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Definition of Capital

To start or expand a business we require money and this money is called CAPITAL. There are two primary sources to obtain funds:-

• Equity finance
• Debt finance

Equity Finance is the finance or funds raised from partners, investors, or shareholders and in return, they are paid a dividend on their shareholding.

Debt Finance is the finance raised by obtaining a loan from a bank and in return, an interest charge is paid to the bank as well.

Although both of the sources have their own pros and cons. Both of them also have a cost associated with them i-e paying the dividend in the case of Equity Finance and interest charge in the case of Debt Finance this is the COST eventually paid out. So the Cost of Capital is defined as

the cost that is paid out as a result of acquiring funds (either by raising equity or acquiring loan or both of them combined)  for the capital budgeting process.

• There is no interest to be paid out either they are paid dividends and dividends are solely the discretion of the management.
• No maturity dates (no capital repayment)
• Equity investors have ownership and control over the business
• Equity investors have voting rights 
• Equity investors expect a high rate of return (dividends and capital appreciation)
• Equity investors lay claim to the firm’s assets in the event of liquidation (shutdown of operations)
• Provides maximum operational flexibility

Pros and cons of Debt

• Debt requires interest payments
• Unlike dividends, there is a fixed payment schedule and a principal repayment.
• In the event of liquidation debt providing institutions and lenders are the first to be paid out.
• Requires covenants and financial performance metrics that must be met
• Contains restrictions on operational flexibility
• Has a lower cost than equity
• Expects a lower rate of return than equity
• Small business lending can be slowed substantially during recessions. In tougher times for the economy, it’s more difficult to receive debt financing unless you are overwhelmingly qualified.

When analysts use the term cost of capital they actually refer to a blend of the cost of equity and the cost of debt. It is also called the weighted average cost of capital or WACC.

Each category of the firm’s capital is weighted proportionally to arrive at a blended rate, and the formula considers every type of debt and equity which includes loan notes, and common and preferred stocks.

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Cost of Debt

The cost of debt is simply the interest charge that is paid when you acquire a loan from a bank, although interest expense is tax-deductible i-e it reduces the amount of tax.

Calculation of Cost of Debt

[latex](interest  charge/total  debt)*1-T[/latex]

Where,

T= Company’s marginal tax rate

interest charge = interest on the company’s current debt

Cost of Equity

Cost of Equity is the rate of return a company pays out to equity investors. Because someone who is investing in your business requires a return on their investments..right!! that’s common sense.

The risk-free rate of return is the theoretical rate of return of an investment with zero risk. Real risk-free return is calculated by subtracting the prevailing inflation rate from the rate of return the treasury bonds offer.

R_f= R_t – i

Where,

• R_f= Risk-free rate of return
• Rt= Rate of government treasury bonds
• i= Rate of inflation

Calculation of Cost of Equity

The cost of equity is calculated by CAPM(Capital Asset Pricing Model)

E(R_i) = R_f + β_i * [E(R_m) – R_f]

• E(R_i) = Expected rate of return or cost of equity 
• R_{f =} Risk-free rate of return
• β_{i =}  Beta of investment
• E(R_m) = Expected market rate

Where Beta is a measure of the volatility of the investment or it can also be called the risk constant of a particular investment…

It is basically the risk associated with the investment relative to the market. It is calculated by regression analysis.

If,

• β_i < 1    Investment is less risky relative to the market (less volatile)
• β_i = 1    Investment is equal in risk relative to the market (equal volatility)   
• β_i > 1    Investment is riskier relative to the market (more volatile)

For Public Companies, the formula would require a  company’s own stock beta. For private companies, Beta is estimated based on the average beta of a group of similar, public firms. Analysts may refine this beta by calculating it on an after-tax basis. The assumption is that a private firm’s beta will become the same as the industry average beta.

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Calculation of Weighted Average Cost of Capital (WACC)

After the calculation of the cost of equity and cost of debt let us consider a scenario in which a company raises capital consisting of 60% equity and 40% debt, its cost of equity is 12% and the after-tax cost of debt is 9%.

Therefore, its WACC would be:

(0.12 * 0.60)+(0.09 * 0.40)=0.072+0.036= 0.108 or 10.8%

This is the cost of capital that would be used to discount future cash flows from potential projects and other opportunities to estimate their net present value (NPV) and the ability to generate value.

Factors affecting the Cost of Capital

There are various factors that can affect the cost of capital mainly are:

• Market opportunity or opportunity cost of capital
• Capital provider preference
• Risk associated 
• Inflation rate
• Capital structure policy
• Investment policy
• Dividend policy

The opportunity cost of capital is the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing in a marketable security. 

If a project yields a return greater than the short-term marketable securities then that project would be taken by the management otherwise no management having a sane mind would think of pursuing it.

For example, the senior management of the business expects to earn 6% on a long-term $10,000,000 investment in a new manufacturing facility, or it can invest the cash in stocks for which the expected long-term return is 9%. Barring any other considerations, the better use of the cash is to invest $10,000,000 in stocks. The opportunity cost of capital for investing in the manufacturing facility is 3%, which is the difference in return on the two investment opportunities.

Market opportunity can also be seen in the context of “demand and supply“. Considering a scenario in which the economy is in boom and more and more entrepreneurs are getting into startups the demand for the capital would increase obviously so does the cost as the venture capitalists, lenders and banks would be tempted to increase their return rates.

Capital provider preference refers to the individual’s preference regarding the provision of capital which includes his/her wants either to save the money or invest it.

Capital providers want to invest in a project that maximizes returns. The minimum return on the investment required by the investor is inflation. At the minimum, an investment should be more than the rate of inflation and there should be some real income. Real income is the returns minus the prevailing inflation. For example, you invested money that could buy you a car a year ago. After a year when your investment is matured and you receive money, you would at least expect that money should be able to buy that same car. If the matured money falls short of buying you the same car, you have diminished the value of your money in the last year. If the money is more than just buying the car, you have earned real income on your investment.

So, How does the cost of capital affect a firm’s value?

The cost of capital is all about making sure a company is profitable for both owners and investors. When two investments of equal risk are considered, investors (or company owners) will determine the cost of capital and generally choose the one providing a higher return.

In addition, investors use the cost of capital as one of the financial metrics they consider in evaluating companies as potential investments.

Because interest on the debt is typically tax-deductible, and because the interest rates associated with debt are typically cheaper than the rate of return expected for equity, debt is usually preferred. However, as more debt is accumulated, the credit risk associated with that debt also increases and so equity must be added to the mix.