Whether you are a business owner, an investor, or an analyst, many financial metrics can help you assess a company’s value and determine the viability of different projects. However, there is a particular metric that is popular with all stakeholders: cost of capital. The cost of capital is the minimum return that the company needs to generate to start generating profits.
By calculating the Weighted Average Cost of Capital (WACC), you’ll have a good idea of how much money new projects or investments need to make to cover the cost of funding. This makes the cost of capital a key metric for investors and owners alike, and the value of WACC is used for different purposes, like budgeting and Discounted Cash Flow Analysis.
In this post, you will learn about the cost of capital and why it’s an important concept to understand. You will also learn how to calculate WACC by first calculating the cost of debt and the cost of equity. Finally, you will learn how it relates to other financial metrics, such as the discount rate used in discounted cash flow analysis.
What is Cost of Capital?
The cost of capital refers to the minimum return a company must earn before it starts generating value. The business needs to generate enough income to cover the cost of the capital it uses to fund its operations, considering debt and equity.
The calculation of the Weighted Average Cost of Capital (WACC) accounts for the company’s capital structure. In other words, you need to specify what proportion of debt and equity are being used for financing. In some cases, the company or project may be funded purely by equity or purely by debt, but it’s common to use a combination of both.
Why is the Cost of Capital Important?
The cost of capital is an important metric. For the company, it facilitates decisions related to budgeting and planning. It can also help you decide on the best mix of debt and equity to fund your operations. For investors, it provides a comparable metric to assess different investment opportunities.
As always, this type of decision is not made based on a single metric or analytical method, and it’s very important to consider the context. However, regardless of how much weight you place on the calculation of the cost of capital, you can be sure that potential investors and other external stakeholders will be very interested in this metric.
How to Calculate Cost of Capital?
A company’s cost of capital is usually calculated using the Weighted Average Cost of Capital Formula (WACC), which considers both the cost of debt and equity capital. It’s common for companies to use both debt and equity for funding in varying proportions.
Let’s have a look at the formulas you can use to calculate the cost of debt, the cost of equity, and finally, the weighted average cost of capital (WACC).
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Cost of Debt
The cost of debt can be calculated in various ways, including before and after tax. To calculate WACC, you would usually use the after-tax cost of debt, as interest expenses are tax deductible, giving you a lower value for the cost of debt.
To calculate the after-tax cost of debt, use the following formula:
cost of debt = (interest expense / total debt) * (1 - tax rate)
To learn more about the cost of debt and how to calculate it, take a look at this post on How to Calculate Cost of Debt.
Cost of Equity
If your company is partly or totally financed by equity, you’ll need to determine the cost associated with this, too. The cost of equity refers to the return that the company must pay out to equity investors. This is more difficult to pin down, however, as it relies on multiple factors, many of which are estimations.
The company’s estimates, cash flows, and historical information are evaluated and compared to those of similar companies. The Capital Asset Pricing Model (CAPM) is used to calculate the cost of equity, as it evaluates the risk relative to the current market. Use the formula below to calculate the cost of equity.
cost of equity = risk-free rate of return + β * (market rate of return - risk-free rate of return)
The value for β - stock’s beta - is specific to each company and represents the return risk. For publicly held companies, this value is calculated and published by investment services. To learn more about the cost of equity and how to calculate it, have a look at this post on Cost of Equity: Formula & How to Calculate it.
Weighted Average Cost of Capital (WACC)
Finally, you can calculate the value of WACC by using the formula below.
WACC = ((equity / (equity + debt)) * required rate of return) + ((debt / (equity + debt)) * cost of debt) * (1 - tax rate)
The formula considers the relative weight of debt and equity and applies the respective cost of each to get an average and weighted value of the cost of capital.
How to Calculate Cost of Debt (With Examples)
Cost of Debt is essentially the interest expense you pay on your business loans. Here’s how to calculate the Cost of Debt.READ MORE
What’s the Difference Between Cost of Capital and Discount Rate?
Though similar and often used interchangeably, the discount rate and WACC are different metrics. The confusion probably arises from the fact that the value of WACC is often used as the discount rate in discounted cash flow analysis.
WACC represents the average cost of financing debt and equity. On the other hand, the discount rate is the desired rate of return on investment. In other words, it’s common for investors to use WACC as the discount rate since it represents the minimum rate of return required by investors.
As you have seen, the cost of capital is a key financial metric. It provides you with valuable information to help you assess whether or not to embark on a project or make an investment. The cost of capital tells you how much money the project or investment needs to make to cover the cost of financing. In other words, how much money it must generate before it becomes profitable.
You now know what the cost of capital is and why it’s an important metric in the financial valuation of companies and projects. You also know how to calculate the Weighted Average Cost of Capital (WACC) by finding the cost of debt and the cost of equity. Finally, you know that although the WACC is often used as the discount rate in Discounted Cash Flow Analysis, they are not the same metric.
To learn more about related financial formulas and analyses, take a look at the posts below.