Cost of Capital: What It Is, Why It Matters, Formula, and Example

In business, the cost of capital is generally determined by the accounting department. It is a relatively straightforward calculation of the breakeven point for the project. The management team uses that calculation to determine the discount rate, or hurdle rate, of the project. That is, they decide whether the project can deliver enough of a return to not only repay its costs but reward the company’s shareholders. Debt financing is more tax-efficient than equity financing since interest expenses are tax-deductible and dividends on common shares are paid with after-tax dollars.

By accurately calculating WACC, businesses can assess the feasibility of projects, determine optimal capital structures, and make informed decisions to maximise shareholder value. The cost of equity, a fundamental concept in finance, the cost of debt capital is calculated on the basis of represents the return required by shareholders for investing in a company’s stock. It reflects the opportunity cost of investing in one stock over another and encompasses factors such as the company’s growth prospects, risk profile, and prevailing market conditions.

The first approach is to look at the current yield to maturity or YTM of a company’s debt. An example would be a straight bond that makes regular interest payments and pays back the principal at maturity. Debt is one part of their capital structures, which also includes equity. Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans.

1. Note that retained earnings are a component of equity, and, therefore, the cost of retained earnings (internal equity) is equal to the cost of equity as explained above.
2. Shareholders and business leaders analyze cost of capital regularly to ensure they make smart, timely financial decisions.
3. The difference between the pre-tax cost of debt and the after-tax cost of debt is attributable to how interest expense reduces the amount of taxes paid, unlike dividends issued to common or preferred equity holders.
4. The growth that is financed with debt may result in higher earnings, and shareholders can expect to gain if the incremental profit increase outweighs the corresponding increase in debt payment costs.
5. Beyond the cost of capital’s role in capital structure, it indicates an organization’s financial health and informs business decisions.
6. The cost of capital measures the cost that a business incurs to finance its operations.

Calculating the Cost of Debt

Debt is an instrumental part of business for most entrepreneurs, and shareholders should know how to calculate the total cost they will pay on the loans they choose to accept. The models state that investors will expect a return that is the risk-free return plus the security’s sensitivity to market risk (β) times the market risk premium. An alternative to the estimation of the required return by the capital asset pricing model as above, is the use of the Fama–French three-factor model.

No, all of our programs are 100 percent online, and available to participants regardless of their location. Our platform features short, highly produced videos of HBS faculty and guest business experts, interactive graphs and exercises, cold calls to keep you engaged, and opportunities to contribute to a vibrant online community. The face value of the bond is $1,000, which is linked with a negative sign placed in front to indicate it is a cash outflow. In our table, we have listed the two cash inflows and outflows from the perspective of the lender, since we’re calculating the YTM from their viewpoint.

The effective interest rate is defined as the blended average interest rate paid by a company on all its debt obligations, denoted in the form of a percentage. Remember, the discounted cash flow (DCF) method of valuing companies is on a “forward-looking” basis and the estimated value is a function of discounting future free cash flows (FCFs) to the present day. The question here is, “Would it be correct to use the 6.0% annual interest rate as the company’s cost of debt?

What are the Limitations of WACC?

In industries where research and development (R&D) is a crucial element for growth, cost of capital is used to evaluate the viability of investing in new products’ development. Therefore, the final step is to tax-affect the YTM, which comes out to an estimated 4.2% cost of debt once again, as shown by our completed model output. Using the “IRR” function in Excel, we can calculate the yield-to-maturity (YTM) as 5.6%, which is equivalent to the pre-tax cost of debt. For the next section of our modeling exercise, we’ll calculate the cost of debt but in a more visually illustrative format. As a preface for our modeling exercise, we’ll be calculating the cost of debt in Excel using two distinct approaches, but with identical model assumptions. That said, a company’s management should challenge its internally generated cost of capital numbers, as they may be so conservative as to deter investment.

Long Term Debt to Capital Formula

The cost of capital is the total cost of debt and equity that a company incurs to run its operations. This method doesn’t consider the relative proportion of each source of financing. WACC, on the other hand, goes a step further by considering the proportion of each financing source used by the company. Suppose the bond had a lifetime of ten years and coupon payments were made yearly. This means that the investor would receive $10,000 every year for ten years, and then finally their $200,000 back at the end of the ten years.

This is because adding debt increases the default risk – and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the “optimal mix” of financing – the capital structure where the cost of capital is minimized so that the firm’s value can be maximized. Another way to calculate the cost of debt is to determine the total amount of interest paid on each debt for the year. The interest rate that a company pays on its debts includes both the risk-free rate of return and the credit spread from the formula above because the lender(s) will take both into account when initially determining an interest rate. Cost of Capital is important in business planning as it represents the minimum return a company must earn on its investments in order to satisfy its creditors and equity investors.

1. WACC is calculated using a variety of factors, including these main factors.
2. An investor might look at the volatility (beta) of a company’s financial results to determine whether a stock’s cost is justified by its potential return.
3. The Adjusted Present Value method (APV) is much easier to use in this case as it separates the value of the project from the value of its financing program.
4. These groups use it to determine stock prices and potential returns from acquired shares.
5. This book may not be used in the training of large language models or otherwise be ingested into large language models or generative AI offerings without OpenStax’s permission.

As we learned from our pre-tax calculation, our effective interest rate is 8%. To get our total interest, we’ll multiply each loan by its annual interest rate, then add up the results. If you’re a small business owner, you know that borrowing money is both inevitable and essential. You need working capital to get your business off the ground or grow it to new heights. A negative D/E ratio indicates that a corporation has negative shareholder equity. This would often be seen as a warning indication of high risk and an incentive to file for bankruptcy.

Cost of debt + cost of equity = overall cost of capital

The Cost of Capital is then used to discount future expected cash flows to arrive at a present value – the valuation of the business using the Discounted Cash Flow method, a leading valuation technique. Suppose that one of the sources of finance for this new project was a bond (issued at par value) of $200,000 with an interest rate of 5%. This means that the company would issue the bond to some willing investor, who would give the $200,000 to the company which it could then use, for a specified period of time (the term of the bond) to finance its project. The company would also make regular payments to the investor of 5% of the original amount they invested ($10,000), at a yearly or monthly rate depending on the specifics of the bond (these are called coupon payments).

However, too much debt can result in dangerously high leverage levels, forcing the company to pay higher interest rates to offset the higher default risk. A firm’s cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and equity capital. Not only are you paying the principal balance, but you’re also responsible for the interest. You can figure out what the cost of debt is by multiplying the value of your loan by the annual interest rate. Determine your effective interest rate by adding together all that interest by the total amount of debt you owe. Put simply, the cost of debt is the effective interest rate or the total amount of interest that a company or individual owes on any liabilities, such as bonds and loans.

The total debt outstanding is $100 million, which we’ll divide by the total capitalization of $200 million to arrive at a total debt to capital ratio of 0.5x, i.e. 50% of the company’s assets are funded by debt capital. However, barring unusual circumstances, the market value rarely deviates much from the book value of debt, so it is acceptable to use the values recorded on the balance sheet in most cases. There is no single target debt to capital ratio that constitutes a “good” ratio, per se, as it varies substantially across different industries. This tax break lowers the amount of interest debtholders pay, which lowers their cost of debt. To see if your tax savings will cover your interest expenses, you’ll use a different formula to calculate your cost of debt after taxes.