Cost of Capital: Definition, Significance, & Formula

As a professional in the world of leasing and financing, I have had the privilege of working closely with our underwriting team and financial advisors, who help founders and company operators navigate the various financial requirements of financing equipment and making capital allocation decisions. Over the years, I have come to understand the role that the cost of capital plays in shaping these decisions.

In this comprehensive guide, I aim to share our company’s collective expertise and several insights on this important financial concept to empower you, whether you’re a first-time founder, a seasoned business owner, or someone simply curious about various dynamics of finance.

What Is Cost of Capital?

The term cost of capital is a fundamental financial metric companies use to determine the minimum acceptable rate of return needed to warrant pursuing a capital budgeting project. These projects typically involve significant investments, such as purchasing land, buildings, machinery, equipment, and other tangible assets, all of which require large expenditures upfront.

In other words, businesses use the cost of capital to quantify the hurdle rate that an investment must surpass to make it financially viable for the company. By analyzing the cost of capital for a project, companies can ensure that the project will generate returns at or above a specified minimum, thus justifying the allocation of resources and money toward it.

Analysts and investors also use cost of capital as a method of analysis to evaluate whether a projected decision can be justified by its cost. Additionally, investors may use the term to assess an investment's potential return with its cost and risks.

To understand how cost of capital is determined, it’s important to understand that companies often use a combination of debt and equity to finance business expansion. For such businesses, the overall cost of capital is derived from the weighted average cost of all capital sources, known as the weighted average cost of capital (WACC). These capital sources can come from various instruments, including debt (like loans and bonds), equity (such as stock issuance), and preferred stock. 

By calculating the overall cost of capital and assessing the risk associated with each source of funding, and determining the appropriate capital cost for each or the expenses related to acquiring, constructing, or upgrading physical assets or investments in a business or project, companies can make more informed decisions with their money.

Utilizing the cost of capital as a metric helps businesses make informed decisions about financing their operations and investments. It ensures that companies can maximize their financial returns.

Importance of Cost of Capital

Knowing the cost of capital can help businesses and investors in their financial journeys.

For businesses, it directly influences decisions related to capital budgeting, project investments, and capital structure. For investors, it’s a key factor in assessing the attractiveness of an investment opportunity. Here’s a further breakdown as to why it’s so significant:

• Strategic decision-making: For businesses, the cost of capital is pivotal in strategic decision-making. It influences capital budgeting, project investments, and capital structure choices. By determining these costs, companies can make informed decisions that optimize their financial structure, minimize costs, and maximize profitability.
• Investment assessment: For investors, the cost of capital is a critical factor in assessing the attractiveness of an investment opportunity. Investors want to know whether the returns from an investment are expected to surpass the company’s cost of capital. It helps them evaluate the risk and potential reward associated with an investment.
• Capital structure optimization: Understanding the cost of capital allows businesses to balance debt and equity financing. This optimization can lead to lower capital costs, increased financial stability, and improved creditworthiness.
• Performance evaluation: Cost of capital is also used to evaluate a company's financial performance. If a company consistently earns returns above its cost of capital, it indicates efficient capital utilization and value creation.
• Market competitiveness: In a competitive market, companies with a lower cost of capital may have a competitive advantage. They can potentially offer lower prices or invest in growth opportunities more aggressively.

Cost of Capital Formula

The cost of capital is typically calculated using the Weighted Average Cost of Capital (WACC) formula, which considers the weighted average of the cost of debt and equity. The formula for WACC is as follows:

WACC = (E/V Re) + (D/V Rd) * (1 - Tax Rate)

Where:

• WACC stands for Weighted Average Cost of Capital.
• E represents the market value of the company’s equity.
• D represents the market value of the company’s debt.
• V is the total market value of both debt and equity (V = E + D).
• Re is the cost of equity.
• Rd is the cost of debt.
• Tax Rate represents the corporate tax rate.

The WACC method is unique because it considers both the cost of debt and the cost of equity, weighted by their respective proportions in the capital structure, and provides a comprehensive measure of a company’s cost of capital by accounting for the relative weight of debt and equity in its capital structure.

