Cost of Capital

The minimum rate of return that a business must earn before generating value

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What is Cost of Capital?

Cost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to fund its operations. This consists of both the cost of debt and the cost of equity used for financing a business. A company’s cost of capital depends, to a large extent, on the type of financing the company chooses to rely on – its capital structure. The company may rely either solely on equity or solely on debt or use a combination of the two.

The choice of financing makes the cost of capital a crucial variable for every company, as it will determine its capital structure. Companies look for the optimal mix of financing that provides adequate funding and minimizes the cost of capital.

In addition, investors use the cost of capital as one of the financial metrics they consider in evaluating companies as potential investments. The cost of capital figure is also important because it is used as the discount rate for the company’s free cash flows in the DCF analysis model.

Cost of Capital - WACC Diagram

How to Calculate Cost of Capital?

The most common approach to calculating the cost of capital is to use the Weighted Average Cost of Capital (WACC). Under this method, all sources of financing are included in the calculation, and each source is given a weight relative to its proportion in the company’s capital structure.

WACC provides us with a formula to calculate the cost of capital:

Cost of Capital Formula

The cost of debt in WACC is the interest rate that a company pays on its existing debt. The cost of equity is the expected rate of return for the company’s shareholders.

Cost of Capital and Capital Structure

Cost of capital is an important factor in determining the company’s capital structure. Determining a company’s optimal capital structure can be a tricky endeavor because both debt financing and equity financing carry respective advantages and disadvantages.

Optimal Capital Structure

Debt is a cheaper source of financing, as compared to equity. Companies can benefit from their debt instruments by expensing the interest payments made on existing debt and thereby reducing the company’s taxable income. These reductions in tax liability are known as tax shields. Tax shields are crucial to companies because they help to preserve the company’s cash flows and the total value of the company.

However, at some point, the cost of issuing additional debt will exceed the cost of issuing new equity. For a company with a lot of debt, adding new debt will increase its risk of default and the inability to meet its financial obligations. A higher default risk will increase the cost of debt, as new lenders will ask for a premium to be paid for the higher default risk.

In addition, a high default risk may also drive the cost of equity up because shareholders will likely expect a premium over and above the rate of return for the company’s debt instruments for taking on the additional risk associated with equity investing.

Despite its higher cost (equity investors demand a higher risk premium than lenders), equity financing is attractive because it does not create a default risk to the company. Also, equity financing may offer an easier way to raise a large amount of capital, especially if the company does not have extensive credit established with lenders. However, for some companies, equity financing may not be a good option, as it will reduce the control of current shareholders over the business.

CFI wants to help you become a world-class financial analyst and advance your career. With that goal in mind, feel free to explore the following resources:

Additional Resources

CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:

The Financial Modeling Certification

Analyst Certification FMVA® Program

CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:

The Financial Modeling Certification

Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.

 

Financial Analyst certification curriculum

 

A well rounded financial analyst possesses all of the above skills!

 

Additional Questions & Answers

CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.

In order to become a great financial analyst, here are some more questions and answers for you to discover:

 

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