We have established in our previous blogs the importance of finance for the survival and growth of a business. However, this finance comes at a cost, which also enables the determination of true profitability. The use of debt and equity to meet the long-term goals of the business makes up for the capital structure. So, what is the cost of capital, and how does it impact the profitability of a business? Check out this blog to learn the meaning of the cost of capital and its relevant details.
The cost of capital is the amount of money a company has to pay to raise funds for its business activities, like starting a new project, buying equipment, or expanding of business. This money can come from different sources, like taking loans (debt), selling shares (equity), or using retained profits. Each of these sources has a cost, which is the return expected by the investors or lenders. Cost of capital essentially represents the minimum return expected by the providers of such funds. Furthermore, understanding the cost of capital also helps the business decide if a project is worth investing in. If the return on investment is higher than the cost of capital, the project is likely to be profitable.
Cost of capital can be clarified under various categories representing the cost of various components of capital structure or the average cost as a whole. The details of the type of cost of capital are explained below.
This is the cost a company pays when it borrows money, usually in the form of interest on loans or bonds. Since interest payments are tax-deductible, the cost of debt is usually calculated after taxes.
The formula to calculate the cost of debt is,
Cost of Debt (after tax) = Kd = Interest Rate * (1 - Tax Rate)
Let us consider the following example to understand the calculation of the cost of debt.
Company Q pays 10% interest on a loan and has a 30% tax rate. The cost of capital in this case will be,
Kd = 10% * (1 - 0.30) = 7%
This is the return that shareholders expect for investing in the company. Unlike debt, equity does not have to be mandatorily paid back or paid back in full, however, shareholders expect dividends and growth in the value of their shares. The cost of equity is usually higher than the cost of debt as shareholders take more risk. There are two main methods to calculate the cost of equity, as explained below.
Dividend Discount Model (DDM)
This is a simple method to calculate the cost of equity and is used when the company pays regular dividends. The formula to calculate the cost of equity under this model is,
Ke = (D1 / P0) + g
Where,
D1 = Expected dividend in the next year
P0 = Current share price
g = Dividend growth rate
Consider the following example to understand it better,
Company Z has an expected dividend is Rs. 2, the share price is Rs. 40, and the growth rate is 5%. The cost of equity in this case will be,
Ke = (2/40) + 0.05 = 10%
Capital Asset Pricing Model (CAPM)
This model is used when dividends are not stable or when market risk is a better measure of return. It calculates the cost of equity based on the risk of the company compared to the overall market.
The formula to calculate the cost of capital using the CAPM model is,
Ke = Rf + β*(Rm - Rf)
Where,
Rf = Risk-free rate (e.g., government bond rate)
β = Beta (a measure of how risky the stock is compared to the market)
Rm = Expected market return
(Rm - Rf) = Market risk premium
Consider the following example to understand the calculation of the cost of equity using the CAPM model
Company C has a risk-free rate is 4%, the market return is 10%, and the company's beta is 1.2. The cost of equity in this case is,
Ke = 4% + 1.2 * (10% - 4%) = 11.2%
This is the cost of issuing preferred shares, which pay a fixed dividend to investors. Preferred shareholders are paid before common shareholders. The formula to calculate the cost of preference capital is,
Kp = Dp / Pp
Where,
Dp = Dividend on preferred shares
Pp = Market price of preferred shares
Consider the following example to understand it better,
Company V has preferred shares paying Rs. 6 annually, and its market price is Rs. 100. The cost of preference shares is calculated as under.
Kp = 6/100 = 6%
Retained earnings are the part of the company’s profit that is not given out as dividends but is reinvested back into the business. Although there is no direct cost, shareholders expect a return on this reinvested profit.
It is usually considered equal to the cost of equity as it is the return shareholders expect.
This is the average cost of all sources of capital (debt, equity, preferred shares), weighted by their proportion in the company’s capital structure. It gives one overall rate that the company uses to decide if a project is worth it. The formula to calculate the WACC is,
WACC = [(E/V) * Ke] + [D/V * Kd * (1 - T)] + [P/V * Kp
Where,
P = Market values of Equity, Debt, and Preferred shares
V = Total Capital = E+D+P
T = Tax rate
Let us understand the calculation of WACC using the following example.
Company D is financed 50% by equity, 40% by debt, and 10% by preferred shares with costs of 10%, 6%, and 7%, respectively. The WACC of Company D is,
WACC = (0.5 * 0.10) + (0.4 * 0.06) + (0.1 * 0.07) = 8.1%
Cost of capital is a crucial metric of consideration and analysis for investors and companies alike. It can help evaluate business options or make strategic capital budgeting decisions that are based on hard facts rather than impulse. The importance of the cost of capital can be explained hereunder.
Cost of Capital acts like a ‘cut-off’ rate for deciding whether a project is worth investing in. If a new project is expected to earn more than the cost of capital, it is considered profitable. If it earns less, the company may avoid it. This helps businesses use their money wisely and avoid losses.
Companies often need to plan how to raise money through loans, equity, or internal profits. This is known as the capital structure. Knowing the cost of capital helps them choose the cheapest and most efficient way to finance their operations and growth. It supports better budgeting and financial decisions, reduces their overall financing cost and increases profits.
The cost of capital shows the minimum returns investors should expect for the risk they are taking. For example, if the cost of equity is 12%, an investor will expect at least that much return from a company’s shares. This helps investors compare different options in the stock market.
