What Is Cost of Capital?
Cost of capital is the financing costs a company has to pay when borrowing money or using equity financing. A company must be able to cover their cost of capital in order to generate value. To determine cost of capital, you would add a company’s cost of equity and cost of debt together, and weight them based on the percentage of debt and equity that the owner uses to run their business.
Want to expand a product line? Open a new location? Buy a new piece of equipment? If you work with creditors and investors (like most small businesses do), then you need to know your business’s cost of capital before you make any decisions.
Cost of capital is an economic and accounting tool that provides you with an idea of the cost it will take to invest in a new opportunity. Knowing your business’s cost of capital will help you, your creditors, and your investors determine if an investment is worthwhile, and what the expected return could be.
It’s an important small business finance metric, albeit a complex one. In this guide, we’re going to explain what cost of capital is, how you can calculate it, and some examples of how you can deploy it. With this knowledge in hand, you’ll be able to better determine where to allocate capital in order to maximize profit.
Cost of Capital Definition
The cost of capital is the financing costs a company has to pay when borrowing money or using equity financing. It’s typically expressed as an annual interest rate. Knowing your cost of capital will show you how much you need to earn on an investment in order for it to be worthwhile (i.e. one that pays back your creditors and investors and also allows you to see a profit).
If you, as a business owner, were looking at a series of different potential investments, the cost of capital calculation would show you the amount of money you could earn by investing the same amount of money into one investment over another. This could help you pick the investment that would theoretically generate the highest return on investment.
Cost of Capital vs. Discount Rate
Cost of capital is often used synonymously with discount rate. However, there is an important distinction. The discount rate is a rate set by a business’s senior leadership that is used to justify an investment. This number is typically slightly higher than the cost of capital as a way to mitigate risk.
So if, for example, your business’s cost of capital is 10%, you might set your discount rate at 12% to provide yourself some cushion in case the investment doesn’t go as planned. Doing so means the investment needs to yield an even higher rate of return to be considered worthwhile.
Cost of Capital Formula
The cost of capital formula is a company’s cost of equity and cost of debt, added together and weighted according to the percentage of debt and equity that the owner uses to run the business. So in order to be able to determine the cost of capital, we first need to understand a company’s cost of debt and cost of equity.
Cost of capital formula
Cost of Debt
Cost of debt is the total amount of interest that a company pays on loans, credit cards, bonds, and other forms of debt. Since companies can deduct the interest paid on business debt, the cost of debt is typically calculated after taxes.
The formula for cost of debt is as follows:
Cost of Debt = Interest Expense (1 – Tax Rate)
To calculate cost of debt, you’ll first need to know your business’s average income tax rate. You can find this number by using a tax schedule to predict your business tax rate. Remember that you must account for federal, state, and local taxes. To do so, divide your total tax liability by your total taxable business income. This will give you your business’s average income tax rate.
The interest expense is the total interest cost of the business loan. This is typically the same as the loan’s APR. If the loan cost isn’t quoted as an APR, ask the lender to break down the total interest cost for you, or use a business loan calculator.
So let’s say you have a loan with a 14.75% APR and your business has a 25% average tax rate. Your cost of debt would be as follows:
14.75 (1 – 0.25) = 11.06
This means that 11.06% of the loan will be used to cover debt. So if you took out a $100,000 loan, your cost of debt would be $11,060.
Cost of Equity
The cost of equity is the return shareholders require when they invest in your business to compensate for their risk. The cost of equity is a much more theoretical number since it is predicated on ever-changing shifts in the market. To calculate it, you’d use the following formula:
Cost of Equity = Risk-Free Interest Rate + Beta (Market Rate – Risk-Free Rate)
In this formula, beta is a measure of a stock’s volatility in relation to the market. The higher the beta, the riskier the stock is. Ideally, you’d want your business’s beta to rise and fall in close relation to the market—which would amount to a beta that is close to 1. If it rises and falls more than the market, the beta will be higher than 1. If it doesn’t fluctuate as much, it will be lower than 1.
The market rate stands for the expected return on the stock market right now. The risk-free rate is the return you’d get on a risk-free investment (such as a treasury bond). Let’s say the current market rate is 10% and the risk-free rate is 3%.
Assuming a company’s beta is 1, here’s how you’d calculate the cost of equity:
3% + 1(10% – 3%) = 10%
This means that, given the current market conditions, investors expect a 10% return on their investment.
Calculating Cost of Capital
Now that we know both the cost of debt (11.06%) and the cost of equity (10%), we can determine the cost of capital. Remember that the cost of capital is a company’s cost of equity and cost of debt, added together and weighted according to the percentage of debt and equity that the owner uses to run the business.
Therefore, the cost of capital formula will look like this:
Cost of capital = (Cost of debt x percentage of debt used to run business) + (Cost of equity x percentage of equity used to run business)
So if you ran a business that was financed by 20% debt and 80% equity, your cost of capital would look like this:
(11.06% x 0.2%) + (10% + 0.8%) = 10.21%
When looking at future potential investments, you would discount 10.21% from projected cash flows as your cost of capital before determining if the investment is viable. This number is also known as the weighted average cost of capital (WACC).
So if you want to invest $50,000 in a new piece of equipment, you’ll know your cost for doing so is $5,105 (50,000 x 0.1021). If the piece of equipment will generate a projected $10,000 in revenue, then it’s worth the investment. But if it will only generate a projected $5,000 in revenue, then it’s probably not a good investment.
Keep in mind that the cost of capital is based on current market conditions, so this number will change as the market fluctuates. However, having a ballpark idea of your cost of capital is still valuable when trying to make business decisions.
Finding Your Ideal Cost of Capital
Companies use the cost of capital formula to determine the best possible financing mix from different funding sources. Since interest payments are tax-deductible, having more debt than equity financing will lead to a lower cost of capital. However, if you have too much debt, you may find yourself over-leveraged.
Equity, on the other hand, usually comes with a higher cost, but it does not create a default risk for the company. What’s more, it’s usually easier to raise a large amount of capital via equity financing, especially if the company doesn’t have an established credit history. Keep in mind though that the more equity financing you raise, the less control you have over your small business.
According to metrics tracked by the Stern School of Business at New York University, the current average cost of capital in the United States across all industries is about 6.9%. The average cost of equity is 8.21%, and the average cost of debt is 3.67%. However, those numbers vary widely across industries.
For example, the average cost of capital in the engineering and construction sector is 8.03%, while the cost of capital in the financial services sector is only 2.79%. Keep in mind how the cost of capital can fluctuate by industry when determining your ideal financing mix.
Using Cost of Capital to Grow Your Business
Using the cost of capital formula, you can make more educated decisions on how to allocate your money. Ideally, you’ll want to raise just enough to execute on an investment at the lowest possible cost of capital.
Now that you know how to use the cost of capital formula, you’re better equipped to manage your business finances in a way that will facilitate growth and minimize overhead.