What is Your Cost of Capital?

Suppose you want to acquire new equipment for your company to make your manufacturing processes more efficient. Or you want to revamp your management team systems. Before you can justify undertaking such projects, you will need to prove to your stakeholders that you can generate a return on investment and that this return will be better than the cost of capital. So, what is it exactly, and how can you calculate it? Let’s take a look.

What do we mean by cost of capital?

The cost of capital is the return that those who have provided you with money for your business expect to get in return for their investment. Or in other words, the evaluation of whether a decision can justify a capital structure budgeting undertaking such as buying new equipment, expanding a factory, or creating a new product line. In some cases, investors can also use the term cost of capital to evaluate a project’s potential return when compared to costs and risks.

Who should calculate cost of capital and how?

The groups of people that will typically put up the capital to run a business are of two kinds: Investors and debt holders. The goal of any investment banking company or debt financing involved in such a project is to get a return and be repaid, respectively.

In most businesses, the cost of capital is calculated by financial analysts mechanically. Then, the number is given to the management team, who must decide on the hurdle rate and discount rate that justifies the investment. In many cases, the cost of capital can be lower than the required rate of return or discount rate. Companies that are more risk-averse will tend to raise these rates, but businesses looking to stimulate investments can use a lower one, at least for a period of time.

Few managers will calculate both the cost of capital and relevant weighted average cost themselves, as this tends to be done by finance professionals. However, the steps to do so are as follows:

  • Calculate the company’s cost of debt: Take all the money the business has borrowed over time and analyse all the interest rates. Then, average the credit line, loans, and bonds, and multiply the result by the corporate tax rate (if it applies). The formula should be:

Cost of debt = Average interest x (1 – tax rate)

  • Do the equity capital calculation: This step is more theoretical, as it needs to account for prevailing interest payments and beta. The beta measures your company’s preferred stock volatility compared to the market value (a higher beta means more risk), while the market rate refers to the expected return you could see right now. The number is up for debate but tends to fall between 10 and 12%. The formula is:

Equity cost = risk-free interest rate + beta (market rate – risk-free rate)

  • Weight your two results: The last step is to take both resulting percentages (the cost of debt and the cost of equity) and calculate the weighted average cost of capital or your company’s WACC. For example, if your cost of debt is 5% and your cost of equity 11%, and your business uses 20% debt and 80% equity, the calculation would be:

(0.2 x 5%) + (0.8 x 10%) = 9%

One important thing to remember is that this number will be made up of several projections. By using a current structure to calculate a return in the future, you are assuming the beta will remain the same – which is rarely the case.

If you don’t know your beta, you can estimate it based on the average for similar public companies. It’s always a good idea to run this number by financial analysis experts to ensure they can add the tax rate percentage and other tax-deductible considerations.

What is the cost of capital used for?

The two main uses for the cost of capital are to evaluate individual investments (usually done by senior leaders) and to assess the risk of a company’s equity (typically carried out by investors). The cost of capital determines future opportunities and discounted cash flow and their ability to generate value.

Most companies will try to invest in initiatives that exceed the cost of capital, so this number is helpful for determining which financing track is better for a company to follow, such as equity, debt financing, or a combination of both. For early-stage companies, which tend not to have seizable assets they can already use as collateral for a loan, equity financing is typically the preferred choice. Debt financing is also generally more tax efficient than equity financing because the interest rates are tax deductible, and dividends are often paid on an after-tax basis. However, too much debt can result in higher leverage levels (and, therefore, a steeper interest expense).

In short, businesses and financial analysts use the cost of capital to determine whether a firm’s funds are used effectively. If an investment return is equal to or lower than the cost of capital, the money is probably not being spent wisely. The number can also help determine a company’s valuation because equity investors are likely to see less value in businesses with higher cost of capital.

Reducing your cost of capital with R&D finance

Cash is indispensable for any company wanting to run successfully. However, many startups haven’t yet had a chance to prove their idea in the market, resulting in a weaker negotiating position when it comes to meeting with investors and lenders.

Your WACC is the average cost of the company’s capital you raise, and when you can only access equity funding, it will rely solely on your company’s evaluation. Most businesses also don’t yet have the assets to pre-revenue to access debt financing, and most lenders will tend to prefer safer bets. In this case, something worth considering is R&D financing.

If you’re interested in exploring your cost of capital under R&D finance, don’t hesitate to contact Fundsquire so you can learn how to use your debt smartly and optimise your WACC so you don’t have to erode your founder equity position.

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