In this topic, you will learn how to calculate cost of capital of a company. Cost of Capital of a company, is the minimum return the company’s investors (equity and debt holders) need to earn given the company’s riskiness. Hence, it is the required rate of return (RRR) of the investors of the company.

From the perspective of the company management, the cost of capital is what the company has to give/provide (i.e., pay as interest and dividends and/or capital gains) to its investors (debt and equity) to obtain funds. If the company’s equity (shares) and debt (bonds) securities are sold in the market, you can observe this cost of capital in the market.

The current price of a particular security reflects the return the market requires from it. For example, for a given amount of future cash inflows (returns), if the required return of the market is higher, the price would be lower. You need to clearly understand this logic!

For example, if the total return (expected cash inflows) (i.e., dividends plus capital gain) from a share is $5 per year and if this is expected to continue for the foreseeable future, and the required rate of return of the market on this share is 10%, the price of the share would be $50; if the required return is 20% the price of the share would be $25. This is calculated using perpetuity model.

Based on the same logic, if the total return of the share (dividend plus capital gain) is estimated to be $5 and current market price of the share is $50, then we know that the required return of the market for this share should be 10%

From the current prices of shares and bonds, you can calculate the required rate of return (RRR) if you know the future cash flows relevant to these securities.

Having set this background, let’s have a look at the concepts you will learn in this topic.

Concept 1: Understanding Cost of Capital

Concept 2: Calculating cost of capital (Weighted Average Cost of Capital (WACC))

Concept 3: Factors affecting cost of capital

Concept 4: Individual project vs firm cost of capital

Concept 1: Understanding Cost of Capital

Understanding the ‘cost of capital’ is essential to understand the importance of capital structure of a company and vice versa. Cost of capital of a firm with no debt is simply the cost of equity (i.e., required return on equity). Cost of capital of a firm with debt is the weighted-average of cost of equity and debts.

In order to take into account the cost of all financing sources, we compute and use the weighted average cost of capital (WACC). From the investors’ perspective, WACC is the weighted average of required returns (weighted by market value) on debt and equity.

From the company’s (managers’) perspective, WACC is the average cost of funds. The return the company has to offer to raise funds now. Conceptually, returns and costs are mirror images of each other.

WACC is the opportunity cost for the company’s investors as of today (now). This cost of capital (WACC) is used as the discount rate (hurdle rate) for evaluating investments in new assets of similar risk.

Example: Proportion of debt and Equity

Suppose you have a market value of equity equal to $500 million and a market value of debt equal to $475 million. What are the capital structure weights (i.e., proportions)?

V = E + D = $500m + $475m = $975m

Weight of E = $500/$975 = 51.28%

Weight of D = $475/$975 = 48.71%

Example: Cost of Capital using intuition

Debt providers have contributed $8 million to ABC company at an interest rate of 10% p.a. Equity holders have contributed $2 million and require a rate of return of 15% on their investment. What is the company’s cost of capital?

Concept 2: Calculating cost of capital (Weighted Average Cost of Capital (WACC))

Cost of capital calculation involves a few steps:

• Identify sources of funding
• Calculate/identify cost of funding
• Interest payment has a tax benefit. Interest cost need to be adjusted to reflect the tax benefit. Ordinary share and preference share do not get any tax benefit.
• Calculate proportion/weight of funding
• Multiply weight and cost of funding and then add all

The cost of debt

The current cost of debt (not past cost of debt) is the appropriate cost of debt for WACC calculations. The current cost of debt (bonds) is estimated using yield to maturity from bond valuation (Topic 4). Recall that you used market interest rate for pricing bonds:

Taxes are an important consideration in the company’s cost of capital. Because interest payments can be deducted from income before tax is calculated. The after-tax cost of interest payments equals the pretax cost times 1 minus the tax rate. If the company has more than one type of debt, to get company’s overall cost of debt you must first estimate the costs of each individual debt, and then calculate a weighted average of these costs (of different debts).

The cost of equity

The cost of equity is the minimum rate of return required (RRR) by a company’s shareholders, given its riskiness. The cost of equity for a company is a weighted average of the costs of the different types of shares that the company has outstanding at a particular point in time.

Ordinary shares

Market information is used to estimate the cost of equity. There are several ways to do this and the most appropriate way will depend on what information is available and how reliable it is.

There are three alternative methods for estimating the cost of ordinary shares.

Method 1: Capital Asset Pricing Model (CAPM)

• Estimate the beta of the shares using historical data (for some shares Beta’s are publicly available)
• Determine the current risk-free rate
• Determine the expected market risk premium
• Substitute these values into the CAPM equation below
• [latex]E(R_i)=R_f+β_i [E(R_M )-R_f ][/latex]

There are some practical issues that must be considered when choosing the appropriate risk-free rate, beta, and market risk premium for the above calculation.

The recommended risk-free rate to use is the yield on a long-term Treasury security (10 year government bonds) because the equity is a long-term claim on the company’s cash flows.

