Cost of Capital
Businesses can buy assets using either debt (borrowed money), cash (equity) or a combination of both; each of these have costs built into them. The cost of using borrowed money is clear: it’s the interest. The cost of using cash is not as clear but it can be calculated and is consistently higher than using debt. Putting the actual calculation aside, the cost of capital gives us a benchmark for improving the value of a company; the returns we get on our assets need to beat the cost of capital or we’re in trouble.
Cost of Capital in-depth
Every business uses two forms of financing for purchase of the assets employed or used in the business: debt and equity. Debt is borrowed money and equity is cash investments. Business owners typically use both forms of financing in some combination that suits management for the risk being tolerated. The important thing to remember is that both forms of financing always have an implied, if not explicit, cost to them: the cost of capital.
In financing, the implicit cost is just as real as the explicit cost. For instance, when it comes to debt, the cost of the debt is the interest rate charged and that is the explicit debt cost. The interest rate is calculated on an after tax rate for the net cost of debt. Principal payments are not a cost of debt but do affect the cash flow. When a zero coupon bond is used for financing, then the cost of debt is implied (rather than explicit) and accrued interest rate would be used for the cost of the interest expense and would be calculated after tax.
But how about equity? Is there a cost to equity and, if so, how is the cost of equity calculated?
There is always a cost to equity, whether explicit or implicit, and that cost can always be calculated. When a business produces a net income after tax (after paying interest expense on outstanding debt), that income is divided by the book equity on the balance sheet for the corresponding period of the income statement. This result of this calculation is the return on equity for the period being measured. But let’s take this a step further.
What if the return on the equity is lower than required by investors who would be interested in purchasing part or all of the equity, what happens then? In this case, the correct return on equity should be used, which is not the explicit or actual return but the implied one.
Your business’s COC is calculated by taking your after tax interest expense and dividing it by your total liabilities to get your cost of debt. Next, your after tax net income is divided by book equity to get your cost of equity. Now, add your debt and equity together and divide both debt and equity separately by this sum to get two percentage proportions. Finally, multiply those two percentages times the respective debt cost and equity cost and add the two results together. This, finally, is our weighted cost of capital and is used as the required rate of return used to discount cash flows to arrive at a total firm value.
The cost of capital is just like having the cost of goods for a product or service that we would want to sell. We, of course, would not want to sell a product or service for less than the cost of goods so our cost of capital gives us a hurdle rate that needs to be exceeded in order to maintain the value. This is the economic value of the total assets employed in the business. The return on assets is the return that we use to measure against the cost of capital.
If the return on assets is higher than the cost of capital, the firm is increasing the economic value of the book total assets. If the return on Assets is equal to the cost of capital, then the economic value of the total book assets are being maintained. Lastly, and unfortunately more common, if the return on assets is lower than the cost of capital then the firm is destroying the economic value of the total book assets by the amount of the spread between the two times the total assets. This spread, by the way, is called the Economic Value Added and, as you can see, can be positive or negative.
Don’t let your Cost of Capital get in the way of the growth of your business!
Cost of Capital example
Cars in America are essential if you live outside of a metropolitan area. You and your family get a certain amount of utility from your car, whether that’s commuting to work or going on vacation or being able to drive to the store.
When you buy a car, typically, you put a certain amount down and finance the rest. The money you finance is charged a certain interest rate and the money you used as a down payment could be used in other ways (paying off debt, investing, etc). If you get a 0% APR on your loan, your cost of capital is improved by financing as much as you possibly can with “cheap” financing freeing up your cash to work elsewhere for higher rates of return. If, on the other hand, you get stuck with a 14% rate, your cost of capital will benefit by putting as much down as you can (assuming you can’t get a better return on your money).
Whether you finance with debt or with equity, there is a cost associated with each. Deciding whether to borrow or use cash is more complicated than business owners might expect. If you’re looking to procure a large asset or grow your business, let the Business Ferret determine the best path to secure the capital you need.