Cost of capital means the cost of a company’s funds (debt and equity), or as an investor, ‘it is the shareholder’s return on a collection of all the company’s existing securities.’ It is used in evaluation of new projects of a company because it is the minimum return which investors expect to provide capital to the company. This is why it is important to know how to calculate cost of capital.
It sets a benchmark that a new project has to meet. It has many functions in finance and accounting, like capital budgeting, evaluation of financial performance and merger and acquisition analysis. Cost of capital means the cost at which the organization’s funds were acquired. It is helpful in evaluating whether a specific investment is worthwhile and is it setting benchmark for the minimum rate of return. In simpler words, knowing what the cost of capital is helps in making the decision making process easy.
Instructions
- At first you have to understand what cost of capital is. Share holders and creditors are those entities who invest in the firm. They expect a return for their investments. The return which is expected by the creditors is called as the cost of debt and the return which is expected by the shareholders is called as the cost of equity. The average return expected by all investors is called the cost of capital. It is like a hurdle rate for investment opportunities which the firm intends to take on. To make it worthwhile, it is necessary for all the projects and investments to exceed the cost of capital.
- Determine the cost of debt. It is the average interest rate on which the firm pays all its debt. The market value of the debt should be used if the data is available as it will be accurate then. The firm’s average interest on all its debt in a footnote should be stated by the firm’s most recent 10000 reports. If the firm is publicly traded, its bond rating and the current rating estimate of the yield to maturity (YTM) of the bonds with these rating should be looked up. For example, standard and poor’s 500 can estimate YTM of AAA rated bonds to be 6%. But if the firm which is being analyzed is small and private, then its recent borrowing history or its debt level should be evaluated. You can evaluate this by comparing its financial ratios to the financial ratios of those companies that have credit ratings.
- Calculate the cost of equity. There are many ways to calculate it but the simplest and most popular approach is given here.
Cost of equity = risk free rate + beta x (market rate of return – risk free rate)
Cost of equity = risk free rate + beta x market risk premium
Here beta stands for the sensitiveness of the firm to its market fluctuation.
Here you can see that finding the cost of equity includes some assumptions and estimations. You have to judge yourself which number you are going to include in your calculation or you are going to use the average of different numbers.
- Compute the firm’s proportion of debt and equity in the firm’s capital structure.
Weight of debt = amount of debt / (amount of debt + amount of equity)
Weight of equity = amount of equity / (amount of debt + amount of equity)
- Compute the cost of capital using the equations worked out previously.
Weighted average cost of capital = cost of debt x weight of debt x (1 – tax rate) + cost of equity x weight of equity.
The cost of capital, we got, is that one which the firm should use to evaluate the investment opportunity.
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