Cost Of Capital

Definition of 'Cost Of Capital'


The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.

Investopedia explains 'Cost Of Capital'


The cost of various capital sources varies from company to company, and depends on factors such as its operating history, profitability, credit worthiness, etc. In general, newer enterprises with limited operating histories will have higher costs of capital than established companies with a solid track record, since lenders and investors will demand a higher risk premium for the former.

Every company has to chart out its game plan for financing the business at an early stage. The cost of capital thus becomes a critical factor in deciding which financing track to follow – debt, equity or a combination of the two. Early-stage companies seldom have sizable assets to pledge as collateral for debt financing, so equity financing becomes the default mode of funding for most of them.

The cost of debt is merely the interest rate paid by the company on such debt. However, since interest expense is tax-deductible, the after-tax cost of debt is calculated as: Yield to maturity of debt x (1 - T) where T is the company’s marginal tax rate.

The cost of equity is more complicated, since the rate of return demanded by equity investors is not as clearly defined as it is by lenders. Theoretically, the cost of equity is approximated by the Capital Asset Pricing Model (CAPM) = Risk-free rate + (Company’s Beta x Risk Premium).

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 after-tax cost of debt is 7%. Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%. This is the cost of capital that would be used to discount future cash flows from potential projects and other opportunities to estimate their Net Present Value (NPV) and ability to generate value.

Companies strive to attain the optimal financing mix, based on the cost of capital for various funding sources. Debt financing has the advantage of being more tax-efficient than equity financing, since interest expenses are tax-deductible and dividends on common shares have to be paid with after-tax dollars. However, too much debt can result in dangerously high leverage, resulting in higher interest rates sought by lenders to offset the higher default risk.



comments powered by Disqus
Hot Definitions
  1. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an investor has bought securities on margin, the minimum required level of margin is 25% of the total market value of the securities in the margin account.
  2. Leased Bank Guarantee

    A bank guarantee that is leased to a third party for a specific fee. The issuing bank will conduct due diligence on the creditworthiness of the customer looking to secure a bank guarantee, then lease a guarantee to that customer for a set amount of money and over a set period of time, typically less than two years.
  3. Degree Of Financial Leverage - DFL

    A ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. Degree of Financial Leverage (DFL) measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT).
  4. Jeff Bezos

    Self-made billionaire Jeff Bezos is famous for founding online retail giant Amazon.com.
  5. Re-fracking

    Re-fracking is the practice of returning to older wells that had been fracked in the recent past to capitalize on newer, more effective extraction technology. Re-fracking can be effective on especially tight oil deposits – where the shale products low yields – to extend their productivity.
  6. TIMP (acronym)

    'TIMP' is an acronym that stands for 'Turkey, Indonesia, Mexico and Philippines.' Similar to BRIC (Brazil, Russia, India and China), the acronym was coined by and investor/economist to group fast-growing emerging market economies in similar states of economic development.
Trading Center