Cost of Capital: Definition, Formula & Uses (2024)

What Is Cost of Capital?

The cost of capital is how much a company has to pay to obtain funding for projects. The cost of capital at a corporation level is calculated by factoring the weight and cost of both a company's debt and equity.

Cost of capital is a vital metric because it serves as a baseline for evaluating new projects. If a company plans to invest in a new building or expand a factory, for example, it will evaluate the expected return on investment against its projected cost of capital.

Investors can also use the cost of capital as a discount rate for evaluating cash flow from investment opportunities.

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is a specific form of the cost of capital idea. The WACC is calculated by taking a company's equity and debt cost of capital and assigning a weight to each, based on the company's capital structure (for instance 60% equity, 40% debt). If a company has preferred stock, that is included as well. Once calculated, the WACC gives a composite rate at which a company has to pay to access funding.

Cost of Capital Formula & How To Calculate

To reach an overall cost of capital, analysts generally calculate a cost of equity and a cost of debt, and then take the weighted average of them both. Here's how the calculation works in more detail.

Cost of Equity

Cost of equity is usually calculated in two ways. One, the Capital Asset Pricing Model (CAPM), is addressed below. The other is the Dividend Capitalization Model. The Dividend Capitalization Model goes as follows:

Cost of Equity = (Dividends Per Share Next Year / Share Price) + Dividend Growth Rate

For example, a company with a $0.30 dividend on a $10, share price (=3% dividend yield) and a 5% growth rate would have an 8% cost of equity using this model.

Capital Asset Pricing Model (CAPM)

The CAPM method is more complex and includes a measure of beta (β) while reflects a stock's (or other asset) expected volatility vis-as-vis the overall market. The market average beta equals 1.0.

The CAPM is a framework developed in the 1960s for determining the expected return of an equity. It uses inputs such as the risk-free rate, the beta of an equity, and the market risk premium to determine a rational price for a given stock or other financial asset.

Using the CAPM model, an investor can calculate the future anticipated returns of a stock. That rate, in turn, can be plugged back into the cost of capital framework as the input for a company's cost of equity.

Cost of Equity = risk free rate + β X (expected market return)

See Also

Cost Of Capital - Definition, Formula, Calculation and Example

Cost of Debt

Cost of debt is the amount of interest that a company has to pay to access funding. More specifically, the following formula is often used to incorporate tax effects into the equation as well:

Cost of Debt = (Risk-Free Rate + Company's Credit Spread) x (1 - Tax Rate)

• Risk-free rate: what investors can earn from lending money to the government
• Credit spread: the additional interest rate premium that a company has to pay for credit compared to the risk-free rate

For example, if a company is paying a 7% coupon on its recently issued debt, and has a tax rate of 40%, the cost of debt = (7% x (1-0.4) = 4.2%

What Affects Cost of Capital?

There are several key factors which can affect investors' perception of a company's prospects:

• Industry: Some industries inherently have lower costs of capital than others. A stable high profit margin industry such as software will have lower costs of capital than a cyclical low profit industry like airlines.
• Management Quality: Investors will typically provide funds at lower rates to companies with superior management teams.
• Balance Sheet: A company's balance sheet composition greatly affects its cost of capital. Debt is generally cheaper than equity. However, if a company takes on too much debt, this can reverse itself as lenders cold deem it more risky to let the company borrow even more money.
• Interest Rates: The prevailing level of interest rates in the economy impacts a company's cost of capital, as when interest rates on risk-free assets increase, companies will have to offer a higher corresponding rate on newly-issued debt to obtain financing.

Implicit vs. Explicit Cost of Capital

Cost of capital is one metric. However, some confusion arises because it is used in two primary and distinct ways.

• Implicit Cost of Capital: Implicit cost of capital refers to the discount rate or hurdle rate that a company needs to achieve to justify new investments. Companies use this as a benchmark when evaluating various capital allocation strategies.
• Explicit Cost of Capital: The explicit cost of capital refers to the formulas above in terms of calculating a company's WACC, cost of debt, cost of equity, and so on.

Note: Management teams tend to focus more on the implicit cost of capital, whereas investors have more uses for explicit cost of capital in analyzing businesses and building cash flow models.

What Cost Of Capital Tells Investors

Cost of capital, at a glance, tells investors what sorts of returns to expect from a company, as the company itself shouldn't normally pursue projects that return less than its cost of capital. More simply, the cost of capital is the rate of return that investors demand from giving funds to a company. If a company has a 5% cost of debt and 10% cost of equity and has an equal amount of both in its capital structure, it's total cost of capital would be 7.5%.

Investors can use these costs of capital to get a sense of what the market is expecting from a firm. A company with a low cost of capital is generally perceived to be stable, high-quality, and not face much near-term risk. Meanwhile, a company with a high cost of capital may be cyclical, facing structural concerns, or be overly-levered, among other factors.

Example of Cost of Capital

To put this into practice, consider the following example. A mall operator has a department store close at one of its properties. Suppose that the owner knows that it can redevelop that vacant space into apartments with an expected return on investment of 10%.

Prior to the 2020 pandemic, most publicly-traded mall REIT operators had cost of capitals below that 10% threshold. This made it attractive for REIT management teams to decide to redevelop their properties with their own capital.

Subsequent to the pandemic, however, cost of capital for the retail REIT sector increased dramatically. Both public market equity investors and lenders have become more reticent about investing in the retail space. Given this, both the debt and equity components of a mall owner's cost of capital have increased significantly. This has made it less attractive to internally redevelop aging malls. The mall owner in this example might leave the space empty or sell it off to a third party rather than attempting to refurbish it with its own funding thanks to the unfavorable change in its cost of capital.

Where To Find a Company’s Cost of Capital

Most financial websites or screening programs do not show a cost of capital or WACC metric for each company. This is in part because some of the inputs can vary from day to day (such as a company's bond yields and dividend yield), and due to possible subjectivity in the calculation of WACC.

As part of this subjectivity, outside analysts can estimate the overall rate at which a company pays to access funds, but without knowing what risk premiums a management team puts on potential projects, it may not be certain which future investments will end up meeting a company's hurdle rate and capital allocation objectives.

Note: Cost of capital is highly useful as a framework for thinking about a company's balance sheet, profitability, and future investment opportunities. It's less useful as a precise day-to-day measurement of a business' prospects.

Bottom Line

Investors and management teams alike use cost of capital in assessing whether a new investment or project is worth pursuing. If expected returns are higher than the estimated cost of capital, the investment may be worthwhile. If, on the other hand, the returns on the capital spent are lower than the cost of sourcing that capital, the project would not be expected to deliver incremental value.