Using the Cost of Capital Formula
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Knowing how to find cost of capital can be very valuable to a business, as it can inform their financial decisions. To calculate the cost of capital, most accountants or analysts use the cost of capital formula, sometimes called the weighted average cost of capital (WACC) formula. You might benefit from being familiar with the cost of capital formula if you work in accounting or for a business that works with investors. In this article, we identify the cost of capital formula and explain how to use it.
What is the cost of capital formula?
The cost of capital formula is a calculation that analysts use to find a company's cost of capital. The formula measures the actual cost of the money that companies acquire and use for their business. This might include funds from fundraising efforts, sale of stock exchange shares or distribution of interest-paying bonds.
Because each of these funds requires an element of repayment or payment up front, the cost of capital formula can tell an analyst how much money a company has to use after considering what it cost to acquire the capital they need.
Here's what the cost of capital formula looks like:
Cost of capital = [(market value of equity ÷ total market value of debt and equity) × cost of equity] + [(market value of debt ÷ total market value of debt and equity) × cost of debt × (1 - corporate tax rate)]
Who uses the cost of capital formula?
Any company can benefit from using the cost of capital formula, as it can tell them about their financial standings. This can help them make decisions about future operations or new initiatives, as a company should only take on new projects that can result in a return that is worth more than the cost of the capital it requires.
Investors who become shareholders of companies can also use the cost of capital formula to determine whether they should invest in a company. This is because an investor might only want to put money toward companies that show a low cost of capital or a profit margin that exceeds their cost of capital consistently.
Elements of the cost of capital formula
Here are the primary components that the cost of capital formula uses:
Cost of equity
The cost of equity refers to the amount of money a company needs to pay back to its investors for a specific project or investment. A company can determine its cost of equity by using the capital asset pricing model (CAPM) that looks like this:
Cost of common stock = risk free rate + [beta × (expected market return - risk free rate)]
Cost of debt
The cost of debt includes any money a business borrows form a bank or other financial source. Companies can consider any short-term or long-term business loans they take out to fund their business when calculating their cost of debt. To find the cost of debt, you can use the following formula:
Cost of debt = effective interest × (1 - marginal tax rate)
Market value of equity
The market value of equity is the value of shares a company has outstanding. This can refer to shares owned by internal board members as well as those owned by shareholders. To find the market value of equity, you can use this formula:
Market value of equity = current stock price × shares outstanding
Market value of debt
The market value of debt refers to how much debt a company currently has. Most analysts or accountants find a company's market value of debt on its balance sheet for the year. However, you can also subtract accounts payable from a company's total debt to find the market value of debt.
Effective tax rate
The effective tax rate is the average tax rate that a company pays. The formula to find the effective tax rate looks like this:
Effective tax rate = income tax expense ÷ earnings before taxes
Total market value of debt and equity
The total market value of debt and equity results from combining the values of a company's equity and debt. To find the total market value of debt and equity, you can simply add the value of a company's debt to the value of its equity.
How to calculate cost of capital using the cost of capital formula
Here are some steps for how to use the cost of capital formula:
1. Divide market value of equity by the total market value of debt and equity
Find the market value of equity and the total market value of debt and equity. Then, divide the market value of equity by the total market value of debt and equity.
For example, if a company's market value of equity is $5 million and their combined market value of debt and equity is $8 million, the result for this portion of the calculation is .625.
2. Multiply the solution by the cost of equity
Find the cost of equity and multiply it by the result of dividing the value of equity by the combined value of debt and equity. You can find the cost of equity using the CAPM.
Considering the example, if the company's cost of equity is 8%, you can multiply .08 by .625 for a result of .05, or 5%.
3. Divide the market value of debt by the total market value of debt and equity
Find the market value of debt and divide it by the total value of debt and equity. Accountants typically list the market value of debt on a company's balance sheet, so most analysts take this value from that source.
Continuing with the example, if the company's market value of debt is $1 million and the accountant knows the company's total value of debt and equity is $8 million, the result for this part of the calculation is .125.
4. Multiply the solution by the cost of debt
Use the value from step three and multiply it by the cost of debt.
For this example, consider that the company has an outstanding business loan with an interest rate of 8%. This means that the company's cost of debt is 8%. Therefore, you can multiply 8% by .125 for a result of .01, or 1%.
5. Find the corporate tax rate
Determine the company's corporate tax rate. You can find a company's tax rate by dividing the amount of money it pays in taxes by its total earnings.
For this example, consider that the company's corporate tax rate is 19%.
6. Enter the values in the formula for the final calculation
Use the WACC formula to find the cost of capital. To do so, you can insert the values from previous steps into the formula and complete any necessary calculations.
In this example, the calculation can look like this:
Cost of capital = (.05 + .01) × (1 - .19) = .0486
This results in a cost of capital of .0486, or 4.86%.
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