Understanding Cost Of Capital (With Examples)

While coming up with something new for your company is an exciting moment, many factors go into implementing that idea. Whether you thought of a new product, a way to renovate an area of management, or discovered a new and useful piece of equipment you want to add to your company’s arsenal, you’ve got to convince everyone else that it’s worth it.

Well, how do you do that?

It’s all about return on investment, or rather, proving that there will be one. After all, other members of your company will want to ensure that all of everyone’s hard-earned money is going to a good place.

That’s where the cost of capital comes in, as it’s just what you need to analyze the cost and potential benefits of new investment.

In this article, we’ll explain the cost of capital, as well as provide you with formulas and examples of its use.

What Is the Cost of Capital?

Regardless of what kind of capital project a company is taking on, the cost of capital is simply the required return necessary to make that new investment worthwhile. It’s typically displayed as a percentage that will indicate the potential return on investment.

For example, the cost of capital can be used to determine if the project is worth its cost in required materials and other resources. Or, investors can determine the overall risk compared to the potential return. Companies can also use the cost of capital to decide between two potential investments.

The cost of capital also commonly relates to equity and debt. It can refer to either, depending on how a project is financed. For instance, for a project financed solely through equity, its cost of capital will refer to equity and vice-versa for debt.

That said, most companies will use a combination of the two to finance a project, meaning that the cost of capital usually derives from the weighted average cost of all capital sources. This is called the weighted average cost of capital (WACC).

What Is the Weighted Average Cost of Capital (WACC)?

The weighted average cost of capital (WACC) considers each category of capital within the company and then weighs them proportionally. This can include common stock, preferred stock, bonds, and other forms of long-term debt.

In general, this calculation is done by blending the weighted average of a firm’s cost of debt and the cost of equity together. This metric is then used to judge whether the capital project will be worth it because it will indicate the investment’s risk level.

For instance, the WACC will display a percentage that gives investors an idea of the returns they can expect. For example, if the cost of capital is 9%, they can expect a $0.09 return on every dollar they invest. Therefore, a high WACC represents a low-risk investment, whereas a low WACC indicates a high-risk investment.

Why Is Cost of Capital Important?

The cost of capital is a crucial part of allowing companies to innovate and start new projects. This is because it helps determine the opportunity cost of investing and outlines the capital budgeting process. In a sense, the cost of capital can be looked at as a financial hurdle companies need to overcome before they can proceed with their desired project.

On top of that, the people who make the most use of this metric are investors and debt holders. Cost of capital can determine whether or not these individuals want to invest in the company’s new idea or project, as they’ll be able to access the risk of a company’s equity. If the company’s ideas seem too risky, they might choose not to invest.

That means the cost of capital is vital for getting new ideas off the ground, as companies will want to maintain or increase the investors purchasing their stock and receive important loans.

How to Calculate the Weighted Cost of Capital (WACC)

Calculating the weighted cost of capital comes down to three important steps. These are:

1. Calculate the company’s cost of debt

2. Calculate the company’s cost of equity

3. Weigh these two percentages to find the WACC

Let’s start with step one: calculating the cost of debt. To do this, you must consider all the company has borrowed, as well as interest rates.

For example, if the company has a credit line with a rate of 6%, bonds used for acquisitions at 5%, and two long-term loans at 3%, all of these must be added up and then divided into an average. So in this instance, we’ll round up to an average of 5%.

Along with that number, you must consider that the interest on debt is tax-deductible. To take this into account, multiply your debt percentage by the corporate tax rate (typically around 30% in the U.S.). Once you consider these factors, you can apply this equation:

Cost of debt = average cost of debt x (1 – tax rate)

When we plug in our numbers, it looks something like this:

5% x (1.00 – 0.30) = 3.5%

Now we have our cost of debt!

Next, we need to consider the company’s cost of equity. In general, this number will relate to beta, which is essentially risk and prevailing interest rates.

Beta is important because it measures how unpredictable a company’s stock is compared to the market average. The higher the beta, the riskier it is to invest stock into that company. Look at it this way: if the company’s stock rises and falls at the same rate as the rest of the market, then it’s not very volatile. In this case, the beta will be close to 1.

So, let’s say our theoretical company has a beta of 0.75%, which means their stock fluctuates slightly less than the market average.

We also have to consider the market rate and the risk-free rate, but these numbers can be more debatable. So for the sake of calculation, we’ll give our company the average market rate of 11% and a risk-free rate of 2%.

All that being said, here’s the formula:

CAPM (Cost of equity) = risk-free interest rate + beta (market rate – risk-free rate)

Plugging everything in once again, we get:

2% + 0.75 (11% – 2%) = 9%

Keep in mind that beta is the most important factor here, as it’s by far the largest number in the equation and the one that can fluctuate the most.

Finally, our third and final step is to weigh our debt and equity percentages. To do this, we need to know how the company’s financial situation is split. AKA, what percentage goes toward debt, and what percentage goes toward equity. In this case, we’ll assume that the company uses 35% debt and 65% equity to maintain its business.

With that, we can use our final formula:

(percent of income toward debt x cost of debt) + (percent of income toward equity x cost of equity) = weighted average cost of capital (WACC)

Sounds complicated, but it’s looks a whole lot more simple when we plug everything in:

(0.35 x 3.5%) + (0.65 x 9%) = 7%

That’s our hypothetical WACC!

Think of this number as an expected return. As in, WACC is the expense of raising one additional dollar of money. So, in this case, if our WACC is 7%, this means the company will be expected to pay its investors $0.07 in return for every $1 of funding.

Is that a good number? Well, it depends. Many investors might want at least a 10% return, but different individuals will have different expectations.

Examples of the Cost of Capital in Action

1. First, let’s start with a single situation that could benefit from analyzing the cost of capital instead of WACC. For example, imagine a company is deciding between whether it wants to buy a couple of new delivery trucks or renovate their offices to be more efficient.

   The renovation will cost $200,000 but is predicted to save the company at least $30,000 per year over the next five years. On the other hand, the company could use that same money to purchase four delivery trucks, which is expected to have a return of 20% per year.

   Now, applying the cost of capital to this situation is all about figuring out which decision has a higher potential return on investment.

   Let’s examine the renovation first. This option will provide a 15% return on investment ($30,000/$200,000). When comparing this to the delivery trucks, which offer a return of 20%, the delivery trucks are clearly the better investment.

2. Now, let’s take a look at WACC in the real world. Companies that operate less risky businesses, like transportation and railroad services, tend to have a higher cost of capital. For example, in 2019, railroad transportation had a cost of capital of 11.17%.

   Why is this number so high? Well, for one, this sort of business is consistent. There’s little risk associated with transporting goods via railroad so that the company can maintain a high-cost capital.

   On the other hand, insurance financial services companies had a cost of capital of 2.79% in the same year. This number is so low because the insurance business is full of risk. As in, they only make money if people don’t have to use their insurance program. So in this way, these companies are a highly risky investment.

Author

Jack Flynn

Jack Flynn is a writer for Zippia. In his professional career he’s written over 100 research papers, articles and blog posts. Some of his most popular published works include his writing about economic terms and research into job classifications. Jack received his BS from Hampshire College.