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Cost of Capital Calculator

What is the cost of capital?How to calculate the cost of capitalThe importance of cost of capitalFAQs

Utilizing our cost of capital calculator, we aim to help you assess the combined impact of a company's cost of equity and cost of debt. For more detailed analysis, explore our WACC calculator and after-tax cost of debt calculator.

This piece is designed to enhance your comprehension of:

• What cost of capital is;
• Its significance in assessing a company's investment potential; and
• How to calculate the cost of capital.

We'll also include examples to elucidate the process of calculating the cost of capital.

What is the cost of capital?

The cost of capital is a fundamental financial metric used to evaluate a company's overall expense to finance its operations and growth, either through debt, equity, or a combination of both. It represents the required rate of return that investors demand to invest in the company's bonds and stocks.

As the costs or expenses of the company (its liability) are the income or return of the investors (their assets), the cost of capital can be assessed from the investors' perspective. Thus, the cost of capital represents the required rate of return that investors demand to invest in the company's bonds and stocks.

There are two components in the cost of capital:

• Cost of equity: This is the return shareholders expect on their investment in the company. It reflects the compensation investors require for taking on the risk associated with owning the company's equity. The cost of equity is typically higher than the cost of debt, as equity does not offer the same security features as debt financing and carries a higher risk of loss.

• Cost of debt: This is the effective rate that a company pays on its borrowed funds. It includes interest payments on bonds and loans. The cost of debt is generally lower than the cost of equity because it is tax-deductible, reducing the company's net expense, and because creditors have a higher claim on company assets than shareholders in the event of bankruptcy.

How to calculate the cost of capital

When evaluating the overall financial efficiency and investment potential of a company, understanding the total cost of capital is crucial. For this illustration, we'll use the cost of capital formula provided: cost of capital = cost of equity + cost of debt. This approach directly adds the cost of equity and the cost of debt, providing a straightforward measure of the total financing cost that a company incurs. Let's explore this with a hypothetical scenario:

• Company name: Delta Technologies
• Cost of equity: 8%
• Cost of debt: 5%
1. Understanding the cost of equity.

The cost of equity represents the return that investors expect for the risk they undertake by investing in the company's equity. For Delta Technologies, this rate is given as 8%. This figure is derived considering the risk-free rate (such as returns from government bonds), the equity market risk premium (additional returns expected over the risk-free rate), and the beta (a measure of the stock's volatility relative to the market). To understand more about this calculation, check our CAPM calculator. This percentage reflects the compensation required by shareholders to justify the inherent risks of their investment.

2. Determining the cost of debt.

The cost of debt is the effective interest rate the company pays on its borrowed funds. For our hypothetical company, this rate is 5%. This rate typically includes interest payments on bonds and loans, adjusted for the tax shield benefit since interest expenses are deductible before taxes. The cost of debt is generally lower than the cost of equity due to its priority in bankruptcy and tax advantages.

3. Calculating the cost of capital.

To compute the total cost of capital, we simply add the cost of equity to the cost of debt using the cost of capital formula:

cost of capital = cost of equity + cost of debt

The result, 13%, represents the combined annual cost percentage that Delta Technologies effectively pays on its financing structure. It's a crucial metric because it sets the baseline rate of return that the company must earn on its investments and projects to ensure they add value, i.e., to meet or exceed this cost of capital. If the company's return on investment falls below this threshold, it might indicate that it is not generating sufficient returns relative to the risks associated with its financing.

The importance of cost of capital

Now that we understand what cost of capital is and how to calculate cost of capital, let's dive deeper into understanding its importance.

Understanding the cost of capital is crucial for corporate finance decisions. It serves as a benchmark for making investment decisions, evaluating new projects, and determining the feasibility of financing options. If the returns on an investment are expected to exceed the cost of capital, the project may be considered viable as it promises to generate value for the shareholders.

Moreover, the cost of capital is often used by investors to assess the risk and potential return of investing in a company compared to other investment opportunities in the market. Lowering the cost of capital can enhance a company's value and improve its competitive position by enabling more profitable investments and acquisitions.

Calculating the cost of capital requires a careful analysis of both market conditions and the company's specific financial situation. It integrates various financial metrics and assumptions, including the risk-free rate, market risk premium, and the company’s specific risk factors, to deliver a comprehensive measure of the financial efficiency and risk involved in financing the company’s operations.

FAQs

What is the cost of capital if cost of debt and cost of equity are 10%?

The cost of capital will be 20%. You can calculate this using the cost of capital formula:

cost of capital = cost of equity + cost of debt

How do I calculate the cost of capital of a company?

You can calculate the cost of capital in three steps:

1. Compute the cost of equity.

2. Determine the cost of debt.

3. Apply the cost of capital formula:

cost of capital = cost of equity + cost of debt

Can the cost of capital change over time?

Yes, the cost of capital can fluctuate due to changes in market conditions, company-specific risks, financial performance, and the overall economic environment.

What is the difference between the cost of capital and the WACC?

The cost of capital is a simplified version typically used for illustrative purposes. The WACC is a more precise calculation that takes into account the proportion of each type of financing in the company’s capital structure.