Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.
A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.
Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure represents how a firm finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.
A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.
Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt increases. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness. We'll discuss optimal capital structure further in section 14.
Controllable Factors Affecting Cost of Capital
These are the factors affecting cost of capital that the company has control over:
- Capital Structure Policy
A firm has control over its capital structure, and it targets an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.
- Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the marginal cost of capital schedule can be changed. For example, as the payout ratio of the company increases, the breakpoint between lower-cost internally generated equity and newly issued equity is lowered. (Read How And Why Do Companies Pay Dividends? and Due Diligence On Dividends to learn more.)
- Investment Policy
It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.
Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has no control over:
- Level of Interest Rates
The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital.
Cost Of Equity
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.