project decision? It is the topmost criterion. A company is supposed to give the green light to a project only if its expected return is greater than the WACC. If the return is less than the WACC, the project will "lose" value, even if it is "profitable".
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