Cost of Capital - Explained
What is Cost of Capital?
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Table of ContentsWhat is Cost of Capital?How Does Cost of Capital Work?Cost of Capital and Funding SourcesCost of Capital and Equity FinancingCost of Capital and TaxCost of Capital vs. Discount Rate Cost of Capital Examples
What is Cost of Capital?
Cost of capital refers to the entire cost or expenses required to finance a major capital project, this include cost of debt and cost of equity. In this case, the meaning of cost of capital is dependent on the type of financing used, whether equity or debts. It is the required rate of return that makes a capital project count. Companies internally judge the worthiness of capital projects through their cost of capital. In most cases, cost of capital informs the decision of a company whether an investment is worth the risk or otherwise, especially when the rate of return is weighed. Costs of capital is often useful in the evaluation of new projects.
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How Does Cost of Capital Work?
Cost of capital is a financial term, it is applicable in economics and accounting. It describes the cost of funding a business or an investment, it also means the expected rate of return on an investment or portfolio securities owned by a company. The management of many companies use the cost of capital of a project or an investment to evaluate whether it is worth investing on or otherwise. Investors describe cost of capital as the required rate of return which they expect for providing funds or capital for a business or a project. They look at the hurdle rate which is the minimum rate which investors expect to earn for investing in a company.
Cost of Capital and Funding Sources
There are different modes of financing a business or a project and the funding source determines how the cost of capital will be described. The amount of funds required to start a business vary from one business to another, so also are their funding sources. Sources of funding also depends on certain qualities of the proposed business or project such as profitability creditworthiness and value-adding capability. For in insurance, a business might be financed solely through equity (cost of equity), while another will be financed through debt (cost of debt). Some businesses can also combine both debt and equity. Companies funded through debts often pledge collaterals, which is why more companies use equity financing.
Cost of Capital and Equity Financing
A business that gets its financing through equity is subjected to cost of equity. However, cost of capital derived through equity financing is often more complicated. The complication arises from the fact the the rate of return that equity investors demand is not explicitly defined. In theory, the cost of equity is calculated using the Capital Asset Pricing Model (CAPM).
(CAPM) = risk-free rate + (company's beta x risk premium)
The overall cost of capital is arrived at using the weighted average cost of capital (WACC). Therefore, a company that has the following capital structure; 70% equity and 30% debt; its cost of equity is 10% and after-tax cost of debt is 7%. would have (0.7 x 10%) + (0.3 x 7%) = 9.1% as its WACC.
Cost of Capital and Tax
Before business owners decide the most appropriate funding source from which they can get finance capitals for their business, they make this decision putting tax advantage into consideration. For instance, when deciding whether to opt for capital through equity or through debts, the look at the tax advantage associated with issuing debt. In the real sense, the cost of capital is a weighted-average (when WACC is used), after the tax cost of long-term debts, equity and preferred stock owed by a company. This means that taxes have significant effect on the weighted average cost capital of a company. .
Cost of Capital vs. Discount Rate
Due to similar attributes that cost of capital and discounts have, both terms are sometimes used interchangeably. Cost of capital is essential to many companies as it helps them make certain business and investment decisions, it is used in the evaluation of which business worths the risk. Many companies set hurdle rates or discount rates that justify a business or an investment using cost of capital. Also, when planning and budgeting for a new project, companies calculate their WACC (weighted average cost of capital) and also use discount rates.
Cost of Capital Examples
Discount rate and cost of capital are two essential factors that management of many companies consider when making managerial decisions on a new project. Cost of capital and discount also differ from one company to another. While some companies have higher cost of capital and lower discount rates, some have their discount rates higher than their cost of capital. For examples, diversifies chemical companies have 10.78% as the highest cost of capital as at January 2018. Insurance financial services and non-banks claimed 2.99% which was the lowest cost of capital. There are some other companies with high cost of capital such as food companies, pharmaceutical drug companies, software companies and others.