What Is Cost of Capital?
Cost of capital is the return a company's investors require in exchange for providing money to the business. Lenders require interest, and shareholders require an expected return that compensates them for taking equity risk. If a company earns less than its cost of capital on its projects, it is destroying value even if it reports an accounting profit.
Because most companies are funded with a mix of debt and equity, the overall figure is usually expressed as the weighted average cost of capital, or WACC. Each funding source is weighted by its share of the capital structure, and the cost of debt is adjusted for the tax deductibility of interest.
How It Works
The standard formula is WACC = (E/V) times cost of equity plus (D/V) times cost of debt times (1 minus tax rate), where E is equity value, D is debt value, and V is their sum. The cost of debt can be observed from a company's bond yields or loan pricing, while the cost of equity is typically estimated with the capital asset pricing model using a risk-free rate, beta, and an equity risk premium.
Riskier businesses have higher costs of capital. A volatile early-stage company might face a cost of capital above 15 percent, while a stable utility might be closer to 6 or 7 percent, which is why the same expected cash flows can be worth very different amounts at different companies.
Example
Imagine a company financed with 60 percent equity and 40 percent debt. Its cost of equity is 10 percent, its pre-tax cost of debt is 5 percent, and its tax rate is 25 percent. WACC equals 0.6 times 10 percent plus 0.4 times 5 percent times 0.75, which is 6 percent plus 1.5 percent, or 7.5 percent.
Any project this company evaluates should be expected to return more than 7.5 percent. A factory expansion projected to earn 9 percent creates value, while one projected to earn 6 percent should be rejected even though it is profitable in a simple sense.
Why It Matters
Cost of capital is the discount rate at the heart of a DCF valuation, so small changes in it can swing an implied company value by billions of dollars. It also guides real corporate decisions, from capital budgeting to whether to fund growth with debt or equity.
For anyone interviewing in investment banking or on the buy side, walking through WACC step by step is one of the most frequently asked technical questions.
