CFM: Cost of capital

Cost of capital

In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or, from an investor's point of view "the required rate of return on a portfolio company's existing securities".^[1] It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new has to meet.

For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital. Given a number of competing investment opportunities, investors are expected to put their capital to work in order to maximize the return. In other words, the cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. However, for projects outside the core business of the company, the current cost of capital may not be the appropriate yardstick to use, as the risks of the businesses are not the same.^[2]

A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. Importantly, both cost of debt and equity must be forward looking, and reflect the expectations of risk and return in the future. This means, for instance, that the past cost of debt is not a good indicator of the actual forward looking cost of debt.

Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows.

The cost of equity is inferred by comparing the investment to other investments (comparable) with similar risk profiles. It is commonly computed using the capital asset pricing model formula:

Cost of equity = Risk free rate of return + Premium expected for risk

Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)

where Beta = sensitivity to movements in the relevant market. Thus in symbols we have

where:

E_s is the expected return for a security;

R_f is the expected risk-free return in that market (government bond yield);

β_s is the sensitivity to market risk for the security;

R_m is the historical return of the stock market; and

(R_m – R_f) is the risk premium of market assets over risk free assets.

The risk free rate is the yield on long term bonds in the particular market, such as government bonds.

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.

Cost of debt

When companies borrow funds from outside or take debt from financial institutions or other resources the interest paid on that amount is called cost of debt. The cost of debt is computed by taking the rate on a risk-free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate.