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Cost of capital

A firm's cost of capital is the cost it must pay to raise funds—either by selling bonds, borrowing, or equity financing. Organizations typically define their own cost of capital in one of two ways:

1. Cost of capital may be taken simply as the financing cost the organization must pay when borrowing funds, either by securing a loan or by selling bonds, or equity financing. In either case, cost of capital would be expressed as an annual interest rate, such as 6%, or 8.2%.
2. Alternatively, when evaluating a potential investment (e.g., a major purchase), the cost of capital is considered to be the return rate the company it could earn if it used money for an alternative investment with the same risk. That is, the cost of capital is essentially the opportunity cost of investing capital resources for a specific purpose.

In many organizations cost of capital (or, more often weighted average cost of capital) serves as the discount rate for discounted cash flow analysis of proposed investments, actions or business case cash flow scenarios. Cost of capital (or weighted average cost of capital) is also used sometimes to set the hurdle rate, or threshold return rate that a proposed investment must exceed in order to receive funding.

Cost of capital percentages can vary greatly between different companies or organizations, depending on such factors as the organization's credit worthiness and perceived prospects for survival and growth. In 2011, for example, a company with an AAA credit rating, or the US treasury, can sell bonds with a yield somewhere between 4% and 5%, which might be taken as the cost of capital for these organizations. At the same time, organizations with lower credit ratings—organizations whose future prospects are viewed as "speculative" by the bond market—might have to pay 10% - 15%, or even more.

Weighted average cost of capital (WACC)

A firm's cost of capital from various sources usually differs somewhat between the different sources of capital used. Cost of capital may differ, that is, for funds raised with bank loans, sale of bonds, or equity financing. In order to find the appropriate cost of capital for the firm as a whole, weighted average cost of capital (WACC) is calculated. This is a simply the arithmetic average (mean) capital cost, where the contribution of each capital source is weighted by the proportion of total funding it provides. 

WACC is not the same thing as cost of debt, because WACC can include sources of equity funding as well as debt financing. Like cost of debt, however, the WACC calculation is usually shown on an after-tax basis when funding costs are tax deductible.

Calculating WACC is a matter of summing the capital cost components, where each is multiplied by its proportional weight. For example, in simplest terms:

WACC = (Proportion of total funding that is equity funding ) x (Cost of equity) 
                    + (Proportion of total funding that is debt funding) x (Cost of Debt)
                    x (1 – Corporate tax rate)

In brief, WACC shows the overall average rate the company pays (average interest rate)  for funds it raises. In many organizations, WACC is the rate of choice to use for discounted cash flow (DCF) analysis to evaluate potential investments and business cash flow scenarios. However, financial officers may choose to use a higher discount rate for DCF analysis of investments and actions that are perceived riskier than the firm's own prospects for survival and growth.

Cost of debt

An organization's cost of debt is the effective rate (overall average percentage) that it pays on all its debts, the major part of which typically consist of bonds and bank loans. Cost of debt is a part of a company's capital structure. (along with preferred stock,  common stock, and cost of equity).

Cost of debt is expressed as a percentage in either of two ways: Before tax or after tax. In cases where interest expenses are tax deductible, the after tax approach is generally considered more accurate or more appropriate.  The after-tax cost of debt is always lower than the before-tax version.

For a company with a marginal income tax rate of 35% and a before tax cost of debt of 6%, the after tax cost of debt is found as follows:

After tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate)

                                     =  (0.06) x (1.00 – 0.35)

                                     =  (0.06) x (0.65)

                                     =  0.039 or 3.9% 

As with cost of capital, cost of debt tends to be higher for companies with lower credit ratings—companies that the bond market considers riskier or more speculative. Whereas cost of capital is the rate the company must pay now to raise more funds, cost of debt is the cost the company is paying to carry all debt it has acquired.

Cost of debt becomes a concern for stockholders, bondholders, and potential investors when a company is highly leveraged (i.e., debt financing is large relative to owner equity). A highly leveraged position becomes riskier and less profitable in a poor economy (e.g., recession), when the company's ability to service its large debt load may be questionable.

The cost of debt may also weigh in management decisions regarding asset acquisitions or other investments acquired with borrowed funds. The additional cost of debt that comes with the acquisition or investment reduces the value of investment metrics such as return on investment (ROI) or internal rate of return (IRR).

Cost of equity

A company's cost of equity (COE) is a measure of the returns that the stock market demands for investors who will bear the risks of ownership. Cost of equity is a part of a company's  capital structure. (along with preferred stock,  common stock, and cost of debt).

