Using the Cost of Capital Formula

There’s a common question that nearly every business leader and stakeholder has heard at least once: Is it in the budget?

While reviewing balance sheets and other financial statements can help answer this question, a firm grasp of financial concepts—such as cost of capital—is critical to doing so.

Stakeholders who want to articulate a return on investment—whether a systems revamp or new warehouse—must understand cost of capital. Here’s an overview of cost of capital, how it’s calculated, and how it impacts business and investment decisions alike.

Weighted Average Cost of Capital (WACC)

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.

What is the cost of capital formula?

The cost of capital formula is a calculation that analysts use to find a companys 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.

Heres 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)]

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 companys market value of debt on its balance sheet for the year. However, you can also subtract accounts payable from a companys 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 companys equity and debt. To find the total market value of debt and equity, you can simply add the value of a companys 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 companys 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 companys 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 companys balance sheet, so most analysts take this value from that source.

Continuing with the example, if the companys market value of debt is $1 million and the accountant knows the companys 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 companys 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 companys corporate tax rate. You can find a companys tax rate by dividing the amount of money it pays in taxes by its total earnings.

For this example, consider that the companys 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%.

FAQ

How do you calculate the cost of capital?

How to Calculate Cost of Capital
  1. Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)
  2. Equity is the amount of cash available to shareholders as a result of asset liquidation and paying off outstanding debts, and it’s crucial to a company’s long-term success.

What is cost of capital with example?

The firm’s overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.

Why do we calculate cost of capital?

Cost of Capital is the rate of return the firm expects to earn from its investment in order to increase the value of the firm in the market place. In other words, it is the rate of return that the suppliers of capital require as compensation for their contribution of capital.

Is cost of capital same as WACC?

Cost of capital is the total of cost of debt and cost of equity, whereas WACC is the weighted average of these costs derived as a proportion of debt and equity held in the firm.

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