In today’s complex financial landscape, making informed investment decisions is crucial for a company’s success and long-term growth. One of the most critical aspects of this decision-making process is understanding how to calculate cost of capital.
A company’s cost of capital refers to the minimum return, it must generate from its projects to satisfy its investors and funders. Finding cost of capital is far from simple; it involves several components, each with its method and implications.
In this article, I’ll delve into the intricate process that companies use to calculate their cost of capital, including the Weighted Average Cost of Capital (WACC), which serves as a benchmark for evaluating investment opportunities. We’ll explore the cost of debt, where companies determine the price of borrowing and factor in tax advantages, and the cost of preferred stock, which provides insight into the fixed returns required by preferred shareholders.
Furthermore, we’ll unpack the cost of retained earnings, emphasizing the opportunity cost for shareholders and the expectation that retained profits will be reinvested wisely.
Table of Contents
- What is the cost of capital?
- Understanding Symbols for Costs and Weights
- Weighted Average Cost of Capital (WACC)
- Cost of Debt: Its Significance and Calculation
- What Is Cost of Debt?
- Why Do We Calculate the Cost of Debt?
- How to Calculate the Cost of Debt
- How to Calculate After-Tax Cost of Debt?
- Cost of Preferred Stock: Importance and Calculation
- What Is Cost of Preferred Stock?
- How to Calculate the Cost of Preferred Stock?
- Cost of Retained Earnings
- What Is Cost of Retained Earnings?
- How to Calculate Cost of Retained Earnings
- Bond-Yield-Plus-Risk-Premium
- Cost of New Common Stock
- How to Calculate Cost of New Common Stock?
- In Summary
What is the cost of capital?
A company’s cost of capital refers to the minimum return, it must generate on its projects or investments to cover the expense of financing its operations. This cost arises because companies use different sources of funds, each with its own price, to support their activities. These sources include debt (loans or bonds), preferred stock, and common equity (money from shareholders), collectively known as capital components.
Each capital component has a specific component cost, representing the return investors or lenders require. When companies combine these costs proportionally, they calculate the Weighted Average Cost of Capital (WACC).
WACC provides a benchmark that helps companies decide if an investment is worthwhile. If the expected return on a project is higher than the WACC, the investment is generally considered favorable.
Understanding Symbols for Costs and Weights
Before finding cost of capital and starting the calculation process, you will first have to understand the various symbols for capital costs and their weights.
- rd: The interest rate a company pays on its debt. This is the before-tax cost.
- rd(1−T): The after-tax cost of debt, which considers tax savings because interest is tax-deductible.
- rp: The cost of preferred stock doesn’t get tax benefits, so the before- and after-tax costs are the same.
- rs: The cost of common equity from profits the company keeps (internal equity).
- re: The cost of new common equity (external equity), which can be higher because of extra costs like issuing stock.
- wd, wp, wc: These represent the weights (percentages) of debt, preferred stock, and common equity in the company’s capital structure.
- WACC: The average cost of capital a company must earn to satisfy both debt and equity investors.
These are the common symbols you need to know before you start finding cost of capital
Now, as you know about all the symbols let’s start learning how to calculate cost of capital.
Weighted Average Cost of Capital (WACC)
Weighted average cost of capital is the average of the costs of all the capital components, adjusted by their respective weights. It tells us the minimum return a company needs to generate to make an investment worthwhile. Only debt has a tax adjustment because interest expenses lower taxable income.
In the blog “How to Calculate Weighted Average Cost of Capital” I explained the theory and the whole calculation process. Remember to read it and come back to this article again.
Let’s learn more about the weights.
Cost of Debt: Its Significance and Calculation
Understanding the whole theory and how to calculate cost of debt is crucial for companies aiming to make informed financial and investment decisions. Calculating cost of debt is not only essential for managing finances efficiently but also for making strategic decisions that can impact a company’s profitability and long-term sustainability.
What Is Cost of Debt?
The cost of debt refers to the effective interest rate a company pays on its borrowed funds, such as loans, bonds, or other forms of debt. This cost represents the price of borrowing and is crucial in determining the overall financial health of a business.
The cost of debt can be expressed in two forms: before-tax cost of debt and after-tax cost of debt. Since interest expenses are tax-deductible, companies typically calculate cost of debt after tax when assessing their capital structure and calculating the weighted average cost of capital (WACC).
Why Do We Calculate the Cost of Debt?
- Evaluating Investment Decisions: Understanding the cost of debt allows companies to determine whether the returns on an investment project are sufficient to cover the expense of borrowed funds.
- Capital Budgeting: For businesses looking to optimize their capital structure, determining cost of debt helps in assessing the proportion of debt to equity.
- Determining WACC: As you already know about WACC, the cost of debt is a fundamental component of the WACC, which is used to evaluate the minimum return a company must earn on its existing assets to satisfy both equity and debt holders.
- Risk Management: By understanding the cost of debt, companies can better manage financial risk.
How to Calculate the Cost of Debt
Calculating cost of debt involves understanding both the before-tax and after-tax interest rates. The process can be broken down into simple steps:
1. Calculate the Before-Tax Cost of Debt: This is the interest rate the company must pay on its borrowed funds. It can be determined by looking at the interest rates on outstanding loans or the yield to maturity on bonds.
Before-Tax Cost of Debt looks like:
2. Determine the Tax Rate: Identify the marginal tax rate applicable to the company. Since interest expenses reduce taxable income, the effective cost of debt is lower than the nominal interest rate.
3. Compute the After-Tax Cost of Debt:
How to Calculate After-Tax Cost of Debt?
The after-tax cost of debt accounts for the tax savings from interest expense deductions. This is calculated using the formula:
The after-tax cost of debt formula
$$ \text{After-tax cost of debt} = r_d(1 – T) $$
Where:
- rd = Before-tax cost of debt
- T = Tax rate
Generally, this is how you can calculate after tax cost of debt and the overall cost of debt of a project
Let’s consider a practical example to illustrate how to calculate cost of debt
Suppose XYZ Corporation has borrowed 1 million dollars at an interest rate of 8% per year. The company’s marginal tax rate is 30%.
1. Determine Before-Tax Cost of Debt:
$$ r_d = 8\% $$
2. Determine the Tax Savings: Since the tax rate is 30%, the tax savings on the interest expense will be:
$$ T = 0.30 $$
3. Calculate After-Tax Cost of Debt:
$$ \text{After-tax cost of debt} = r_d(1 – T) = 8\%(1 – 0.30) = 8\% \times 0.70 = 5.6\% $$
Therefore, the after-tax cost of debt for XYZ Corporation is 5.6%.
This means the effective cost of borrowing, after accounting for the tax benefit, is 5.6%.
Cost of Preferred Stock: Importance and Calculation
Understanding the cost of different capital components is crucial for making well-informed financial decisions. One such component is preferred stock, a type of equity that pays fixed dividends to shareholders.
What Is Cost of Preferred Stock?
The cost of preferred stock refers to the dividend rate that a company must pay to preferred shareholders, expressed as a percentage of the price at which the stock is issued. Unlike common stock, preferred stockholders are entitled to a fixed dividend payment, which does not change over time.
Because of this stability, the cost of preferred stock is relatively straightforward to calculate. However, it is important to note that dividends on preferred stock are not tax-deductible, unlike interest expenses on debt.
How to Calculate the Cost of Preferred Stock?
Calculating cost of preferred stock is relatively simple, as it primarily involves dividing the annual dividend payment by the current price of the preferred stock.
Cost of Preferred Stock Formula
$$ r_p = \frac{D_p}{P_p} $$
where:
- rp = Cost of preferred stock
- Dp = Annual dividend on preferred stock
- Pp = Current price of the preferred stock
Let’s look at an example to better understand how to calculate cost of preferred stock:
Suppose ABC Corporation issues preferred stock that pays an annual dividend of $10 per share. The current market price of the preferred stock is $97.50 per share.
1. Use Cost of Preferred Stock Formula
$$ r_p = \frac{D_p}{P_p} = \frac{10}{97.50} = 0.103, \text{ or } 10.3\% $$
In this case, the cost of preferred stock for ABC Corporation is 10.3%. This means that the company must earn at least 10.3% on the funds raised through preferred stock to satisfy its shareholders.
Key Considerations
1. Fixed Nature of Dividends: Unlike common equity, preferred stock pays a fixed dividend. This makes the cost of preferred stock relatively stable but also means it cannot be reduced through tax deductions, as preferred dividends are not tax-deductible.
2. Impact on Financial Planning: Companies must carefully consider the cost of preferred stock when planning their finances. If the cost is too high, it may make sense to explore alternative funding options, such as debt or common equity.