A high cost of equity indicates that the market views the company's future as risky, thus requiring greater return rates to attract investments. A lower cost of equity indicates just the opposite. Not surprisingly, cost of equity is a central concern to potential investors applying the capital asset pricing model (CAPM), who are attempting to balance expected rewards against the risks of buying and holding the company's stock. 

The two most familiar approaches to estimating cost of equity are illustrated here:

     Dividend Capitalization Model Approach:

Cost of equity = (Next year's dividend per share + Equity appreciation per share) / (Current market value of stock) + Dividend growth

Consider for example, a stock whose current market value is $8.00, paying annual dividend of $0.20 per share. If those conditions held for the next year, the investor's return would be simply 0.20 / 8.00, or 2.5%.  If the investor requires a return of, say 5%, one or two terms of the above equation would have to change:

• If the stock price appreciates 0.20 to 8.20, the investor would experience a 5% return: (0.20 dividend + 0.20 stock appreciation) / (8.00 current value of stock).
• If, instead, the company doubled the dividend (dividend growth) to 0.40, while the stock price remained at 8.00, the investor would also experience a 5% return.

     Capital asset pricing model (CAPM) approach

Cost of equity = (Market risk premium) x ( Equity beta) + Risk-less rate

Consider a situation where the following holds for one company's stock:

Market risk premium:               4.0%

Equity beta for this stock:        0.60

Risk free rate:                            5.0%

Cost of equity = (4.0%) x (0.60) +  5.0%

                          = 7.4%

In the CAPM, beta is a measure of the stock's historical price changes compared to price changes for the market as a whole. A beta of 0 indicates the stock tends to rise or fall independently from the market. A negative beta means the stock tends to rise when the market falls and the stock tends to fall while the market rises.  A positive beta means the stock tends to rise and fall with the market.

Cost of borrowing

The term Cost of borrowing might seem to apply to several other terms in this entry. As used in business and especially the financial industries, however, the term refers the total cost a debtor will pay for borrowing, expressed in currency units such as dollars, euro, pounds, or yen.

When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Cost of borrowing may include, for instance, interest payments, plus (in some cases) loan origination fees, loan account maintenance fees, borrower insurance fees, and still other fees. As an example, consider a loan with the following properties:

Amount borrowed (loan principle): $100,000.00
Annual interest rate: 6.0%
Amortization time:  10 Years
Payment frequency:  Monthly
Loan origination fee: $200.00
Monthly account maintenance fee: $5.00
Annual borrower insurance: $25.00

Such a loan calls for 120 monthly payments of $1,110.21. Thus, the borrower who makes all payments on schedule ends up repaying a total of 120 x $1,110.21, or $133,225. The borrower will also pay $200 for loan origination, $600 in account maintenance fees (120 x $5), and $250 in borrower insurance. The cost of borrowing may be calculated as:

Total repayments:                               133,225.20
Less principal repaid:                      (100,000.00)
Total interest payments:                     33,225.20
Loan origination fees:                               200.00
Account maintenance:                              600.00
Borrower insurance fees:                        250.00
Total cost of borrowing:                      34,225.20

Over the last few decades, lending institutions everywhere have begun to face increasingly stringent laws requiring them to disclose total cost of borrowing figures to potential borrowers, in clear, accurate terms, before signing loan agreements.

Cost of funds / Cost of funds index (COFI)

The term cost of funds, like cost of borrowing (above) might seem to apply to several other terms in this entry, but in practice the proper use of the term refers to the interest cost that financial institutions pay for the use of money.

Whereas other kinds of businesses (for example, those in product manufacturing or service delivery) raise funds that ultimately support more product production and/or service delivery in one way or another, financial institutions make money essentially by making funds available to individuals, firms, or institutions. The funds used for this purpose are acquired at a cost—the cost of funds.

• For banks or savings and loan firms, cost of funds is the interest they pay to their depositors on, for example, certificates of deposit, passbook savings accounts, money market accounts, The bank uses depositor funds for loans it issues, but the use of those funds comes with a cost.
• For a brokerage firm, cost of funds represents the firm's interest expense for carrying its inventory of stocks and bonds.

Besides interest expenses, the cost of funds may also include any non-interest costs required for the maintenance of debt and equity funds. These non-interest components of cost of funds may include such things as labor costs or licensing fees, for instance. 

A bank's cost of funds is related to the rates it charges for adjustable rate loans and mortgages. Banks will set interest rates for borrowers based on a cost of funds index (COFI) for their region. In the United States, for instance, banks set variable mortgage interest rates with reference to the COFI established for their region by a Federal Home Loan Bank.