Cost Of Capital

AAA

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.

RELATED TERMS
  1. Equivalent Annual Annuity Approach ...

    One of two methods used in capital budgeting to compare mutually ...
  2. Replacement Chain Method

    A capital budgeting decision model that is used to compare two ...
  3. Composite Cost Of Capital

    A company's cost to borrow money given the proportional amounts ...
  4. Cost Of Equity

    In financial theory, the return that stockholders require for ...
  5. Capital Budgeting

    The process in which a business determines whether projects such ...
  6. Weighted Average Cost Of Capital ...

    A calculation of a firm's cost of capital in which each category ...
RELATED FAQS
  1. How does a master limited partnership (MLP) differ from other business structures?

    The master limited partnership (MLP) is a unique hybrid legal structure that combines elements of a partnership with elements ... Read Full Answer >>
  2. What's the difference between economic value added (EVA) and producer surplus?

    The difference between economic value added (EVA) and producer surplus is that EVA measures the returns of a company above ... Read Full Answer >>
  3. What is the point of calculating economic value added (EVA)?

    Economic value added, or EVA, is a management performance measure that shows the profit earned by a company minus the cost ... Read Full Answer >>
  4. What do people mean when they say debt is a relatively cheaper form of finance than ...

    In this case, the "cost" being referred to is the measurable cost of obtaining capital. With debt, this is the interest expense ... Read Full Answer >>
  5. Which is a better measure for capital budgeting, IRR or NPV?

    In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each ... Read Full Answer >>
  6. What is the difference between the cost of capital and the discount rate?

    The cost of capital refers to the actual cost of financing business activity through either debt or equity capital. The discount ... Read Full Answer >>
Related Articles
  1. Investing Basics

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  2. Investing Basics

    Capital Budgeting

    Learn the process through which businesses determine whether projects are worth pursuing.
  3. Bonds & Fixed Income

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  4. Entrepreneurship

    The Basics Of Financing A Business

    From debt financing to equity financing, there are numerous ways to fund a business startup. But which is the best?
  5. Personal Finance

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  6. Fundamental Analysis

    Internal Rate Of Return: An Inside Look

    Use this method to choose which project or investment is right for you.
  7. Fundamental Analysis

    The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  8. Bonds & Fixed Income

    Investors Need A Good WACC

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
  9. Fundamental Analysis

    Calculating Future Value

    Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.
  10. Economics

    What is Deadweight Loss?

    Mainly used in economics, deadweight loss can be applied to any deficiency caused by an inefficient allocation of resources.

You May Also Like

Hot Definitions
  1. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  2. Covered Call

    An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset ...
  3. Butterfly Spread

    A neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration ...
  4. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
  5. Moving Average - MA

    A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random ...
  6. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
Trading Center