What Is Cost of Capital? Calculation Formula and Examples
Updated August 8, 2022
Cost of capital is an important component of accounting and financial analysis for a business. The cost of capital should be minimal for a business that successfully manages its finances. In this article, we discuss what the cost of capital is, why it is important and how you can calculate it to benefit your business with a few examples.
What is cost of capital?
Cost of capital refers to the return a company expects on a specific investment to make it worth the expenditure of resources. In other words, the cost of capital determines the rate of return required to persuade investors to finance a capital budgeting project.
The cost of capital is heavily dependent on the type of financing used in the business. A business can be financed through debt or equity. However, most companies employ a mixture of equity and debt financing. Therefore, the cost of capital comes from the weighted average cost of all capital sources.
Read more: Using the Cost of Capital Formula
How to calculate cost of capital
To calculate the weighted average cost of capital (WACC), you must first calculate the cost of debt and the cost of equity, which are represented by these formulas:
1. Cost of debt
The cost of debt refers to interest rates paid on any debt, such as mortgages and bonds. Interest expense is the interest paid on current debt.
2. Cost of equity
Cost of equity refers to the return a company requires to determine if capital requirements are met in an investment. Cost of equity also represents the amount the market demands in exchange for owning the asset and therefore holding the risk of ownership.
The cost of equity is approximated by the capital asset pricing model (CAPM):
In this formula:
Rf= risk-free rate of return
Rm= market rate of return
Beta = risk estimate
3. Weighted average cost of capital
The cost of capital is based on the weighted average of the cost of debt and the cost of equity.
In this formula:
E = the market value of the firm's equity
D = the market value of the firm's debt
V = the sum of E and D
Re = the cost of equity
Rd = the cost of debt
Tc = the income tax rate
Examples of cost of capital
Companies that are operating efficiently should have a cost of capital lower than or equal to their competitors in the same industry. Here are some examples of cost of capital and how it is calculated:
New Homes Real Estate Investment Trust is analyzing a kitchen and bathroom renovation on 25 apartment homes. The renovation will cost $30 million and is expected to save $5 million per year for the next five years. There is a slight risk that the renovation may not save New Homes a full $5 million per year. New Homes could also choose to invest in a five-year bond that has the same amount of risk, with a return of 10% per year.
The renovation project is expected to return 16% per year ($5,000,000 / $30,000,000). The renovation project is a better investment than the five-year bond because the required rate of return exceeds the 10% return New Homes could've gotten elsewhere.
The newly formed Gold Company needs to raise $1.5 million in capital to buy an office and the necessary equipment to run its business. The company raises the first $800,000 by selling stocks. Shareholders demand a 5% return on their investment, so the cost of equity is 5%.
Gold Company then sells 700 bonds for $1,000 each to raise the remaining $700,000 in capital. The individuals who purchase those bonds expect a 10% return, so Gold Company's cost of debt is 10%.
Gold Company's total market value is $1.5 million, and its corporate tax rate is 25%. The weighted average cost of capital can be calculated as:
Gold Company's weighted average cost of capital is 6.1%.
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