Cost of capital is a necessary economic and accounting tool that calculates investment opportunity costs and maximizes potential investments in the process.
The cost of capital is tied to the opportunity cost of pouring cash into a specific business project or investment. Once those costs are evaluated, businesses can make better decisions to deploy their capital to maximize profit potential.
Here's the skinny on the cost of capital, and why it's so important in business and in investing circles.
What Is Cost of Capital?
Cost of capital is the amount of return an investment could have garnered if that investment was executed. Loosely defined in general, cost of capital can involve debt, equity or any source of capital.
Basically, cost of capital is the opportunity cost of investing the same amount of cash into different investment opportunities, with the real cost of capital the amount of money that could have been earned by choosing one investment over the other.
Like many accounting principles, the meaning of cost of capital can vary from one scenario to another. For example, cost of capital can also be defined as the return of investment (ROI) that could be gained if the right amount of money is steered into a specific investment, like a large construction project or the purchase of a company's stock.
How Cost of Capital Works
In defining the cost of capital, it's also helpful to know the different cost of capital categories, as follows:
- Cost of equity. This is the cost of leveraging the capital supplied by company shareholder, repayable in (hopefully) stronger capital gains and a higher share price.
- Cost of debt. This type of capital represents the cost of a company or individual that borrows money from a bank or financial institution to invest money in a project or other investment opportunity. The financial institution earns its money back in the form of interest paid, along with any appropriate fees and charges as noted in the loan contract.
By and large, companies often apply their cost of capital in two definitions:
- Cost of capital is defined as the financing costs a company has to pay when borrowing money, using equity financing, or selling bonds to fund a big project or investment. In each case, the cost of capital is expressed as an annual interest rate, such as 7%.
- When weighing a big investment, like funding a new manufacturing plant, the cost of capital represents the return rate the company could garner if it invested cash in an alternative investment, with the same risk applied. That's why economists equate the cost of capital with the opportunity cost of a company using financial capital for a significant project or investment.
Why Is Cost of Capital So Critical?
Cost of capital is a useful finance and accounting tool that companies and investors can use to make better decisions on how they allocate their money.
How companies will finance a project or make an investment is an important decision, since that choice will determine a firm's capital structure. Ideally, businesses seek a fair balance in this scenario, with enough financing to get a project or investment done, while reducing or limiting the cost of capital.
Cost of capital is especially important in the following ways:
- The cost of capital aids businesses and investors in evaluating all investment opportunities. It does so by turning future cash flows into present value by keeping it discounted.
- The cost of capital can also aid in making key company budget calls that use company financial sources as capital.
- In a cost of opportunity scenario, the cost of capital can be used to evaluate the progress of ongoing projects and investments by matching up the progress of those investments against the cost of capital.
How Cost of Capital Works
Cost of capital is very important to companies who need capital to expand their operations and fund their business, while keeping debts as low as possible to satisfy shareholders.
In the cost of capital game, there are two main forms of capital - implicit cost of capital and explicit cost of capital.
- Implicit cost. This represents the opportunity cost cited above, i.e., the cost of an investment opportunity considered, but ultimately not taken. There is no bottom-line reduction in revenues - it's implied. But under the cost of capital model, it can be factored into opportunity costs not earned.
- Explicit cost. The explicit cost of capital is the cost that companies can actually use to make capital investments, payable back to investors in the form of a stronger stock price or bigger dividend payouts to shareholders.
Company accountants use the cost of capital to estimate the cost of financing a project or engaging in a large investment opportunity.
At minimum, any capital used by a company for such initiatives must have a minimum return that's in line with what shareholders, stakeholders, and lenders expect for the use of their money. In short form, the cost of capital represents a benchmark which any company investment or project must meet or exceed in financial returns.
Cost of Capital Examples
In a real-life example, here's what cost of capital means in two common scenarios:
Cost of Capital for Investing
In investing, the cost of capital is the variation between an investment that you make and one that you could have made - but didn't.
Consider a stock market trader or real estate investor that invests $10,000 into a particular opportunity. The opportunity cost is the difference between any profit actually earned, and the profit that could have been earned. Let's say the investor earned a 5% profit on the actual investment (Opportunity "A") but could have earned 10% on the investment opportunity not chosen (Opportunity "B".) The difference between the profit earned on Opportunity "A" and Opportunity "B" (5%) is the actual cost of capital.
Cost of Capital for Business
In business, the goal with the cost of capital is to improve on the rate of return that might have been generated by steering the amount of money into a separate investment, and with the same amount of risk.
After all, companies count on the cost of capital to be the return rate it earns on business-related investment projects, in order to maximize opportunities to attract investors, and to stay profitable and competitive in its marketplace.
How to Calculate the Cost of Capital
Calculating the cost of capital means taking the total costs of debt, common stock and preferred stock and using separate calculations for each of those three components. Ultimately, you'll need to combine all three calculations to figure out the total cost of capital on a weighted average basis.
Here is the breakdown:
- To derive the cost of debt, multiply the interest expense associated with the debt by the inverse of the tax rate percentage, and divide the result by the amount of debt outstanding.
- The amount of debt outstanding that is used in the denominator should include any transactional fees associated with the acquisition of the debt, as well as any premiums or discounts on the sale of the debt.
- These fees, premiums, or discounts should be gradually amortized over the life of the debt, so that the amount included in the denominator will decrease over time.
The formula for the cost of debt is as follows:
(Interest Expense x (1 - Tax Rate) ÷
Amount of Debt - Debt Acquisition Fees + Premium on Debt - Discount on Debt
Key Things to Know About Cost of Capital
Lean on these takeaways to learn more about the cost of capital:
- Figuring out the cost of capital generally relies on two key criteria - a lender's required rate of return and a borrower's weighted average cost of capital.
- Two key themes in calculating the cost of capital are recognizing the time value of money and knowing how to discount cash flows and returns into present value.
- Investors looking for a better grip on the cost of capital should focus on the opportunity cost of alternative investments, stemming from that investment's risk level and the investment's estimated return.
- In formulating the total cost of equity and the cost of debt, companies need to calculate a weighted average cost of capital (WACC), combing all company financing sources into the calculation.
- In general, the definition of cost of capital is two-fold: For businesses, it's the cost of an organization's debt and equity funds. For investors, the cost of capital is the required rate of return on a particular investment.