Definition of Cost of Capital
Cost of capital is the required return that is necessary to make a capital budgeting project make sense to take on. Big Systems Inc. wants to buy a new building for its operations. The company would need to consider all of the costs associated with financing a project, including both the costs of debt and the costs of equity. These costs depend on the financing Big Systems Inc. uses to fund the project. If only equity, or securities representing ownership in the company, is used to finance an upgrade, for example, the required return is referred to as the cost of equity. If a project is financed through debt, then the required return is referred to as the cost of debt.
When a company is thinking about implementing a project or buying an asset, the actual cost of capital is the hurdle rate, the minimum rate of return required by an investor or management to proceed with a project. If the project is not going to make more money than it costs, then it may not be justifiable to investors unless another factor makes the project necessary or worthwhile. Legal and customer obligations sometimes fall into this category.
Calculating the Cost of Each Component of Capital with Examples
The weighted average cost of capital (WACC) is a formula for determining the relative average a company is expected to pay to all its security holders to finance its assets. The WACC represents the total costs of all capital ("total capital," or TC), weighted in proportion to their balance sheet percentages held by the business. The WACC measures the current cost of a particular component of capital used by the business to fund operations including working capital and long-term investments. WACC will not inform management of the weighted average cost of capital a company is expected to pay to equity and debt holders to acquire additional capital from them because the current market costs may be different than the historical costs paid by the business. But the current WACC will help managers determine whether they should raise new debt or equity based on current market costs in order to decide whether they should refinance to reduce their capital costs.The WACC is a calculation of the firm's cost of capital in which each category of capital is proportionately weighted. This would include items such as common stock, preferred stock, bonds, and any other long-term debt.
For example, Big Systems Inc. holds total debt and equity of $100 million. Big Systems Inc.'s total debt is $50 million and is comprised of long-term debt and bonds. Big Systems Inc. also has $50 million in equity from common stock and preferred stock. Assume Big Systems Inc.'s equity is comprised of 50 percent common stock and 50 percent preferred stock. Next, the cost of common equity is determined.
|Capital||Amount||Proportional % TC Costs||TC Component Costs|
Note that the 4 percent debt costs are after-tax using the bond's pretax coupon rate of 6 percent and given a corporate tax rate of 33.3 percent.