Cost of capital and leverages - meaning,significance and components

Understanding Cost of Capital

Understanding the Cost of Capital Investors Lenders Cost of Capital Company Obligations

What is Cost of Capital?

Imagine you need money to start or grow a business. You can get this money from various sources, like:

Your own savings (Equity): Money you or your partners invest.
Loans (Debt): Borrowing from a bank or other financial institution.

Each of these sources comes at a cost. The cost of capital is the rate of return a company must earn on its investments to satisfy its investors and lenders. It's basically the price a company pays for using other people's money.

Think of it this way: If you borrow money to buy a car, you need to pay interest. Similarly, a company needs to pay a return to its investors and lenders for the money they provide. This return is the cost of capital.

Why is the Cost of Capital Significant?

The cost of capital is a crucial factor for businesses because it impacts various decisions:

Investment Decisions:
- Project Evaluation: A company needs to earn a return on an investment that is higher than its cost of capital to create value. If a project's return is less than the cost of capital, it's not worth pursuing.
- Capital Budgeting: The cost of capital is used to discount future cash flows of potential projects to assess their Net Present Value (NPV) and profitability.
Financing Decisions:
- Optimal Capital Structure: Companies aim for the right mix of debt and equity financing to minimize their cost of capital. Too much debt can be risky, while too much equity might not be cost-efficient.
- Raising Funds: Knowing the cost of different sources of capital helps companies decide the most economical way to raise money.
Company Valuation:
- Discount Rate: The cost of capital is a key discount rate used in valuation models to determine the present value of a company's future cash flows.
- Investor Perspective: Investors use the cost of capital to evaluate whether a company's returns are sufficient for the risk they're taking.
Performance Measurement:
- Return on Investment (ROI): The cost of capital serves as a benchmark to assess whether the company's performance is adequate and creating value for shareholders.

Components of Cost of Capital

The cost of capital is derived from the cost of each financing component a company uses. These components are:

Cost of Equity (Ke):
- This is the return shareholders expect for investing in the company.
- It's more difficult to calculate directly, as it's not an explicit cost like interest.
- It's usually estimated using models like the Capital Asset Pricing Model (CAPM), Dividend Discount Model (DDM), or Bond Yield Plus Risk Premium.
Cost of Debt (Kd):
- This is the interest rate a company pays on its borrowings (loans or bonds).
- This is an explicit cost, as it's a contractual obligation.
- However, interest payments are tax-deductible, so the after-tax cost of debt is used. The formula for after-tax cost of debt is: Kd * (1 - Tax Rate).
Cost of Preference Shares (Kp):
- This is the return required by preference shareholders.
- Often calculated as the dividend paid on preference shares divided by the current market price of a preference share.

Computation: Cost of Capital and Weighted Average Cost of Capital (WACC)

Individual Component Cost Calculation

Cost of Equity (Ke) - using CAPM
- CAPM Formula: Ke = Rf + Beta * (Rm - Rf)
  - Rf = Risk-free rate (e.g., yield on government bonds)
  - Beta = Measure of a stock's volatility relative to the market.
  - Rm = Expected return of the market.
- Example: Let's say Rf=4%, Beta = 1.2 and Rm = 10%. Then, Ke = 4% + 1.2 * (10% - 4%) = 4% + 1.2 * 6% = 11.2%.
Cost of Debt (Kd) - After-tax
- Formula: Kd * (1 - Tax Rate)
  - Kd = Interest rate on debt
- Example: A company has a loan with a 7% interest rate and the company's tax rate is 25%. Then, the after-tax Kd = 7% * (1 - 0.25) = 7% * 0.75 = 5.25%
Cost of Preference Shares (Kp)
- Formula: Kp = Dividend per share / Market price per share
- Example: A company issued preference shares with an annual dividend of $2 per share, and each preference share trades at $25. The cost of preference shares is then Kp = $2 / $25 = 8%

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) combines all the individual component costs into a single, overall cost of capital for the company. It is "weighted" by the proportion of each capital component in the company's total capital structure.

Formula:

WACC = (We * Ke) + (Wd * Kd * (1 - Tax Rate)) + (Wp * Kp)

Where:
- We = Proportion of Equity in the Capital Structure
- Ke = Cost of Equity
- Wd = Proportion of Debt in the Capital Structure
- Kd = Cost of Debt
- Tax Rate = Corporate Tax Rate
- Wp = Proportion of Preference Shares in the Capital Structure
- Kp = Cost of Preference Shares
Example:

Let's assume:
- Equity (E): 60% of capital, Ke = 11.2%
- Debt (D): 30% of capital, Kd = 7%, Tax Rate = 25% so after-tax Kd = 5.25%
- Preference Shares (P): 10% of capital, Kp = 8%
- WACC = (0.60 * 11.2%) + (0.30 * 5.25%) + (0.10 * 8%)
- WACC = 6.72% + 1.575% + 0.8%
- WACC = 9.095%
Therefore, the overall WACC for the company is approximately 9.1%. This means the company needs to earn a return of at least 9.1% on its investments to satisfy its investors and lenders.

Key Takeaways

Cost of capital is the minimum return a company needs to earn to satisfy its investors.
It plays a significant role in investment decisions, financing decisions, valuation and performance measurement.
It consists of the cost of equity, debt, and preference shares.
WACC is the overall cost of capital, calculated by weighing each component cost based on its proportion of total financing.
Understanding cost of capital is vital for making sound financial decisions and maximizing company value.