What Is Cost of Capital and How Does It Determine the Health of Your Business?

Sep 29, 2018 | 4 months ago | Read Time: 3 minutes | By iKnowledge Team

Cost of capital is the minimum a company must maintain to ensure an investor’s continued trust and its brand value in the market.

What Is Cost of Capital? - Aegon Life

Business capital means ‘financing that a company uses to fund its operations and purchase assets.’ The cost of capital then, is what the company must pay to secure the said finances from different sources, whether it comes from the owner’s pocket or from third party investors. The cost of capital can be referred to as the cost of a specific project.

All businesses, big and small need money to operate and unless it comes out of the owner’s own pocket, that money comes at a price. However, efficient companies aim to keep that cost as low as possible.

What is cost of capital?

The cost of capital is simply the interest rate you pay to obtain financing. Capital can mean differently to businesses, one such example can be credit extended by suppliers, such as an account with a payment due in 30 days. Or it may include longer-term debt such as bank loans, or other liabilities.

Given the size and type of the business, its capital structure will also include equity capital or common stock. Also considered as equity are retained earnings, paid-in capital, and possibly preferred stock.

What Does “Cost” Mean?

Cost to a company’s capital is simply the cost of money it uses for financing. If they only use current liabilities, such as supplier credit, and long-term debt, then its cost of capital is equal to the interest rate it pays on that debt.

For public companies, the 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. However, when capital raised through equity in exchange for stocks are considered, 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.

Equity and CAPM

Equity financing is the capital you generate from investors in exchange for stake in the company. This however, complicates equity cost calculation, as each investor would strike a different deal in exchange for capital funds, as opposed to the interest rate charged by a bank. 

Still, an approximate cost can be calculated using the Capital Asset Pricing Model, or CAPM.

CAPM = risk-free rate + (company beta x risk premium)

The formula for CAPM can be broken down as the following:

Risk Free Rate – It refers to the rate of return on an investment that incurs no risk of loss, often considered to be treasury bills or government bonds.

Company Beta – It refers to a measure of the stock’s volatility compared to the market, however most analysts use the overall market’s beta instead. S&P 500 index is often used to represent the market beta at a value of 1 for the CAPM equation.

Risk Premium – 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 a company’s stock versus the safer, risk-free option of the 10-year Treasury bond.

What makes Funding So Important?

From expansion to research, marketing to sales, production upgrades and so on, capital or money is a primary necessity. For each of these decisions, your profit must exceed the cost of the money it takes to invest in either of the mentioned projects project.

So, make sure your investment planning is on point. Also, when it comes to funding your business, make sure you don’t dip into your savings from you retirement plans. There are other ways for wealth creation, and you should make use of them.

Successful growth can be ascertained when capital invested is greater than or at least equal to the cost of the capital used to finance projects. This makes cost of capital an underlying factor in almost all business decisions.

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