3. Investment Risk: Although preferred stock is generally considered less risky than common stock, it still carries more risk than debt. Investors typically expect a higher return on preferred stock than on debt to compensate for this additional risk.
By understanding how to calculate cost of preferred stock and its implications, businesses can better manage their funding sources and ensure sustainable growth.
Cost of Retained Earnings
Effective management of a company’s capital is crucial for achieving sustainable growth and maximizing shareholder value. One important concept that aids in strategic financial planning is the cost of retained earnings.
What Is Cost of Retained Earnings?
The cost of retained earnings (rs) refers to the return that shareholders expect when the company retains its earnings rather than paying them out as dividends. Even though it seems like there is no direct cost associated with retained earnings, there is an opportunity cost because shareholders could have invested this money elsewhere to earn returns.
Retained earnings are less expensive compared to raising new common stock, which is usually more expensive due to additional costs like flotation fees.
The concept emphasizes that retaining earnings has an implicit cost. Managers must ensure that reinvested funds generate returns that are at least as high as alternative investment options available to shareholders.
How to Calculate Cost of Retained Earnings
The cost of retained earnings is the rate of return that investors expect. in determining the cost of retained earnings companies use financial models like the Capital Asset Pricing Model (CAPM) and the Bond-Yield-Plus-Risk-Premium Approach.
CAPM Approach: This method involves estimating the risk-free rate, the stock’s beta (which measures risk compared to the market), and the market risk premium.
The formula for cost of retained earnings or CAPM
$$ r_s = r_{RF} + (RP)b $$
Where:
- rs = Cost of retained earnings
- rRF = Risk-free rate (e.g., yield on government securities)
- RP = Market risk premium (extra return expected by investors over a risk-free investment)
- b = Beta of the stock (a measure of the stock’s volatility compared to the market)
Example Calculation of Cost of Retained Earnings Using CAPM
Imagine ABC Corporation wants to calculate the cost of retained earnings. Assume:
- The risk-free rate (rRF) is 3%.
- The market risk premium (rp) is 5%.
- The company’s stock has a beta (b) of 1.2.
Step 1: Plug the values into the formula:
$$ r_s = r_{RF} + (RP)b $$ $$ r_s = 3\% + (5\% \times 1.2) $$ $$ r_s = 3\% + 6\% = 9\% $$
In this case, the cost of retained earnings is 9%. This means ABC Corporation needs to earn at least 9% on its retained earnings to meet shareholder expectations.
Generally, this is how you can calculate cost of retained earnings using the CAPM approach. But there is also another way of calculating cost of retained earnings, we use that approach when we don’t have enough data to calculate the CAPM, the approach is the bond-yield-plus-risk-premium approach.
Bond-Yield-Plus-Risk-Premium
Bond-Yield-Plus-Risk-Premium Approach for estimating the cost of equity, which is especially useful when traditional models (like CAPM) are difficult to apply, such as for private or closely held companies.
Key Points of the Approach
1. Basic Idea: Since some companies do not have enough data to use traditional models like CAPM, analysts use an alternative approach. This method involves adding a risk premium to the company’s bond yield to estimate the cost of equity.
Risk Premium: The risk premium is an additional percentage added to account for the risk involved in investing in the company’s equity compared to its debt. Studies suggest that this premium generally falls within the range of 3% to 5%.
How to Calculate Bond-Yield-Plus-Risk-Premium
The formula for calculating bond-yield-plus-risk-premium:
$$ \text{Cost of Equity} (r_s) = \text{Bond Yield} + \text{Risk Premium} $$
To apply the bond-yield-plus-risk-premium approach, follow these steps:
1. Determine the Bond Yield: Identify the yield on the company’s long-term bonds. This is the interest rate the company pays to bondholders.
2. Select an Appropriate Risk Premium: Choose a risk premium, typically between 3% and 5%, depending on the perceived risk level of the company’s equity.
3. Add the Bond Yield and Risk Premium: Sum the bond yield and risk premium to arrive at the estimated cost of equity.
Let’s walk through a hypothetical example to see how the Bond-Yield-Plus-Risk-Premium Approach is applied.
Suppose a company, Allied Industries, has a bond yield of 8%. An analyst estimates that the risk premium for this company should be 4% based on its financial health, industry conditions, and other risk factors. Here’s how the cost of equity is calculated:
$$ \text{Cost of Equity} (r_s) = \text{Bond Yield} + \text{Risk Premium} $$ $$ r_s = 8\% + 4\% = 12\% $$
In this example, Allied’s cost of equity is estimated at 12%. This means that, on average, investors would expect a 12% return on Allied’s equity to compensate for the risk they are taking.
