Cost of Capital Formula: Key Components and How to Calculate It
Learn how to calculate cost of capital by understanding its key components, improving financial decision-making and evaluating investment opportunities.
Every business decision, from launching a new product to expanding operations, involves considering the cost of capital. This figure represents the minimum return a company must earn to satisfy its investors and lenders. Understanding this cost influences investment choices, financial planning, and overall corporate strategy.
Calculating the cost of capital involves several components. Knowing how it’s determined can help businesses make funding decisions and assess potential projects.
Components in the Formula
A company’s overall cost of capital combines the costs associated with each type of funding it uses. These components reflect the returns demanded by different capital providers based on the risk they assume.
Cost of Debt
The cost of debt is the effective interest rate a company pays on its borrowings, such as bank loans and bonds. Interest paid on debt is often a tax-deductible expense, creating a “tax shield” that reduces the actual cost.
For instance, if a company borrows at a 5% interest rate and faces a 21% corporate tax rate, the after-tax cost of debt is calculated as the interest rate multiplied by (1 – tax rate). This results in 5% * (1 – 0.21) = 3.95%. This lower after-tax figure reflects the true cash outflow considering tax savings and is used in the overall cost of capital calculation.
Cost of Equity
Equity financing represents ownership, and its cost is the return required by equity investors for the risk of owning the stock. This return comes from potential dividends and stock price appreciation.
Calculating this cost is less direct than for debt. Common methods include the Capital Asset Pricing Model (CAPM), which uses the risk-free rate, the stock’s beta (volatility relative to the market), and the expected market risk premium. Another approach is the Dividend Discount Model (DDM), estimating the cost based on expected future dividends, current share price, and dividend growth rate.
Cost of Preferred Stock
Preferred stock combines features of debt and equity. Holders usually receive fixed dividends before common stockholders, but typically lack voting rights. The company isn’t legally obligated to pay preferred dividends if funds are insufficient, though unpaid dividends often accumulate.
The cost of preferred stock is found by dividing the annual fixed dividend payment per share by the current market price per share. If a preferred share pays a $3 annual dividend and trades at $50, the cost is $3 / $50 = 6%. Unlike debt interest, preferred dividends are paid from after-tax profits and are not tax-deductible for the company.
Steps for Calculation
Calculating the overall cost involves blending the individual costs into a single figure, the Weighted Average Cost of Capital (WACC). This requires determining the proportion, or weight, of each capital type—debt, equity, and preferred stock—in the company’s total capital structure. Analysts usually use market values for these weights as they better reflect current economic conditions.
To find the market value weights, start with the market value of equity (market capitalization), calculated by multiplying the current share price by the number of outstanding shares.
Next, determine the market value of the company’s debt. While book value is sometimes used, estimating the current market price of bonds or loans is more precise, often using the yield to maturity (YTM) on traded debt or comparing to similar companies. Sum the market values if there are multiple debt issues.
Similarly, find the market value of preferred stock by multiplying the current market price per preferred share by the number of outstanding preferred shares.
Once the market values for equity (E), debt (D), and preferred stock (P) are known, the total market value of capital (V) is their sum (V = E + D + P). The weight for each component is its market value divided by the total market value: E/V for equity, D/V for debt, and P/V for preferred stock.
With the weights and the individual costs—cost of equity (Re), after-tax cost of debt (Rd * (1-T)), and cost of preferred stock (Rp)—the WACC is calculated using the formula:
WACC = (E/V * Re) + (D/V * Rd * (1-T)) + (P/V * Rp).1Investopedia. Weighted Average Cost of Capital (WACC): Definition and Formula
This formula multiplies each component’s cost by its market value weight and sums the results, yielding the company’s blended, after-tax cost of capital. Remember to use the after-tax cost for debt due to the tax deductibility of interest payments.
Interpreting the Results
The Weighted Average Cost of Capital (WACC) serves as a benchmark for financial decisions. It represents the average return required to satisfy all capital providers. A lower WACC often suggests a healthier business able to attract capital at lower costs, while a higher WACC usually indicates greater perceived risk and more expensive financing.2Investopedia. What Is a Good WACC? Analyzing Weighted Average Cost of Capital
WACC is frequently used as a “hurdle rate” for evaluating new investments.3Investopedia. Hurdle Rate: What It Is and How Businesses and Investors Use It A potential project’s expected rate of return, like its Internal Rate of Return (IRR), should exceed the WACC to be considered financially viable.4Saylor Academy. Cost of Capital: WACC and Investment Decisions If the return is higher, the project is expected to add value; if lower, it may diminish value.
WACC is also used in determining business value, particularly via the Discounted Cash Flow (DCF) method.5Investopedia. Discounted Cash Flow (DCF) Explained With Formula and Examples Future free cash flows are projected and discounted back to their present value using WACC as the discount rate. This estimates the company’s intrinsic value based on future earnings potential, adjusted for risk and the time value of money. A lower WACC results in a higher valuation, and vice versa.
Interpreting WACC requires acknowledging its limitations. The calculation relies on estimates, such as the cost of equity and market risk premium, and assumes a constant capital structure and tax rate, which might change. Also, the standard WACC reflects the company’s average risk. Applying this single rate to projects with different risk profiles can be misleading. Some companies adjust the hurdle rate for specific projects based on their individual risk. WACC provides a useful baseline but should be considered alongside other financial metrics and qualitative factors.