What is the Cost of Capital?

Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.

Cost of capital represents the weighted average cost of capital of all sources of capital, as the free cash flow represents cash available to all providers of capital. The cost of capital is defined in nominal terms as the free cash flow is stated in the nominal terms.

The cost of capital is calculated in post-tax terms because the free cash flow is expressed in the post-tax term.

It is the weighted average of firms' cost and equity together.

Weighted average cost of capital

Weighted average cost of capital is the combination of cost of capital that is equity as well as debt.

Interest-bearing liabilities such as trade creditors are not included in the weighted average cost of capital. This is done for the purpose of maintaining consistency simplifying valuation. Debt that has interest-bearing liabilities has a cost. This cost is implicitly reflected by the firm in the price paid to acquire goods and services. Therefore, it is already taken care of before determining free cash flow.

The formula for calculating cost of capital

$\text{WACC = r}\left(\text{e}\right)\left(\frac{\text{S}}{\text{V}}\right)\text{ + r}\left(\text{p}\right)\left(\frac{\text{P}}{\text{V}}\right)\text{ +r}\left(\text{d}\right)\left(\text{1-T}\right)\left(\frac{\text{B}}{\text{V}}\right)$

$\text{WACC = r}\left(\text{e}\right)\left(\frac{\text{S}}{\text{V}}\right)\text{ + r}\left(\text{p}\right)\left(\frac{\text{P}}{\text{V}}\right)\text{ +r}\left(\text{d}\right)\left(\text{1-T}\right)\left(\frac{\text{B}}{\text{V}}\right)$

WACC is the weighted average cost of capital

r(e) is the cost of equity capital

S is the market value of the equity

V is the value of the firm

r(p) is the cost of preference capital

P is the cost of preference capital

R(d) is the cost of debt before tax

T is the rate of tax payable

B is the market value of interest-bearing debt

Cost of capital matric

It is used by the firms internally to decide whether a capital project is worth the expenditure of resources.

Investors use this to understand whether the investment is worth the risk compared to the return.

Financial modelling helps in determining the cost of capital.it is understood as the cost of equity if the firm is financed solely by the equity capital.

Factors of cost of capital

Zero risk-return stated that the expected rate of return when a firm is involved in some project has no financial or business risk.

Business risk is determined by capital budgeting decisions. The premium factor plays an important role. Normal risk projects are selected by the firm while taking investment decisions.

Financial risk refers to the capital structure pattern of the firm. The firm is involved in higher risk when there is more capital debt.

Cost of debt

Cost of capital helps a firm to decide the financial strategy of the firm. It helps to decide which financial structure to follow. For example, debt, equity, or both. During the early stage, the firm normally follows equity financing.

Interest expense is tax-deductible hence debt is calculated after deducting tax.

Cost of debt = interest expense/ total debt * (1- T)

Interest expense refers to the amount of interest paid on the firm’s current debt

T is the firm's marginal tax rate

Cost of Equity

Defining the cost of equity is difficult as the rate of return demanded by equity shareholders is not clearly defined. Normally firms follow the capital asset pricing model (CAPM), and dividend growth model (DGM).

Capital asset pricing model (CAPM) = Rf+v beta (Rm- Rf)

Rf is risk-free rate of return

Rm is market rate of return

For example, the weighted average cost of capital of a firm is a mixture of debt and equity.

When a firm has capital structure of 70% equity and 30% debt

Cost of equity be 10%

Cost of debt after tax be 7%

In this case WACC would be

WACC = (0.7*10%) + (0.3*7%) = 9.1%

Hence, the weighted average cost of capital, in this case, would be 9.1%

Dividend growth model (DGM) = (D₁/(P₀ - f)+g

D₁ is expected dividend of next year

P₀ is  current stock price

f is flotation cost

g is growth rate

There are both advantages as well as disadvantages of the financial model.

For example, the debt financing model is more tax-efficient than the equity financing model as interest payments are tax-deductible.

Dividends on the other hand are paid after paying tax. Nevertheless, too much of the debt financing model may result in high leverage and higher tax rate and may result in higher risk.

Cost of Retained Earnings

The cost of retained earnings is the cost that occurs when a company generated income from its retained fund. It the calculated same as the cost of equity, but for calculating the cost of retained earnings, flotation cost is not considered.

Cost of Capital and Tax

Interest payments are tax-deductible and hence firms may decide to opt for debt financing over equity to avoid tax payment. The income tax liability is lowered when the firms adopt debt financing.

However, the market value of the firm is independent of the way it finances itself and shows under certain circumstances the leveraged and non-leveraged capital structure of the firm are equal.

Difference between cost of capital and discount rate

Cost of capital and discount rate are similar and are used interchangeably. The finance department calculates the cost of capital used by the firm in order to set a discount rate that must be compressed to justify an investment.

The cost of capital of the firm differs from project to project.

Example of Cost of Capital

Suppose a firm wants to invest in a new project and source finance from bonds which is issued at par value for $ 200000. The interest rate is 5%. This means the company would issue a bond of $ 200000 to the investors of the firm who are willing to purchase bonds. Also, the firm has to pay interest at the rate of 5% at a regular interval that is monthly or regularly to its investors at the rate of5%.

Suppose the lifespan of the bond is ten years and payments needed to be done yearly basis. In this case, investors of the bond will receive %10000 every year for ten years. The gain for the investors would be $100000. This is the compensation for the risk taken by the firm.

Limitations of Cost of Capital

Weighted average cost of capital is difficult to estimate in private firms as there is a lack of information available in the public. Public companies use various methods to calculate the cost of equity. As there is no particular formula for the cost of equity, it becomes difficult to calculate WACC.

It is supported out by the hypothesis that debt to equity ratio remains constant which is practically not possible.

Opportunity cost is also an important factor to be considered while calculating the cost of capital.

Unforeseen risks are not taken into consideration while calculating WACC.

Content and Applications

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for 

• CA
• Bachelor of Commerce
• Master of Commerce
• MBA