It's just one method for calculating the cost of capital. There are other methods for estimating the cost of capital, which may focus solely on the cost of equity or debt. Let’s review some other methods.

Other Methods of Calculating Cost of Capital

Cost of equity methods, such as the Dividend Discount Model (DDM) and the Capital Asset Pricing Model (CAPM), primarily focus on estimating the cost of equity capital.

These methods evaluate the required return expected by equity investors, considering various factors such as dividends and market risk. It’s essential to note that cost of equity methods do not consider the cost of debt. As a result, they provide a limited perspective and offer a partial view of a company’s overall cost of capital. 

Finding the cost of equity via the CAPM is for investors, but it’s good information to know.

Conversely, cost of debt methods concentrate solely on estimating the cost of debt capital. These methods assess the expenses associated with borrowing funds, typically by analyzing bond yields, loan interest rates, or other debt-related metrics.

While they provide insights into the cost of borrowing, cost of debt methods exclude the cost of equity from their calculations. Therefore, they do not offer a complete representation of a company’s total cost of capital, as they focus exclusively on one component of the capital structure.

Let’s break down DDM and CAPM.

Dividend Discount Model (DDM)

The Dividend Discount Model (DDM) is a financial method that primarily focuses on estimating the cost of equity. It is particularly relevant for companies that pay dividends to their shareholders. To utilize the DDM:

1. First, one needs to estimate the expected dividends the company will distribute to its shareholders over a specific period.
2. Next, the discount rate, representing the required rate of return expected by shareholders, must be determined. This rate can effectively serve as the cost of equity.
3. Finally, the DDM formula is applied, which calculates the cost of equity (Re) as Dividends per Share (DPS) divided by Stock Price (P).

For example, if Company X pays a dividend of $2 per share, and its stock currently trades at $50 per share, the equity (Re) cost would be $2 / $50, resulting in 0.04 or 4%.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a widely utilized method for estimating the cost of equity, primarily focusing on assessing a stock’s sensitivity to market fluctuations. To apply the CAPM method:

1. First, the risk-free rate (Rf) is determined, often based on government bond yields.
2. Next, the market risk premium (Rm - Rf) is calculated, representing the additional return expected from investing in the market compared to a risk-free investment.
3. The stock’s beta (β) is assessed, measuring its volatility relative to the overall market.
4. The CAPM formula is then used to calculate the cost of equity (Re), which involves adding the risk-free rate (Rf) to the product of beta (β) and the market risk premium (Rm - Rf).

For example, suppose the risk-free rate (Rf) is 3%. In that case, the market return (Rm) is 10%, and the stock’s beta (β) is 1.2, the cost of equity (Re) would be calculated as 3% + (1.2 * (10% - 3%)), resulting in 10.6%.

Components of Cost of Capital

Understanding the components of cost of capital and their calculations holds significant importance, as they collectively contribute to establishing a company’s overall cost of capital. This comprehensive cost metric serves as a critical foundation for two key aspects:

• Informed investment decisions: Analyzing the cost of capital components offers insights into funding sources, empowering strategic investment decisions for profitability and risk management.
• Holistic financial health assessment: A company’s overall cost of capital, calculated by weighting each component, measures its financial health. It represents the minimum return required to satisfy debt and equity stakeholders. Assessing actual returns against this benchmark gauges capital efficiency and financial well-being. This aids in identifying areas for improvement, ensuring growth and competitiveness.

Let’s break down the components of the cost of capital, provide their respective formulas and explanations, and offer practical examples to enhance understanding:

Cost of Debt

The cost of debt represents the interest expense a company incurs on its debt financing. It is the cost of borrowing money through loans or bonds. Interest payments made to debt holders are tax-deductible, which can reduce the effective cost of debt.

• Formula: Cost of Debt (Rd) = Interest Expense / Total Debt
• Example: Suppose a company has a total debt of $1,000,000 and pays $50,000 in annual interest expenses on that debt. The cost of debt would be: Cost of Debt (Rd) = $50,000 / $1,000,000 = 5%

Cost of Equity

The cost of equity represents the return required by investors who hold the company's common stock. It includes the dividend yield (DPS/P) and the expected growth rate of dividends (g). Investors demand a return for taking on the risk of holding equity, which is typically higher than the cost of debt.

