What is 'Cost of Capital’?

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. Cost of capital is the minimum rate of return that a business must earn before
generating value. Before a business can turn a profit, it must at least generate sufficient income
to cover the cost of the capital it uses to fund its operations.

Cost of capital consists of both the cost of debt and the cost of equity used for financing a
business. Many companies use a combination of debt and equity to finance their businesses
and, for such companies, the 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.

Cost of Capital and Equity Financing:

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.

HOW IT WORKS (EXAMPLE):

Cost of capital is determined by the market and represents the degree of perceived risk by
investors. When given the choice between two investments of equal risk, investors will
generally choose the one providing the higher return.
Let's assume Company XYZ is considering whether to renovate its warehouse systems. The
renovation will cost $50 million and is expected to save $10 million per year over the next 5
years. There is some risk that the renovation will not save Company XYZ a full $10 million per
year. Alternatively, Company XYZ could use the $50 million to buy equally risky 5-year bonds in
ABC Co., which return 12% per year.

Because the renovation is expected to return 20% per year ($10,000,000 / $50,000,000), the
renovation is a good use of capital, because the 20% return exceeds the 12% required return
XYZ could have gotten by taking the same risk elsewhere.

How to Calculate Cost of Capital?

The most common approach to calculating the cost of capital is to use the Weighted Average
Cost of Capital (WACC). Under this method, all sources of financing are included in the
calculation and each source is given a weight relative to its proportion in the company’s capital
structure.

WACC provides us a formula to calculate the cost of capital: