Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.
Capital structure is a mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. The capital structure represents how a firm finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.
A company’s proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm’s debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.
Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and minimizes the firm’s cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company’s risk generally increases as debt increases. A healthy proportion of equity capital, as opposed to debt capital, in a company’s capital structure is an indication of financial fitness. We’ll discuss optimal capital structure further in section 14.
Controllable Factors Affecting Cost of Capital
These are the factors affecting cost of capital that the company has control over:
- Capital Structure Policy
A firm has control over its capital structure, and it targets an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.
- Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the marginal cost of capital schedule can be changed. For example, as the payout ratio of the company increases, the breakpoint between lower-cost internally generated equity and newly issued equity is lowered. (Read How And Why Do Companies Pay Dividends? and Due Diligence On Dividends to learn more.)
- Investment Policy
It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.
Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has no control over:
- Level of Interest Rates
The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital.
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.
The cost of equity is the return that stockholders require for their investment in a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:
A firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. (Learn more about investing in Hate Dealing With Money? Invest Without Stress and Investment Options For Any Income.)
Here’s a very simple example: let’s say you require a rate of return of 10% on an investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a combination of dividends and share appreciation you require a $1.00 return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70, which, combined with the $0.30 from dividends, gives you your 10% cost of equity.
A company that earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)
Calculating the Cost of Equity
The cost of equity can be a bit tricky to calculate as share capital carries no “explicit” cost. Unlike debt, which the company must pay in the form of predetermined interest, equity does not have a concrete price that the company must pay, but that doesn’t mean no cost of equity exists.
Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders’ required rate of return is a cost from the company’s perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price that is theoretically satisfactory to investors. (For further reading on share price, see Top 5 Stocks Back From The Dead and The Highest Priced Stocks In America.)
On this basis, the most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed formulaically below:
Re = rf + (rm – rf) * β
- Re = the required rate of return on equity
- rf = the risk free rate
- rm – rf = the market risk premium
- β = beta coefficient = unsystematic risk
But what does this mean?
- Rf – Risk-free rate – This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury Bills is frequently used as a proxy for the risk-free rate.
- ß – Beta – This measures how much a company’s share price reacts against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market’s movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold-mining company), which means the share price moves in the opposite direction to the broader market. (Learn more in Beta: Know The Risk.)
For public companies, you can find database services that publish betas. Few services do a better job of estimating betas than BARRA. While you might not be able to afford to subscribe to the beta estimation service, this site describes the process by which they come up with “fundamental” betas. Bloomberg and Ibbotson are other valuable sources of industry betas.
- (Rm – Rf) = Equity Market Risk Premium (EMRP) – The equity market risk premium (EMRP) represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become more risky.
The EMRP frequently cited is based on the historical average annual excess return obtained from investing in the stock market above the risk-free rate. The average may either be calculated using an arithmetic mean or a geometric mean. The geometric mean provides an annually compounded rate of excess return and will in most cases be lower than the arithmetic mean. Both methods are popular, but the arithmetic average has gained widespread acceptance.
Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease a company’s risk profile. Such factors include the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment, and they vary from company to company. (Learn more in The Capital Asset Pricing Model: An Overview.)
Cost of Newly Issued Stock
Cost of newly issued stock (Rc) is the cost of external equity, and it is based on the cost of retained earnings increased for flotation costs (cost of issuing common stock). For a constant-growth company, this can be calculated as follows:
|Rc = D1__ + g
F = the percentage flotation cost, or (current stock price – funds going to company) / current stock price
Example: Cost of Newly Issued Stock
Assume Newco’s stock is selling for $40, its expected ROE is 10%, next year’s dividend is $2 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. What is Newco’s cost of new equity?
Rc = 2 + 0.07 = 0.123, or 12.3%
It is important to note that the cost of newly issued stock is higher than the company’s cost of retained earnings. This is due to the flotation costs. (For more on newly issued stock, see Why Investors Can’t Get Enough Of Social Media IPOs and 5 Signs That Social Media Is The Next Bubble.)