• Formula: Cost of Equity (Re) = Dividends per Share (DPS) / Stock Price (P) + Growth Rate (g)
• Example: If a company’s stock has a current price of $50 per share, pays an annual dividend of $2 per share, and is expected to grow dividends at 5% per year, the cost of equity would be: Cost of Equity (Re) = $2 / $50 + 0.05 = 4% + 5% = 9%

Cost of Preferred Stock

The cost of preferred stock is the return expected by preferred stockholders. It is calculated as the annual dividends paid on preferred stock divided by the market price of preferred shares.

• Formula: Cost of Preferred Stock (Rp) = Dividends on Preferred Stock / Preferred Stock Price
• Example: If a company pays $4 per share in annual dividends on its preferred stock, and the market price of preferred shares is $80 per share, the cost of preferred stock would be: Cost of Preferred Stock (Rp) = $4 / $80 = 5%

Weighted Average Cost of Capital (WACC)

Considering the company's capital structure, the Weighted Average Cost of Capital (WACC) is the weighted average of the cost of equity and the after-tax cost of debt. It represents the overall cost of financing a company’s operations and investments. In this example, the company's weighted average cost of capital is 6.9%, representing the minimum return the company needs to earn on its investments to satisfy equity and debt investors.

• Formula: WACC = (E/V) Re + (D/V) Rd * (1 - Tax Rate)
• Example: Consider a company with 60% equity (Re = 9%) and 40% debt (Rd = 5%) and a tax rate of 25%. The WACC would be calculated as: WACC = (0.60  0.09) + (0.40  0.05 * (1 - 0.25)) = 5.4% + 1.5% = 6.9%

After-Tax Cost

The after-tax cost of debt reflects the adjusted cost of debt capital, accounting for the tax benefits of interest payments. It recognizes that interest expenses on debt are usually tax-deductible, reducing the effective borrowing cost.

• Formula: After-Tax Cost of Debt (ATCD) = Cost of Debt * (1 - Tax Rate)
• Example: Suppose a company has a cost of debt of 6%, and the corporate tax rate is 25%. The after-tax cost of debt would be calculated as follows: ATCD = 6% (1 - 0.25) = 6% 0.75 = 4.5%

Marginal Cost

The marginal cost of capital represents a company's cost when raising additional funds beyond its current funding level. It quantifies the additional cost incurred for each new dollar of money raised.

• Formula: Marginal Cost of Capital (MCC) = (Cost of New Capital - Cost of Existing Capital) / (Incremental Capital Raised)
• Example: Let’s say a company has an existing capital structure with a cost of capital of 8% and is considering raising an additional $1 million in capital. If the cost of raising this new capital is 10%, the marginal cost of capital would be calculated as follows: MCC = (10% - 8%) / $1,000,000 = 0.02 / $1,000,000 = 0.002 or 0.2%

Factors Affecting Cost of Capital

Companies must adapt their financial strategies and capital structures to navigate changing market conditions and maintain competitive financing costs, and understanding the factors that affect the cost of capital can help you assess and manage your cost of funds effectively. Let’s break down some of the key factors that influence a company’s cost of capital.

