### 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

### WACC Formula

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.

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 |
---|---|---|---|

Common | $\${25{,}000{,}000}$ | ${25}\times{10}\%$ | ${2.50}\%$ |

Preferred | $\${25{,}000{,}000}$ | ${25}\%\times{5}\%$ | ${1.25}\%$ |

10-year bond | $\${50{,}000{,}000}$ | ${50}\%\times{4}\%$* | ${2.00}\%$ |

WACC = | $5.75\%\;{\text{or}}\;0.025+0.0125+0.02$ |

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.

*r*) derives the calculation of the risk-free rate of return (

_{s}*r*) which is the rate of return paid on investments that are considered "risk-free," such as Treasury bonds. The risk-free rate is added to the difference of the market return (

_{rf}*r*) and the risk-free rate (

_{m}*r*) times beta (

_{rf}*b*). Once this is calculated, the risk-free rate of return (

*r*) is added to (

_{rf}*rp*), the risk of the market minus risk premium, times beta (

_{m}*b*). Beta is a measurement used to calculate risk based on a company's stock price and we can assume that with a beta of 1 the security will be less volatile than the market. When a company's stock price is more volatile, its beta will generally be higher. For Big Systems Inc., beta is designated as 1, the risk-free rate is 3 percent, and the market return is 10 percent. Thus, using these values, the cost of equity can be calculated using a formula and is 10 percent.

**Cash pooling**is a cash management strategy wherein a company consolidates the cash balances of its subsidiaries. Cash pooling allows a company to pull all of its resources together. Big Systems Inc. went public by issuing 1 million shares of common stock at $25 per share, which are now trading at $30 per share. The current risk-free rate is 4 percent, the market risk premium is 8 percent, and the company has a beta coefficient (the amount of systematic risk an asset or portfolio has with respect to the market) of 1.2. During the last year, it issued 50,000 bonds of $1,000 each, paying a 10 percent coupon rate in 20 years. The bonds are currently trading at $950. The tax rate is 30 percent. With this information, using the WACC formula, WACC can be calculated.

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