A long-term risk-free rate better reflects long-term inflation expectations and the cost of getting investors to invest their money for a long period of time.

Beta (β_i) for a share can be estimated using a regression analysis. (for most listed shares Beta’s are publicly available).

Identifying the appropriate beta is much more complicated if the share is not publicly traded.

This problem may be overcome by identifying a “comparable” company, with publicly traded shares, that is in the same business and that has a similar amount of debt.

When a good comparable company cannot be identified, it is sometimes possible to use an average of the betas for the public companies in the same industry.

The following website updates the equity risk premium every year for each country.

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

Method 2: Constant-growth dividend model

See Topic 5 – Share valuation, when the dividends are expected to grow at a constant rate. Rearranging the constant growth model to solve for R.

[latex]𝑃_0=(𝐷_0×(1+𝑔))/(𝑅−𝑔)=𝐷_1/(𝑅−𝑔)[/latex]

[latex]R=(D_1/P_0) +g[/latex]

Preference shares

The characteristics of preference shares allow you to use the perpetuity model, to estimate the cost of preference equity. Similar to ordinary shares, you can find the cost of preference equity by rearranging the pricing equation for preference shares:

[latex]𝑃_0=𝐷_0/𝑅[/latex]

[latex]R=D_0/P_0[/latex]

Note that the CAPM also can be used to estimate the cost of preference equity, just as it can be used to estimate the cost of ordinary equity.

Concept 3: Factors affecting cost of capital

The factors that can affect cost of capital can be determined by looking at the formula for cost of capital.

Interest payments on loans and bonds. Whether firms bond rating is investment grade (BBB or above) or junk (below BBB) because this would determine the interest rate and further the cost of capital.

Cost of equity: R_E  (if CAPM is used from Topic 3)

WACC can be affected by cost of equity. If CAPM is used to calculate cost of equity then Risk free rate, Systematic risk (beta) and Market risk premium can affect WACC.

Cost of equity: R_E  (if Dividend growth model is used from Topic 5)

However, if dividend growth model is used then dividends, share price and growth rate of dividends can affect WACC.

Concept 4: Individual project vs firm cost of capital

Cost of capital refers to the cost of borrowing money from creditors or raising capital from equity investors, and it includes the cost of both debt and equity financing. In simple terms, the cost of capital is the expense a company incurs to obtain the money it needs to run its business.

As you can understand, a firm is a collection of various individual projects. The cost of capital of the firm reflects the overall risk of the company and it is the sum of the risks associated with each project. The cost of capital for the company as a whole will reflect the weighted average of the cost of capital for each individual project, adjusted for the risk associated with each project.

Therefore, when evaluating individual projects using the cost of capital of the firm, it is important to consider the following:

• The individual project has the same risk level as the overall firm’s operations.  The cost of capital reflects the risk associated with a firm’s operations, and if the individual project has a similar risk level, the firm’s cost of capital can be used to evaluate the project.
• The financing structure for the individual project is the same as the overall firm’s financing structure: If the individual project is funded using the same combination of debt and equity financing as the overall firm’s financing structure, the firm’s cost of capital can be used to evaluate the project.
• The project is expected to generate similar returns as the firm’s other investments: If the project is expected to generate returns similar to those generated by the firm’s other investments, the cost of capital can be used to evaluate the project.

The APV method is an alternative way of calculating the weighted average cost of capital (WACC) for a company.

The APV method considers the specific financing structure of a project and adjusts the cost of capital accordingly. The basic idea behind the APV method is to first calculate the value of a project without considering any financing and then add the present value of any tax shields or other benefits associated with the financing.

Here are the general steps involved in the APV method:

1. Calculate the value of the project assuming an all-equity financing structure. This value is often called the unlevered value or the base-case value.
2. Calculate the present value of any tax shields or other financing benefits that would be generated using debt financing.
3. Add the value of the project from step 1 to the present value of the financing benefits from step 2 to arrive at the total project value.
4. Calculate the WACC for the levered project using the adjusted value from step 3.

The APV method is often used when a project has a unique financing structure or when the financing structure of a project changes over time. The APV method allows analysts to more accurately reflect a project’s specific risk and return profile. It can lead to a more accurate estimate of the cost of capital for that project.

References

• Peirson, G., Brown, R., Easton, S. A., Howard, P., & Pinder, S. (2015). Business finance (Twelfth edition). McGraw-Hill Education.
• Ross, S. A., Trayler, R., Hambusch, G., Koh, C., Glover, K., Westerfield, R., & Jordan, B. (2021). Fundamentals of corporate finance (Eighth edition.). McGraw-Hill Education (Australia) Pty Limited.
• Parrino, R., Au Yong, H. H., Dempsey, M. J., Ekanayake, S., Kidwell, D. S., Kofoed, J., Morkel-Kingsbury, N., & Murray, J. (2014). Fundamentals of corporate finance (Second edition.). John Wiley and Sons Australia, Ltd.