• Various market conditions: Broadly speaking, the prevailing economic and financial market conditions significantly impact cost of capital. Interest rates, stock market performance, and overall economic stability can influence the cost of debt and equity capital.
• Industry-specific factors: Different industries have varying risk profiles and capital cost expectations. Highly regulated industries, emerging markets, and cyclical sectors may have different cost of capital considerations.
• Market sentiment: Investor sentiment and market dynamics can lead to fluctuations in a company's cost of equity. Positive news or strong market performance can lower the cost of equity capital, while negative sentiment can increase it.
• Company's risk profile: The risk associated with a company affects its cost of capital. Investors and lenders demand higher returns when a company is perceived as riskier. Factors include the company's creditworthiness, stability, and historical financial performance.
• Interest rates: As mentioned, changes in interest rates directly affect the cost of debt capital. When interest rates rise, the cost of borrowing increases, impacting the overall cost of capital.
• Credit rating: A company's credit rating plays a crucial role in determining the cost of debt capital. A higher credit rating typically leads to lower interest rates on loans and bonds.
• Inflation: Inflation erodes the purchasing power of money over time. Companies often require a higher nominal return to compensate for expected inflation, which can increase the cost of capital.
• Financial leverage: The use of financial leverage, or debt financing, affects the cost of equity. Higher leverage can increase perceived risk, leading to higher equity costs.
• Capital structure: The mix of debt and equity in a company's capital structure influences the overall cost of capital. Companies need to strike a balance between debt and equity financing to minimize their cost of capital.
• Taxation: Tax laws can impact the after-tax cost of debt. Interest expenses on debt are often tax-deductible, reducing the effective cost of debt financing.
• Regulatory environment: Regulations can affect the cost of capital by imposing restrictions on specific financial instruments or influencing capital structure decisions.

Practical Applications

With a stronger understanding of cost of capital and its importance, let’s discuss how you can practically apply the cost of capital in your decision-making. Here are some typical applications of cost of capital analysis for businesses:

• Capital budgeting decisions: In capital budgeting, businesses use the cost of capital to assess the feasibility of potential projects and investments. They should prioritize projects with expected returns that exceed their cost of capital. For instance, if a manufacturing company has a cost of capital of 10% and evaluates a new project with an expected return of 12%, proceeding with the project will likely create value for shareholders.
• Optimizing capital structure: A crucial application of the cost of capital for businesses is optimizing their capital structure. Companies aim to balance debt and equity financing to minimize their overall cost of capital. Debt financing often comes with tax advantages, making it attractive. Companies with a high cost of equity might consider taking on more debt to lower their overall cost of capital, provided they can handle the additional leverage.
• Assessing mergers and acquisitions (M&A): When considering M&A activities, businesses determine the cost of capital of the target company and how it aligns with their own. This influences the decision to acquire or merge. For example, if Company A is considering acquiring Company B and finds that Company B has a lower cost of capital, it may make the acquisition more attractive from a financial perspective.

By applying these strategies, you can make informed investment decisions, optimize your financing structures, and strategically plan for growth and value creation. This way, you can more efficiently oversee capital expenditures and enhance your company’s financial performance.

Summary & Key Takeaways

The cost of capital is a vital concept in finance. It measures the company's expenses when obtaining funds from debt and equity sources. This knowledge is invaluable for informed financial decisions, influencing project feasibility, capital structure optimization, and investment evaluation. 

The cost of capital is typically calculated using the Weighted Average Cost of Capital (WACC) formula, which considers the weighted average of the cost of debt and equity. The formula for WACC is as follows:

WACC = (E/V Re) + (D/V Rd) * (1 - Tax Rate)

Lowering the cost of capital can significantly boost financial performance and enhance overall value creation. Applying these principles enables individuals and businesses to make more profitable and strategic financial choices, leading to greater success in their financial endeavors.

Lease with Excedr & Optimize Your Cost of Capital

So why am I, a team member at Excedr (a leasing company), talking about the cost of capital? Well, the cost of capital is essential in the decision to lease equipment. It serves as a benchmark for evaluating the financial feasibility of leasing versus buying.

Companies compare the cost of leasing to their cost of capital and consider factors like risk, financing flexibility, and tax benefits. Leasing is a favorable option when it aligns with a company’s cost of capital and offers advantages in terms of flexibility and tax deductions.

It helps preserve capital for other investments, reduces the need for high-cost capital financing, provides tax efficiency through deductible lease payments, allows adaptation to changing equipment needs without a significant capital outlay, and sometimes offers lower financing costs, all of which contribute to making leasing an intelligent financial choice for managing cost of capital effectively.

If you’re interested in leasing lab equipment to optimize your life sciences company’s cost of capital and boost flexibility, we’re here to help. Contact Excedr today to explore our tailored leasing solutions and enhance your research capabilities. Take advantage of the opportunity to streamline your operations and drive scientific innovation.