Cost of capital is the return that is necessary for a company to invest in a major project like building a plant or factory. To optimize profitability, a company will only invest or expand operations when the projected returns from a project are greater than the cost of capital, which includes both debt and equity. Debt capital is raised by borrowing funds through various channels, such as acquiring loans or credit card financing. On the other hand, equity financing is the act of selling shares of common or preferred stock. The primary way that market risk affects cost of capital is through its effect on cost of equity.

Understanding Cost of Capital

A company's total cost of capital includes both the funds required to pay interest on debt financing and the dividends on equity funding. The cost of equity funding is determined by estimating the average return on investment that could be expected based on returns generated by the wider market. Therefore, because market risk directly affects the cost of equity funding, it also directly affects the total cost of capital.

Key Takeaways

  • Cost of capital refers to the return required to make a company's capital investment project worthwhile.
  • Cost of capital includes debt financing and equity funding.
  • Market risk affects cost of capital through the costs of equity funding.
  • Cost of equity is typically viewed through the lens of CAPM.
  • Estimating cost of equity can help companies minimize total cost of capital, while giving investors a sense of whether or not expected returns are enough to compensate for the risk.

The cost of equity funding is generally determined using the capital asset pricing model, or CAPM. This formula utilizes the total average market return and the beta value of the stock in question to determine the rate of return that stockholders might reasonably expect based on the perceived investment risk. The average market return is estimated using the rate of return generated by a major market index, such as the S&P 500 or the Dow Jones Industrial Average. The market return is further subdivided into the market risk premium and the risk-free rate.

The risk-free rate of return is typically estimated using the rate of return of short-term Treasury bills because these securities have stable values with guaranteed returns backed by the U.S. government. The market risk premium is equal to the market return minus the risk-free rate and reflects the percentage of investment return that can be attributed to stock market volatility.

For example, if the current average rate of return for investments in the S&P 500 is 12% and the guaranteed rate of return on short-term Treasury bonds is 4%, then the market risk premium is 12% - 4%, or 8%.

Computing Cost of Capital with CAPM

The cost of equity capital, as determined by the CAPM method, is equal to the risk-free rate plus the market risk premium multiplied by the beta value of the stock in question. A stock's beta is a metric that reflects the volatility of a given stock relative to the volatility of the larger market.

A beta value of 1 indicates that the stock in question is equally as volatile as the larger market. If the S&P 500 jumps 15%, for instance, the stock is expected to show similar 15% gains. Beta values between 0 and 1 indicate the stock is less volatile than the market, while values above 1 indicate greater volatility.

Assume a stock has a beta value of 1.2, the Nasdaq generates average returns of 10%, and the guaranteed rate of return on short-term Treasury bonds is 5.5%. The rate of return that can reasonably be expected by investors can be computed using the CAPM model:

Return=5.5%+1.2×(10%5.5%)=10.9%\begin{aligned} &\text{Return} = 5.5\% + 1.2 \times (10\% - 5.5\%) = 10.9\% \\ \end{aligned}Return=5.5%+1.2×(10%5.5%)=10.9%

Using this method of estimating the cost of equity capital enables businesses to determine the most cost-effective means of raising funds, thereby minimizing the total cost of capital. From the perspective of the investor, the results can help decide whether the expected return justifies investment given the potential risk.