What Is Cost of Capital?
Cost of capital can best be described as the ability to cover both asset and liability expenditures while generating a profit.
In a nutshell, it’s a rate of return that helps companies decide whether to move forward on a project or it can be used to help an investor determine the risk of investing in a company.
The Use of Cost of Capital in Financial Management
Cost of capital is the return (%) expected by investors who provide capital for a business. Once this cost is paid for, the remaining money is profit. Since it generates a specific number that determines profitability, it’s used to determine the hurdle rate. Since it generates a specific number that determines profitability, it’s used to determine the hurdle rate.
Why Is Cost of Capital Important to Investors?
For investors, the cost of capital is the opportunity cost of making a specific investment (as well as the rate of return that can be earned by putting money into an investment). Investors use the cost of capital to compare different investments with equal risk. Therefore, the cost of capital is the rate of return required to persuade the investor to make an investment.
The cost of capital represents the degree of perceived risk. An investor always wants to put money into a company that will exceed the cost of capital and thus generate returns that are proportionate with the risk. Cost of capital is used to compare different investments with equal risk. Therefore, the cost of capital is the rate of return required to persuade the investor to make an investment.
Why Is Cost of Capital Important to Companies?
Companies use the cost of capital to analyze projects. This number determines if the company should invest in more assets and when they might see a return on this investment.
The Two Components of Cost of Capital
Companies are looking for the optimal amount of equity and debt to minimize their cost of capital. It’s relatively simple to find the cost of debt for a company since it’s the interest rate paid (on loans/bonds) by the company.
The cost of equity refers to a shareholder’s demanded return. It’s a percentage that’s based on the market, which demands a certain amount in exchange for owning the asset and bearing that risk.
Cost of capital accounts for both the cost of equity and cost of debt (to finance business activity).
Cost of Capital Formula
Cost of capital involves debt, equity, and any type of capital. Accountants and financial analysts use the Weighted Average Cost of Capital (WACC) formula to calculate cost of capital.
Cost of Capital Calculator
Cost of Capital vs. WACC
The cost of capital is calculated using the WACC. These terms can be used interchangeably in conversation. It’s important to note that WACC refers to the formula and specific calculation. Cost of capital, however, is a general term used to describe the outcome of this equation.
Cost of Capital Example
Cost of capital is all about making sure a company is profitable for both owners and investors. When given the choice between two investments of equal risk, investors (or company owners) will determine the cost of capital and generally choose the one which provides a higher return.
Let's assume Company XYZ is considering whether to renovate its warehouse systems or buy equally risky bonds.
The renovation will cost $50 million and is expected to save $10 million per year over the next 5 years. Alternatively, Company XYZ could use the $50 million to buy 5-year bonds in Company ABC (which are expected to return 12% per year).
The renovation is expected to return 20% per year ($10,000,000 / $50,000,000). In this case, the expected return is a risk. The renovation is the better use of capital because the 20% return exceeds the 12% required return Company XYZ could have gained by investing in Company ABC.
A Common Mistake When Reviewing Cost of Capital
Analysts commonly make the mistake of equating the cost of capital with the interest rate on that money. Remember: Cost of capital is not dependent upon how and where the capital was raised. Put another way, cost of capital is dependent on the use of funds – not the source of funds.
Ask The Experts About Cost of Capital
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Is Cost of Capital the Same as Discount Rate?
The discount rate and cost of capital are often used interchangeably in conversation.
Most frequently, the discount rate is calculated after computing the cost of capital by using WACC. If you recall, WACC is the average interest rate of debt and dividend percentage. The resulting number is not only the cost of capital, but it's also the present value of future cash flows.
The WACC result is an approximation of risk. Some companies use the WACC as a discount rate, however, the discount rate incorporates a risk premium (or cushion) so it's almost always higher than the WACC.
*Discount rate is also a term used to describe the interest rate charged to commercial banks and other institutions on loans from a Federal Reserve bank. This is not the definition that pertains in this case.
How Does the Cost of Capital Relate to the Hurdle Rate?
Note that the discount rate is in fact the same thing as the hurdle rate, which is effectively what the company requires to justify an investment.
A hurdle rate is an investor's minimum rate of return required in order to offset costs for investments. A hurdle rate is like a benchmark: You need to hit that benchmark in order to cover costs. You can determine the hurdle rate by examining the cost of capital, WACC, any risks involved with the investment, etc.
Companies use the cost of capital to evaluate possible investment in specific projects, and also on a larger scale, it is a measure of investment risk as reflected by beta. Beta reflects the cost of raising equity and issuing debt which measures volatility relative to the market. This is just starting to dig into the answer to this very complex question. To learn more, it's recommended to study more about hurdle rate.
How Cost of Capital Affects Taxes
When a company decides how they will finance a project (with either debt or equity), taking on debt can lower the company’s taxable income and, therefore, tax liability. In this way, debt can be a beneficial form of financing for a company. WACC takes this into account by including the tax bracket for a company.
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