Understanding Cost of Capital

It is the fundamental principle that "Higher the risk, higher the returns." That is from the view of investors. For a business, it is "Higher the risk higher is the cost." 

That is why "Risk Hai to Ishq Hai" is exciting only in a web series. In real life, an intelligent investor tries to minimize risk while getting adequate returns. And a company aims to curtail the risk involved to reduce the cost of capital.

But do you know what it is? Let's understand its meaning and importance. 

What Is the Cost of Capital?

In simple words, the cost of capital is the minimum rate of return that a firm must earn from its investments before a business could turn a profit. The business must at least generate sufficient returns to cover the cost of capital that it uses to fund its operations.  

The cost of capital is the cost of different components of the capital of a firm, i.e., cost of debt and cost of equity. 

In today's world, it has become impossible for a business to survive solely on debt or equity. It is so because owners don't have enough capital to fund the entire project. And the banks are hesitant to give loans if the equity invested is low. That is why all companies take the financing decision to combine both equity and debt. It helps to undertake projects without much equity and also in getting loans from banks comfortably. Therefore, the cost of capital is widely known as the Weighted Average Cost of Capital (WACC).

Why Is Cost of Capital Important?

You know that there are two ways to finance your business: Debt or Equity. A wise person always aims to minimize the cost to increase profits. Cost includes the cost of capital also. So, try to minimize it by analyzing the different alternatives available.

Moreover, it is considered to decide whether to make a capital budgeting decision. It includes acquiring an asset or undertaking a project. If the investment can't generate more returns than WACC, why will the company take it in the first place? It will prefer to invest in other instruments like share market or mutual funds.

Besides being vital for the company, it is also crucial for investors. They analyze whether the investment is worth investing in by comparing the returns with the risk involved. The risk is assessed by calculating the beta of a stock. If it is volatile, investors expect higher returns. If the returns are not worth the risk, they quit that investment and invest somewhere else.

Computation

You would have known that returns should be more than the cost. You can get data about absolute returns and CAGR effortlessly. But how will you compare them if you don't even know how to compute the cost of capital. So let's understand how to calculate the cost of capital.

Cost of Debt

It is merely the interest paid by the company on its debt. But the interest expense is deductible from tax, which should also be considered. Ignoring tax will lead to overvaluation of the cost of debt. 

Cost of debt = Interest paid on debtTotal Debt* (1-T) where T= Company’s Marginal Tax Rate

Cost of Equity

It is more difficult to compute as the desired rate of return is not clearly defined by equity investors.

Cost of Equity = Rf​ + β(Rm−Rf​)

Where

Rf​ = risk-free rate of return

Rm ​= market rate of return​

β = Beta of a stock, which is calculated based on stock data

The overall cost of capital is the weighted average of the above costs. For example, if the capital structure of a company consists of 80% equity and 20% debt. And the cost of equity and cost of debt is 10% and 7% (after-tax). Then WACC will be:

(0.8*10%) + (0.2*7%) = 9.4%

It is the cost of capital that we consider for various purposes. A company will undertake projects if the returns generated are more than 9.4%. Investors will also try to find investments having more than 9.4% returns, assuming the cost of capital to be constant. 

Role of WACC in Financial Modeling

Did you know that WACC is also considered in Financial Modeling? If no, don't worry. We have got you covered.

WACC acts as a discount rate in financial modelling. It is used in the DCF model to discount the future cash flows from different projects and calculate their Net Present Value and the capability to generate value.

How to Minimize the Cost of Capital?

As mentioned above, the cost of capital is a cost for the company. That is why it aims to minimize the cost of capital. Here are some ways to cut it down:

• Lowering the cost of equity: Cost of equity is the returns desired by the equity investors. They depend on the risk profile of the company. If the company can lower its business risk, then investors can also be satisfied with lower returns due to less risk present in their investment. It will reduce the cost and maximize profits.
• Financial Leverage: You may believe that becoming debt-free is a goal for many companies. But companies can get the benefit of financial leverage by raising debt to fund the business. It is so because interest paid is relatively cheaper due to tax deduction and lower cost due to less risk associated with debt funds. 

Debt should be raised to a limit until Return on Investment exceeds the cost of debt. But a company should avoid over-leveraging as it can create an enormous financial burden in case of instability, as it happened in 2020 due to lockdown. 

Closing Words

Cost of capital is the total cost of the capital structure present in a company. It is considered to take a capital budgeting decision by the company. And to assess the investment by an investor. It includes the cost of debt (interest expense of a company) and cost of equity (returns desired by investors). It is also used as a discount rate to discount the future cash flows of a business. To minimize it, reduce the business risk and avail the benefit of financial leverage. But avoid the excessive use of debt.

In the end, remember that intelligent people make decisions based on opportunity costs. So, compare all costs before making the final decision.