What Is Composite Cost of Capital?
Composite cost of capital is calculated by multiplying the cost of each capital component by its proportional weight. A company's debt and equity, or its capital structure, typically includes common stock, preferred stock, bonds, and any other long-term debt.
- Composite cost of capital represents a company's cost to finance its business as determined by its weighted average cost of capital (WACC).
- It is calculated by multiplying the cost of each capital component, including common stock, preferred stock, bonds, and other long-term debt, by its proportional weight.
- Composite cost of capital, or WACC, is used by companies to determine whether they could profitably finance a new expansionary project.
- Investors, meanwhile, rely on the metric to gauge if a stock is well-positioned to grow and worth buying.
Understanding Composite Cost of Capital
Companies have a variety of options available to raise money to make investments and fund their operations. They include selling equity by issuing shares of company stock, selling debt, borrowing money in the form of bonds or loans that must be paid back at a later date, or a mixture of the two.
Composite cost of capital tells us how much a company forks out, after tax, to get its hands on the money it needs to get by and expand. Figuring out this average rate can come in handy for a number of reasons. Among other things, it gives lenders and equity holders an idea of the return they can expect to receive on the funds or capital they have provided.
A high composite cost of capital signals that a company has high borrowing costs. A low composite cost of capital, on the other hand, implies the opposite.
Example of Composite Cost of Capital
Company ABC yields returns of 22% and has a composite cost of capital of 12%. In other words, it generates 10% returns on every dollar the company invests—or creates 10 cents of value for each dollar spent.
Company XYZ, on the other hand, registered returns of 11% and a composite cost of capital of 17%. Based on these numbers, it would appear that XYZ is losing 6 cents for every dollar spent.
How Composite Cost of Capital Is Used
Company management relies on composite cost of capital internally to make decisions. Based on the resulting figure, directors are able to determine whether the company could profitably finance a new expansionary project.
The goal is to identify whether an investment is worthwhile and not liable to generate less than it cost.
Investors, meanwhile, may use a company's composite cost of capital as one of several factors in deciding whether to buy the company's stock. A company with a relatively low composite cost of capital may be better positioned to grow and expand, potentially rewarding shareholders.
While the cost of issuing debt is fairly straightforward, the cost of issuing stock has more variables.
Securities analysts frequently consult WACC when assessing the value of investments. For example, in discounted cash flow (DCF) analysis, the WACC can be applied as the discount rate for future cash flows in order to derive a business's net present value (NPV).
The average investor might have difficulty computing composite cost of capital. WACC requires access to detailed company information, and certain elements of the formula, such as cost of equity, are not consistent values and may be reported differently.
As a result, while composite cost of capital can often help lend valuable insight into a company, it must also be treated with caution. In most cases, investors are advised to use this metric alongside others to determine whether or not to invest in a stock.