Cost of Capital Explained: How to Calculate Cost of Capital

Cost of capital is a corporate finance term related to the cost of funds a company uses and the rate of return a firm or investor can expect from an investment. Firms and investors use cost of capital as a financial analysis tool to weigh a company’s debt and equity capital and evaluate the opportunity cost of a particular investment. Cost of capital considers the costs of financing—like loan interest or the minimum return investors expect to earn on their investment in the company, for example. Cost of capital considers all sources of capital, including common stock, preferred stock, bonds, and long-term debt.

Weighted average cost of capital (WACC) is a financial metric used to identify a particular company’s cost of capital. Firms and investors use WACC to find the average rate a firm expects to pay to finance its operations. Financial analysts determine a company’s weighted average cost of capital by using the WACC formula, which takes into account the weighted average cost of debt and the weighted average cost of equity.

Cost of capital is a useful tool for financial analysts and investors alike.

• Cost of capital influences a company’s decision to take investments. Finance departments use cost of capital to determine the required rate of return, or hurdle rate, for a capital budgeting project. Worthwhile investments have an expected return on capital benchmark that’s higher than the cost of capital.
• Cost of capital impacts a company’s valuation. Companies with growing costs of capital can have higher risks and lower valuations. Investors can demand a higher risk premium for a company with a higher cost of capital.
• Cost of capital determines a company’s discount rate. Financial analysts often use the weighted average cost of capital to determine the discount rate of a company’s future cash flows in discounted cash flow (DCF) analysis. Additionally, WACC acts as the discount rate when calculating a company’s net present value (NPV).

Professional accountants and financial analysts typically perform WACC calculations. They use the WACC formula to calculate the cost of capital:

WACC = (E/V x Re) + (D/V x Rd)

In this formula, “E” equals the market value of the company’s equity, “D” equals the market value of the company’s debt, and “V” is the total value of the company’s capital (equity plus debt). “E/V” equals the percentage of capital that is equity, while “D/V” equals the percentage of capital that is debt. “Re” is the cost of equity, and “Rd” is the cost of debt.

To calculate WACC for yourself, follow three general steps.

1. 1. Calculate your company’s cost of debt. Your company’s cost of debt is determined by interest rates you pay to lenders on existing debt, including mortgages and bonds. Calculate the cost of debt by multiplying the interest expense on debt by the inverse of the tax rate percentage and dividing the product by the company’s outstanding total debt. Your company’s market value of debt is typically lower than your company’s market value of equity as interest payments are tax-deductible.
2. 2. Calculate your company’s cost of equity. Calculate your company’s equity by using the capital asset pricing model (CAPM). Find the difference between the market rate of return and the risk-free rate of return. Multiply the difference by beta, which measures market volatility. Add this product to the risk-free interest rate. The sum is your cost of equity.
3. 3. Calculate the weighted average cost of capital. Find your company’s WACC by taking the cost of debt and the cost of equity and weighing them based on the percentage of debt and equity that is used to finance the company’s operations.

For this example, a company has a cost of equity of ten percent and a cost of debt of five percent. This company finances its operations with sixty percent equity and forty percent debt. With this information, calculate the cost of capital with the following equation:

(0.6 x 10%) + (0.4 x 5%) = 8%

Based on this calculation, the company’s WACC is eight percent. Financial analysts and investors can use this eight percent WACC as a benchmark to determine if an investment’s rate of return exceeds the weighted average cost of capital.

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