What is the cost of capital and why is it important?

If you are involved in corporate finance, you need to understand what the cost of capital is and why it is important. The cost of capital is the minimum rate of return that a company must earn on its investments to maintain its market value and attract funds. It reflects the risk and opportunity cost of investing in a specific project or business. In this article, you will learn how to calculate the cost of capital, how it affects capital budgeting decisions, and what factors influence it.

Key takeaways from this article

Optimize capital structure:

Adjusting your mix of debt, equity, and retained earnings can fine-tune your cost of capital. For example, not paying dividends and instead boosting retained earnings can decrease your cost of capital, enhancing company value.
Adjust hurdle rates:

When assessing projects with varying risk levels, apply a risk premium to the weighted average cost of capital. This ensures you’re evaluating each initiative’s true potential against the right benchmark, leading to more informed investment decisions.

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1 How to calculate the cost of capital

The cost of capital is usually a weighted average of the costs of different sources of financing, such as debt, equity, and preferred stock. Each source has its own cost, which depends on the interest rate, the tax rate, the dividend rate, and the market price. To calculate the weighted average cost of capital (WACC), you need to multiply the cost of each source by its proportion in the total capital structure, and then add them up. For example, if a company has 40% debt, 50% equity, and 10% preferred stock, and the costs of each source are 6%, 12%, and 8%, respectively, the WACC is:

WACC = 0.4 x 6% + 0.5 x 12% + 0.1 x 8% = 9.2%

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Ernest Festus Awudey

BSc. Accounting • Financial Analyst (FMVA®) • BI & Data Analyst (BIDA®) • ICAG Level 3
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The cost of capital for a business is the required rate of return for the investor, hence it is an important issue to consider in financing projects. Usually, the cost of capital is the weighted average cost of all sources of capital that a company uses because in practice, these different sources of funds are put into a "pool of funds" from which projects are financed. Depending on the capital structure of a company, the WACC seems to be the most representative measure of this rate. To calculate the WACC, we calculate the cost of each individual source of finance and weight it according to its importance in the financing mix.

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2 How the cost of capital affects capital budgeting decisions

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the company's goal of maximizing shareholder value. One of the main criteria for choosing a project is its net present value (NPV), which is the difference between the present value of its cash inflows and outflows. A project is acceptable if its NPV is positive, meaning that it generates more value than it costs. The cost of capital is the discount rate that is used to calculate the present value of the cash flows. Therefore, the higher the cost of capital, the lower the NPV, and the less likely the project will be accepted. The cost of capital also serves as a hurdle rate, which is the minimum required rate of return for a project to be viable.

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Maulik Nagri

Experienced Finance Executive | FP&A Process Builder | Shareholder Value Creator | SaaS Finance Expert | Profitable Growth Driver
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Cost of capital is a fantastic tool for prioritizing capital projects yielding higher NPV/ROI. This concept is even more useful when there are multiple positive NPV project options available in a capital-scarce environment. Also, it is common practice to add an arbitrary project risk premium to the corporate cost of capital (its weighted cost of capital, or WACC). Intuitively, the cost of capital for building a new plant to serve unmet existing customer demand is lower than that of building a new plant for a new product with an unproven demand profile, reflecting the higher underlying risk of the latter project. This hurdle rate concept goes hand in hand with a firm's finite budget for capital expenditures.

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Ernest Festus Awudey

BSc. Accounting • Financial Analyst (FMVA®) • BI & Data Analyst (BIDA®) • ICAG Level 3
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The cost of capital, which is the weighted average cost of capital (WACC) is also the rate used in discounting cash flows from capital investment projects (projects of a long-term nature and demands huge amount of funding) to obtain present values which when totalled equals the NPV. And the decision rule for accepting any capital investment project is its ability to generate a positive NPV. So in effect, using the discounting formula [1/(1+r)^n] Where: r is the cost of capital, and n is the number of years the project will take, an increase in the cost of capital will mean that the NPV will be lower and the less likely such project will be accepted. Companies therefore seek to reduce their cost of capital as much as possible.

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3 What factors influence the cost of capital

The cost of capital is influenced by both external and internal factors. External factors are the market conditions and expectations that affect the availability and cost of financing, such as the interest rate, the inflation rate, the risk premium, and the investor preferences. Internal factors are the company-specific characteristics and decisions that affect the risk and return of its investments, such as the capital structure, the dividend policy, the growth rate, and the profitability. The company can control some of the internal factors, but not the external ones. Therefore, it is important to monitor and adjust the cost of capital according to the changing environment and the strategic objectives.

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Ernest Festus Awudey

BSc. Accounting • Financial Analyst (FMVA®) • BI & Data Analyst (BIDA®) • ICAG Level 3
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Just as investors face systematic and unsystematic risks in making investment decisions, so do companies in optimising their cost of capital. Unfortunately, systematic risk factors which are external and outside of the control of the investor cannot be done away with. Companies however have control over the unsystematic risk factors that influence their cost of capital including capital structure, dividend policies, and the level of profitability. Streamlining these internal influences is the best way to affect the cost of capital internally. For instance, a dividend policy in which dividends are not paid but rather added to retained earnings will increase the company's value and thus reduce its overall cost of capital.

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4 How to optimize the cost of capital

The cost of capital is not a fixed or static number. It can vary over time and across different projects or divisions. The company can optimize its cost of capital by finding the optimal mix of financing sources that minimizes the WACC and maximizes the value of the firm. This involves balancing the benefits and costs of debt and equity, such as the tax shield, the financial flexibility, the risk, and the agency costs. The company can also optimize its cost of capital by selecting the appropriate projects that match its risk and return profile, and by diversifying its portfolio to reduce the overall risk.

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5 How to measure the cost of capital

The cost of capital is not directly observable or measurable. It is an estimate based on assumptions and models. Therefore, it is subject to errors and uncertainties. The company can measure its cost of capital by using different methods and sources of information, such as the capital asset pricing model (CAPM), the dividend discount model (DDM), the bond yield plus risk premium (BYPRP) method, the market data, and the industry averages. The company can also compare its cost of capital with its peers and competitors, and with its historical and expected performance. The company should use multiple methods and sources to cross-check and validate its cost of capital estimate, and to update it regularly.

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