Weighted Average Cost of Equity
Weighted average cost of equity (WACE) is a way to calculate the cost of a company’s equity that gives different weight to different aspects of the equities. Instead of lumping retained earnings, common stock and preferred stock together, WACE provides a more accurate idea of a company’s total cost of equity.
Here is an example of how to calculate WACE:
First, calculate the cost of new common stock, the cost of preferred stock and the cost of retained earnings. Let’s assume we have already done this and the cost of common stock, preferred stock and retained earnings are 24%, 10% and 20% respectively.
Now, calculate the portion of total equity that is occupied by each form of equity. Again, let’s assume this is 50%, 25% and 25%, for common stock, preferred stock and retained earnings, respectively.
Finally, multiply the cost of each form of equity by its respective portion of total equity, and sum of the values to get WACE. Our example results in a WACE of 19.5%.
WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5%
Determining an accurate cost of equity for a firm is integral in order to be able to calculate the firm’s cost of capital. In turn, an accurate measure of the cost of capital is essential when a firm is trying to decide if a future project will be profitable or not.
Recall from Section 5 that companies sometimes finance their operations through debt in the form of bonds because bonds provide more flexible borrowing terms than banks. How much do companies pay for this debt?
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.
Calculating the Cost of Debt
Because companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment.
The after-tax cost of debt can be calculated as follows:
|After-tax cost of debt = Rd (1-tc)|
|Note: Rd represents the cost to issue new debt, not the cost of the firm\’s existing debt.|
Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco’s total (both federal and state) tax rate is 40%. What is Newco’s cost of debt?
Rd (1-tc) = 7% (1-0.40) = 4.2%
Calculating the Cost of Preferred Stock
As we discussed in section 6 of this walkthrough, preferred stocks straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate.
Cost of preferred stock (Rps) can be calculated as follows:
|Rps = Dps/Pnet
Dps = preferred dividends
Pnet = net issuing price
Example: Cost of Preferred Stock
Assume Newco’s preferred stock pays a dividend of $2 per share and sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco’s cost of preferred stock?
Rps = Dps/Pnet = $2/$100(1-0.04) = 2.1%
For more on this subject, read Prefer Dividends? Why Not Look At Preferred Stock?
Next, we’ll take a look at the weighted average cost of capital, a calculation that will put our formulas for both the cost of equity and the cost of debt to work.
Weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.
The WACC equation is the cost of each capital component multiplied by its proportional weight and then summed:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.
A firm’s WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. (Learn more in Evaluating A Company’s Capital Structure.)
Further Understanding WACC
The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC tells us the return that both stakeholders – equity owners and lenders – can expect. WACC, in other words, represents the investor’s opportunity cost of taking on the risk of putting money into a company.
To understand WACC, think of a company as a bag of money. The money in the bag comes from two sources: debt and equity. Money from business operations is not a third source because, after paying for debt, any cash left over that is not returned to shareholders in the form of dividends is kept in the bag on behalf of shareholders. If debt holders require a 10% return on their investment and shareholders require a 20% return, then, on average, projects funded by the bag of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC.
If the only money the bag held was $50 from debtholders and $50 from shareholders, and the company invested $100 in a project, to meet expectations the project would have to return $5 a year to debtholders and $10 a year to shareholders. This would require a total return of $15 a year, or a 15% WACC.
WACC: An Investment Tool
Securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a business’s net present value. WACC can be used as a hurdle rate against which to assess ROIC performance. It also plays a key role in economic value added (EVA) calculations.
Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let’s say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company’s return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.
WACC serves as a useful reality check for investors. To be blunt, the average investor probably wouldn’t go to the trouble of calculating WACC because it is a complicated measure that requires a lot of detailed company information. Nonetheless, it helps investors to know the meaning of WACC when they see it in brokerage analysts’ reports.
Be warned: the WACC formula seems easier to calculate than it really is. Just as two people will hardly ever interpret a piece of art the same way, rarely will two people derive the same WACC. And even if two people do reach the same WACC, all the other applied judgments and valuation methods will likely ensure that each has a different opinion regarding the components that comprise the company’s value.