Cost of Capital (Encyclopedia of Business)
In the context of financial management, the term "cost of capital" refers to the remuneration required by investors or lenders to induce them to provide funding for an ongoing business. If the firm's goal is to remain profitable and to increase value to its shareholders, any use of capital must return at least its cost of capital, and optimally, an amount greater than its cost of capital. The Weighted Average Cost of Capital (WACC) is often used as a benchmark, or "hurdle rate" when evaluating new projects and businesses that would require use of the scarce resource of funding.
Computing a company's cost of capital is not as simple as using, for example, the rate of interest it is charged on bank financing. The true cost of capital must be determined considering economic, market, and tax issues. Sometimes investor relations and market perception play a role in determining a company's capital structure as well.
Most firms do not rely on only one type of financing, but seek to maintain an acceptable capital structure using a mix of various elements. These sources of financing include long-term debt, common stock, preferred stock, and retained earnings. In this discussion we will examine the four types of capital, their relative costs, and the methods by which a Weighted Average Cost of Capital is derived for practical use.
COST OF LONG-TERM DEBT
The cost of long-term debt is the after-tax cost of borrowing through the issuance of bonds. The proceeds of the bonds are reduced by the costs incurred to issue and sell the securities, called flotation costs. The following formula illustrates the computation of the before-tax cost of debt of a $1000 bond:
where I = Annual interest
P = Net proceeds of bond issue
n = Number of years to maturity
Kd = Before-tax cost of debt
It is important to state the cost of financing on an after-tax basis because interest on debt is tax-deductible. The before-tax cost of debt can be converted to the after-tax cost of debt by applying the following equation:
where T = the firm's corporate tax rate
Ki = the after-tax cost of debt to the firm
COST OF COMMON STOCK EQUITY
The cost of common stock equity is estimated by determining the rate at which the investor discounts the expected dividends to determine the share value. That is, the amount an investor is willing to pay for a share of stock is determined by his view of the future dividends potential of the security. One method used to determine the cost of common stock equity is the Constant Growth Valuation (Gordon) Model. This model is based on the assumption that a share's value is based on the present value of all future dividends in perpetuity. The following formula illustrates the model:
where Ki = the cost of common stock equity
D1 = the expected dividend for the next period
Po = the present value of future dividends
g = the expected percentage dividend growth rate in decimal form
COST OF PREFERRED STOCK
Preferred stock is a unique type of ownership in a firm. Its dividends are senior to, or take priority over, the payment of those on common stock. The amount of dividends that will be paid to the holders of preferred shares may be stated as a percent of its par value, or as a flat dollar amount. For purposes of analysis, dividends based on a percentage should be converted to dollar amounts before computation.
The cost of preferred stock is determined by dividing the annual preferred stock dividend by the net proceeds from the issuance. The following formula illustrates:
where Dp = the annual dollar dividends
Np = the net proceeds from the issuance
Kp = the cost of preferred stock equity
COST OF RETAINED EARNINGS
Earnings that are retained are either kept by the company or paid out to shareholders in the form of dividends. Therefore, retained earnings increase the shareholders equity in the company in much the same way as a new issue of common stock. Therefore, the cost of earnings retained as financing is the same as the company's cost of common stock equity.
If the company can deploy its profits to get the shareholder's required return on its internal investments, stockholders are amenable to the firm's retention of earnings. However, if the company cannot manage its assets to meet this requirement, erosion of shareholder value occurs. This can happen if large amounts of low performance assets, such as cash, are retained.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
After the cost of each component of the capital structure is estimated, a blended or weighted average cost must be computed. The result of this calculation is the company's WACC, a piece of information that is very important to the management of the firm's assets. The WACC is used to make investment and business decisions, and is often used as a benchmark in determining a business unit's performance.
To compute the WACC, multiply the specific cost of each form of financing by its proportion in the firm's capital structure, then sum the weighted values.
where Wi = proportion of long-term debt in capital structure
Wp = proportion of preferred stock in capital structure
Ws = proportion of common stock equity in capital structure
The determination of the proportions may be based on the company's book or market value. Since the market value more closely approximates the actual dollars that would be received from the sale of the securities, this method is preferable to book, or accounting value.
The careful approximation of a firm's specific financing and WACC is essential to good financial management. When the WACC is applied to specific investment decisions, it can make the difference between accretion and erosion of shareholder value.
[Joan K. Cousins, CCM]