What is the cost of capital? The cost of capital of an investor in financial management is equal to the return an investor can fetch from the next best alternative investment. In simple words, it is the opportunity cost of investing the same money in a different investment having similar risks and other characteristics. From a financing angle, it is simply the cost paid for using the capital. Alternatively, a percentage return on investment that convinces an investor to invest in a particular project or company is the appropriate cost of capital for that investor.
Types of Cost of Capital
The term cost of capital is vague in general. Does it not clarify which capital we are talking about? It could be equity or debt, or any other source of capital. We can classify the cost of capital into the following broad classifications.
Cost of Equity
The cost of equity is the cost of using the money of equity shareholders in the operations. We incur this in the form of dividends and capital appreciation (increase in stock price). Most commonly, the cost of equity is calculated using the following formula:
The formula for Cost of Equity Capital = Risk-Free Rate + Beta * (Market Risk Premium – Risk-Free Rate)
Read Models for Calculating Cost of Equity for more details.
Cost of Debt
The cost of debt capital is the cost of using a bank’s or financial institution’s money in the business. The banks get their compensation in the form of interest on their capital. The formula for calculating the cost of debt is as follows.
Cost of Debt Capital = Interest Rate * (1 – Tax Rate)
Also, visit Cost of Preference Share Capital to learn more about it.
Weighted Average Cost of Capital (WACC)
Most of the time, we also use WACC in place of the cost of capital because of its frequent and vast utilization, especially when evaluating existing or new projects. As the term itself suggests, WACC is the weighted average of all types of capital present in the capital structure of a company. Assuming these two types of capital in the capital structure, i.e., equity and debt, we can calculate the WACC using the following formula:
WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt.
To understand why we use capital values (market value or book value) as weights of each capital, visit: Market vs. Book Value Weights
You can also take a quick quiz here:
Quiz on Cost of Capital
This quiz will help you to take a quick test of what you have read here.
There are practically 2 important participants relevant for using this concept, i.e., the company’s financial managers or the investor.
How and Why do Financial Managers Use it?
Typically, financial managers use WACC as a benchmark or a qualifying criterion for selecting the new projects of a company or evaluating the existing projects. If a company is accepting or implementing projecting with IRR less than WACC, it means that it is not getting the best use of the investor’s capital and hence diminishing the wealth of the investors. Indirectly, it signals the investors to switch their capital to better investments. If they remain invested in the company, there are chances that they may not earn their required rate of return.
How and Why do Investors use it?
Investors can use it to judge the riskiness of the investment in a company’s stock. Note that the cost of capital is not a very authoritative metric to guide risk, especially when there are other good metrics to get a better view of risk.
Factors Affecting Cost of Capital
There are various factors that can affect the cost of capital. Some fundamental factors are as follows:
Primarily, the market opportunity available to entrepreneurs is the most contributing factor. If no new profitable businesses are available in the market, a business person would not need money. Therefore the demand for money will fall, resulting in a fall in the cost of capital.
Preferences of capital providers in terms of consumption or savings are other important factors that vary from person to person and country to country. If the capital providers bent towards consumption, the supply of capital would reduce and thereby increase in cost.
We have already discussed the importance of risk. The higher the risk, the higher the required rate of return and vice versa.
In economics, it is said that inflation plays an important role in deciding this cost. The higher the inflation, the higher would be expectations of the capital providers. Else they may opt to consume or invest somewhere else.