See Also:
Arbitrage Pricing Theory
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return
APV Valuation
Cost of Capital Definition
The cost of capital definition is a company’s cost of funding. Depending on the company’s capital structure, the cost of capital will incorporate its cost of debt as well as its cost of equity. Cost of debt refers to the company’s cost of raising funds through debt financing; whereas, cost of equity refers to the company’s cost of raising funds through equity offerings.
The cost of capital of a business represents the market’s required rate of return on capital invested in that company. It equals the rate of return on a project or investment with similar risk. A company’s cost of capital is the rate of return the company would earn if it invested its capital in a company of equivalent risk.
For a corporate project, cost of capital equals the rate of return on an investment or project of similar risk. The project cost of capital is the required rate of return, or hurdle rate, for the project. The expected returns of the project or investment must exceed the project cost of capital for the project to be deemed a worthwhile investment opportunity.
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Determining the Cost of Capital
Evaluating a project or investment requires determining the cost of capital. The investment will be attractive as long as the expected returns on the project or investment exceed the cost of capital. The cost of capital can be the cost of debt, the cost of equity, or a combination of both.
Cost of Debt
A company’s cost of debt represents its borrowing costs on loans, bonds, and other debt instruments. It is the company’s debt financing costs. A higher cost of debt means the company has poor credit and higher risk. A lower cost of debt implies the company has good credit and less risk.
Calculating the cost of debt is relatively simple. It is the interest rate on the company’s debt obligations. If the company has numerous differing debt obligations, then the cost of debt is the weighted average of those interest rates.
Cost of Equity
Cost of equity refers to the market’s required return on an equity investment. It is the return required to get investors to purchase shares of a company’s equity. Furthermore, investors will demand a specific return for invested capital given the risk of the equity investment. The cost of equity, which compensates investors for time value and a risk premium, is that required rate.
You can either calculate the cost of equity by using the capital asset pricing model (CAPM) or the dividend capitalization model. It can also be estimated by finding the cost of equity of projects or investments with similar risk. Like with the cost of debt, if the company has more than one source of equity – such as common stock and preferred stock – then the cost of equity will be a weighted average of the different return rates.
Cost of Equity Formula
The following formula is the dividend capitalization model, or the cost of equity formula.
Ke = ( D1 / P0 ) + G
Ke – cost of equity
D1 – next year’s dividend
P0 – current stock price
G – dividend growth rate
Weighted Average Cost of Capital (WACC)
Combining the cost of equity and the cost of debt in a weighted average will give you the company’s weighted average cost of capital, or WACC. This rate can also be considered the required rate of return, or the hurdle rate of return, that a proposed project’s return must exceed in order for the company to consider it a viable investment.
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