## 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:

**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:

**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:

**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: