Cost of Capital for a Business
The Relationships of Capital, Cost of Capital, and Return on Capital
Capital for a small business is simply money or the financing that the company uses to fund its operations and purchase assets. The cost of capital represents the cost of obtaining that money or financing for the small business. The cost of capital is also called the hurdle rate, especially when referred to as the cost of a specific project.
Even a very small business needs money to operate and that money costs something unless it comes out of the owner's own pocket. Companies aim to keep that cost as low as possible.
What is Capital?
Capital is the money businesses use to finance their operations. The cost of capital is simply the interest rate it costs the business to obtain financing. Capital for very small businesses may just be credit extended by suppliers, such as an account with a payment due in 30 days. For larger businesses, capital may include longer-term debt such as bank loans, or other liabilities.
If a company is public or takes on investors, its capital structure will also include equity capital or common stock. Other equity accounts include retained earnings, paid-in capital, and possibly preferred stock.
What Does "Cost" Mean?
A company's cost of capital is simply the cost of money the company uses for financing. If a company only uses current liabilities, such as supplier credit, and long-term debt to finance its operations, then its cost of capital is whatever interest rate it pays on that debt.
If a company is public and has investors, then cost of capital gets more complicated. If the company only uses funds provided by investors, then its cost of capital is the cost of the equity. This company may have has but also chooses to finance with equity financing through money that investors supply in exchange for the company's stock. In this case, the company's cost of capital is the cost of debt plus the cost of equity.
The combination of debt and equity financing a company holds represents its capital structure.
Getting a Return on Investment
Return on capital is the amount of profit you earn out of a business or project as compared to the amount of capital you've invested. A company's investment rate of return (return on capital) must equal or exceed its financing rate of return (cost of capital) for the firm to turn a profit.
Interest and Other Costs
One component of the cost of capital is the cost of debt financing. For larger businesses, debt usually means large loans or corporate bonds. For very small companies, the debt can mean trade credit. For either, the cost of debt is the interest rate the company pays on debt.
Equity and CAPM
The cost of capital includes equity financing if you have investors in your company who provide money in exchange for an ownership stake in the company. Calculating the cost of equity becomes more difficult, as investors have different requirements for their return on equity investments as compared to the interest charged by a bank.
A company can approximate its equity cost of capital using the Capital Asset Pricing Model, or CAPM. This formula is as follows:
CAPM = risk-free rate + (company beta * risk premium)
Where the risk-free rate equates to the return on a 10-year government bond. Calculating the company's beta can involve a decent amount of work, so some analysts use a market-derived beta instead. Beta reflects the price volatility of a given stock or the market overall, and the beta of the Standard & Poor's 500 index is often used to represent the market beta at a value of 1 for the CAPM equation.
The risk premium is estimated by taking the average return on the market, which analysts might approximate by using the S&P 500 rate of return and then subtracting the risk-free rate. This approximates the premium investors expect for taking the risk of investing in this company's stock versus the safer, risk-free option of the 10-year treasury bond.
For very small firms, the cost of capital may be much simpler. There are advantages and disadvantages to both debt and equity financing that any business owner must consider before adding them to the company's capital structure.
Why Is Funding So Important?
If a company wants to build new plants, buy new equipment, develop new products, and upgrade information technology, it needs to have to have money or capital. For each of these decisions, a business owner or Chief Financial Officer (CFO) must decide if the return on the investment is greater than the cost of capital. In other words, the projected profit must exceed the cost of the money it takes to invest in the project.
Business owners would find themselves in bankruptcy fairly quickly if they don't invest in new projects where the return on the capital they invest is greater than or at least equal to the cost of the capital they have to use to finance their projects. The cost of capital is an underlying factor in almost all business decisions.
Weighted Average Cost of Capital
Once a business owner understands the concepts of capital and cost of capital, the next step is to calculate the company's weighted average cost of capital. Each capital component makes up a certain percentage of the company's capital structure. To arrive at the true cost of capital for a business, the owner must multiply the percentage of the company's capital structure for each component, debt, and equity, by the cost of that component and sum the two parts.