When calculating the value of a company by using models like Discounted Cash Flow (DCF), the cost of capital is used to discount future profits. A lower cost of capital increases the company’s value, while a higher one decreases it. This is very important for startups and businesses looking for funding or IPOs.
Companies can use the cost of capital as a standard to check if a business unit or project is performing well. If a business earns more than its cost of capital, it is adding value. If it earns less, it is destroying value. This helps firms evaluate the performance of different divisions clearly.
If a company manages its cost of capital well, it can achieve higher profits and better returns for shareholders. This increases investor confidence and can raise the company's share price on the stock market.
Cost is the singular factor that has the most direct and prominent impact on the profitability of a project or the business as a whole. Thus, it is important to understand the true impact of the cost of capital on the profitability of the business to make sound business decisions. Here is a detailed analysis of the same.
Any business, whether large or small, needs to take strategic investment decisions that come with a cost. This cost is known as the cost of capital, i.e., the minimum return the company must earn to justify the money spent. If a company invests in a new project (like building a new factory or launching a new product), and the expected return from the project is higher than the cost of capital, then the company earns a profit. However, if the return is lower than the cost of capital, the company loses money. Hence, the cost of capital directly decides whether a business decision adds to profitability or not.
When a company borrows money (debt) or raises funds from investors (equity), it has to pay interest or give returns. These payments are part of the company’s expenses. A higher cost of capital means higher payments, which reduce the net profit. For example, if a manufacturing company borrows at a high-interest rate of 14%, its profits will be lower than a competitor who borrows at 9%. So, the lower the cost of capital, the higher the potential profits.
A company that manages to keep its cost of capital low can take more investment opportunities, expand faster, and grow its market share. Companies with lower costs can invest in new technologies, open new branches, or enter new markets more easily. This leads to higher long-term profits. On the other hand, companies with a high cost of capital may miss growth opportunities because their expected returns do not exceed their financing costs.
Profitability is not just about total profit, rather, it is also about how much return a company earns compared to the money invested. If a company earns more than its cost of capital, it is creating value for shareholders. This improves financial ratios like Return on Capital Employed (ROCE) and Return on Equity (ROE), which are closely watched by investors. Investors use these metrics to judge how well a company is using its funds, where high performance in these areas means higher profitability and trust.
Sometimes, businesses are tempted to invest in projects that ‘look good’ but do not actually deliver enough returns. By comparing the projected return with the cost of capital, companies can avoid projects that would harm profitability. This protects the business from wasting money and helps focus on areas that truly increase profit.
When a company earns profits greater than its cost of capital, the market sees it as an efficient and well-managed business. This builds confidence among investors, including retail and institutional investors. As a result, the company’s stock price increases, making it easier to raise funds in the future. If the company consistently earns less than its cost of capital, its stock price may fall, and investors may lose interest.
Although the cost of capital is vital for any business to monitor and manage, there are a few limitations in using this fundamental concept that also should not be ignored. These limitations include,
Difficult to Estimate Correctly - It is challenging to get accurate numbers for inputs like future dividends, market return, or beta (risk factor). Small errors in these inputs can result in the wrong cost of capital, leading to incorrect decisions.
Changes Over Time - The cost of capital is not fixed. It changes with interest rates, inflation, market risks, and company performance. In India, for example, rising repo rates can increase the cost of debt quickly.
Ignores Market Conditions Sometimes - Models like CAPM or DDM assume ideal conditions. But in real markets, there are sudden ups and downs, political risks, or regulatory changes, which are not always captured.
Hard to Calculate for New or Small Companies - Startups and small businesses may not have enough data to calculate the cost of equity (like beta or market return). This makes it hard to use the standard models.
Assumes Risk and Return Are Stable - Most models assume that a company's risk (like beta) and investor expectations stay the same. However, in real cases, these can often change, especially in fast-growing or risky sectors. Inability to accurately account for such factors can result in wrongful calculation of the cost of capital.
Can Be Biased by Assumptions - Organisations may use different assumptions for growth rate, tax rate, or capital structure. This can lead to different cost of capital values, which may confuse decision-makers.
Does Not Reflect Liquidity or Practical Issues - Even if the cost of capital looks low on paper, the company may not get money at that rate due to poor credit rating or low investor interest, especially in rural or less-developed parts of India.
Overlooks Strategic or Social Value - Sometimes projects with social or long-term benefits (like green energy, rural expansion, or CSR) may have low financial returns but high impact. The cost of capital may reject such useful projects.
Tax and Regulatory Changes Can Affect It - In countries like India, frequent changes in GST, tax rules, or SEBI regulations can affect borrowing cost or investor behaviour, making the original cost of capital estimate outdated.
Cost of capital is a very important concept for both companies and investors. It tells how much return a company must earn to cover the cost of raising money through loans, shares, or profits. Understanding COC helps in making smart investment decisions, planning business growth, and improving profitability, thus aiding businesses to use money wisely and create more value for investors.
This article is a detailed analysis of the cost of capital of a business and its various aspects. We hope we could provide valuable insight into the topic to help clarify and simplify this fundamental concept. Let us know your thoughts on the topic, and watch this space for detailed analysis on similar concepts.
Till then, Happy Reading!
Read More: Solvency Ratio - What are they and what do they say?
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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