What is Capital?
Capital is the money that businesses use to finance their operations. The cost of capital is simply the interest rate that a business pays to obtain financing. For very small businesses, capital might just be credit extended by suppliers, such as an account payable within 30 days. For larger companies, capital may include long-term debts such as bank loans or other obligations.
What Does “Cost” Mean?
The cost of capital for a company is simply the cost of the money that the company uses for financing. If the company only uses current obligations such as trade credit and long-term debt to finance its operations, the cost of capital is the interest rate that the company pays on that debt. If the company is public and deals with investors, the cost of capital becomes more complex. If the company only uses funds provided by investors, the cost of capital is the cost of equity. In this case, the company’s cost of capital is the cost of debt plus the cost of equity. The combination of debt financing and equity financing represents the company’s capital structure.
Getting a Return on Investment
The return on capital is the amount of profit you earn from a business or project compared to the amount you invested in capital. The rate of return on investment (return on capital) for the company must equal or exceed the rate of return on financing (cost of capital) for the company in order to make a profit.
Interest and Other Costs
One component of the cost of capital is the cost of debt financing. For larger companies, debt usually means significant loans or corporate bonds. For very small businesses, debt can mean trade credit. For either, the cost of debt is the interest rate that the company pays on the debt.
Equity and the CAPM Model
The cost of capital includes equity financing if you have investors in your company providing money in exchange for an ownership stake in the company. Calculating the cost of equity capital becomes more complicated, as investors have different requirements for their equity investment returns compared to the interest charged by banks.
A company can approximate the cost of equity capital using the Capital Asset Pricing Model (CAPM). This model is as follows:
CAPM = Risk-free rate + (Company Beta * Market risk premium)
Where the risk-free rate is equivalent to the yield on a 10-year government bond. Calculating the company beta can involve a significant amount of work, so some analysts use a market-derived beta instead. The market beta reflects the volatility of a particular stock price or the market as a whole, and the Standard & Poor’s 500 beta is often used to represent the market beta with a value of 1 in the CAPM equation.
The market risk premium is estimated by taking the average market return, which analysts can approximate using the return rate on the S&P 500 market, and then subtracting the risk-free rate. This approximates the additional return that investors expect for taking on the risk of investing in this company’s stock compared to the safe and risk-free option of a 10-year treasury bond.
For very small businesses, the cost of capital may be much simpler. There are benefits and drawbacks to both debt financing and equity financing that any business owner should consider before adding them to the company’s capital structure.
Why is Financing So Important?
If a company wants to build new factories, purchase new equipment, develop new products, and upgrade its information technology, it needs money or capital. For each of these decisions, the business owner or CFO must decide whether the expected returns exceed the cost of capital. In other words, the expected profit must exceed the cost of the money required to invest in the project.
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Business owners themselves go bankrupt quickly if they do not invest in new projects with a return on the capital they invest that is greater than or at least equal to the cost of capital they need to use to finance their projects. The cost of capital is a critical 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 component of capital constitutes a certain percentage of the company’s capital structure. To arrive at the true cost of capital for the company, the business owner must multiply the capital structure ratio for the company for each component, debt and equity, by the cost of that component and sum the two parts.
Source: https://www.thebalancemoney.com/cost-of-capital-for-a-business-393132
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