Adjusting for Different Risk Levels
If Allied were a riskier company with a higher bond yield of, say, 12%, the calculation would change as follows:
$$ r_s = 12\% + 4\% = 16\% $$
In this scenario, the estimated cost of equity rises to 16% to reflect the increased risk associated with investing in a riskier company. This adjustment shows how the approach can accommodate different levels of perceived risk.
The Role of Judgment in This Approach
It’s important to recognize that the risk premium in this approach is a subjective measure, meaning it’s based on the analyst’s judgment. For instance, an analyst might decide to use a range of 3% to 5% for the risk premium to account for varying levels of risk.
This range can lead to a cost of equity estimate of 11% to 13% for Allied, depending on where within that range the risk premium falls. Although this variability introduces some uncertainty, the estimate is usually close enough to provide a useful “ballpark” figure.
Limitations and Practical Utility
While the Bond-Yield-Plus-Risk-Premium Approach doesn’t deliver the precision of CAPM, it serves as a valuable tool for situations where CAPM is impractical or impossible to use. By basing the cost of equity on the bond yield and a subjective risk premium, analysts can arrive at a reasonable estimate that supports decision-making without requiring extensive data.
This approach is particularly valuable in industries where companies often lack market data, as well as for smaller firms that may not be publicly traded. Although the cost of equity derived from this method is not exact, it gives analysts and decision-makers a rough idea of the return investors would expect for holding the company’s equity.
Now, the question is what if a company wants to calculate the cost of new common stock?
Cost of New Common Stock
The cost of new common stock refers to the required return or rate of return that a company must offer to attract new equity investors. It is essentially the cost the company incurs when issuing new shares to raise capital.
This cost is typically higher than the cost of retained earnings because it includes flotation costs—the fees and expenses associated with issuing new shares, such as underwriting fees, legal expenses, and administrative costs.
How to Calculate Cost of New Common Stock?
Cost of New Common Stock Formula
$$ r_e = \frac{D_1}{P_0 (1 – F)} + g $$
where:
- re = Cost of new common stock
- D1 = Dividend expected next year
- P0 = Current price of the stock
- F = Flotation cost percentage
- g = Growth rate of dividends
Example Calculation of Cost of New Common Stock
Suppose XYZ Corporation is planning to issue new common stock. The company expects to pay a dividend of $2 next year. The current stock price is $40, the flotation cost is 5%, and the dividend growth rate is 4%.
Step 1: Calculate the adjusted stock price:
$$ P_0 (1 – F) = 40 \times (1 – 0.05) = 40 \times 0.95 = 38 $$
Step 2: Use the cost of new common stock formula:
$$ r_e = \frac{D_1}{P_0 (1 – F)} + g $$ $$ r_e = \frac{2}{38} + 0.04 = 0.0526 + 0.04 = 0.0926, \text{ or } 9.26\% $$
Here, the cost of new common stock for XYZ Corporation is 9.26%. This reflects the return that the company must generate to make issuing new stock worthwhile, considering the flotation costs.
So, you have all the knowledge regarding calculating the components or weights of WACC and the overall WACC which is calculating the cost of capital. If you have any confusion let me know in the comment box.
In Summary
Calculating cost of capital or WACC is a fundamental concept in finance that plays a pivotal role in guiding a company’s financial strategy and investment decisions. By understanding and accurately estimating the cost of capital, businesses can evaluate whether proposed projects or investments are likely to generate returns that exceed their financing costs, thus creating value for shareholders.
Different methods, such as the Capital Asset Pricing Model (CAPM), Bond-Yield-Plus-Risk-Premium Approach, and Weighted Average Cost of Capital (WACC), offer various ways to estimate the cost of capital. Each method has its strengths and is suited to different types of companies and situations. While CAPM is widely applicable for publicly traded companies with sufficient market data, the Bond-Yield-Plus-Risk-Premium Approach provides an alternative for privately held companies lacking such data.
Ultimately, understanding the cost of capital enables firms to make informed decisions on capital structure, evaluate investment opportunities, and assess overall business sustainability. By striving for an optimal cost of capital, companies can improve their competitiveness, enhance profitability, and ensure long-term growth, thereby maximizing value for their investors.
Happy Financing!