Understanding the Cost of Capital
Cost Of Capital-
The overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the weighted average cost of capital (WACC).
Cost of capital represents the return a company needs in order to take on a capital project, such as purchasing new equipment or constructing a new building.
Significance of Cost of Capital
Cost of Capital is significant in the following decisions:
- Investment Decision
- It provides a basis for comparison among projects as a standard or cut-off rate.
- It is useful in taking capital budgeting/investment decisions.
- It assists capital budgeting decisions since businesses must decide if a project is worthwhile before starting.
- It can also be used to evaluate the performance of certain projects as compared to the cost of capital.
2. Capital Structure of Firm
- It recognises the various sources of finance from which the investment proposal derives its life-blood (i.e. finance).
- It indicates an optimum combination of various sources of finance for the enhancement of the market value of the firm.
- It is essential for businesses to design the ideal capital structure of their firm.
- Cost of Debt
The cost of debt is merely the interest rate paid by the company on its debt.
Cost of debt = Total debt×(1−T)/Interest expense
where: Interest expense=Int. paid on the firm’s current debt, T=The company’s marginal tax rate
Interest/total debt= interest rate= risk free rate+ risk premium
2. Cost of Equity
The cost of equity is more complicated since the rate of return demanded by equity investors is not as clearly defined as it is by lenders. The cost of equity is approximated by the capital asset pricing model as follows:
CAPM(Cost of equity)=Rf+β(Rm−Rf)
where: Rf=risk-free rate of return, Rm=market rate of return
Beta is used in the CAPM formula to estimate risk and public company’s own stock beta. For private companies, a 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 unleveled, after-tax basis. The assumption is that the private firm’s beta will be the same as the industry average beta.
The firm’s overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.
Therefore, its WACC would be: (0.7×10%) + (0.3×7%)=9.1%
Now, assumptions about the costs of equity and debt, overall and for individual projects, profoundly affect both the type and the value of the investments a company makes. Expectations about returns determine not only what projects managers will and will not invest in, but also whether the company succeeds financially.
The Consequences of Misidentifying the Cost of Capital
Overestimating the cost of capital can lead to lost profits; underestimating it can yield negative returns.
Points which cause Miscalculation
1. Investment time horizon
2. Tax rate misjudgement
The decision about what tax rate to use can have major implications for the calculated cost of capital. Whether a company uses its marginal or effective tax rates in computing its cost of debt will greatly affect the outcome of its investment decisions.
This seemingly innocuous decision about what tax rate to use can have major implications for the calculated cost of capital. The median effective tax rate for companies on the S&P 500 is 22%, a full 13 percentage points below most companies’ marginal tax rate, typically near 35%. At some companies, this gap is more dramatic. GE, for example, had an effective tax rate of only 7.4% in 2010.
3. Risk-Free Rate — Most investors, managers, and analysts use U.S. Treasury rates / RBI repo rate (India) as the benchmark.
4. Equity market premium (risk premium)- Depends on the credit rating of the company hence varies for each company.
About half the companies use a risk premium between 5% and 6%, some use one lower than 3%, and others go with a premium greater than 7% — a huge range of more than 4 percentage points. However, many companies are not adjusting the market risk premium in line with events like the Financial crisis or Covid 19 outbreak.
5. Risk of the company stock-
The final step in calculating a company’s cost of equity is to quantify the beta, a number that reflects the volatility of the firm’s stock relative to the market. A beta greater than 1.0 reflects a company with greater-than-average volatility; a beta less than 1.0 corresponds to below-average volatility. There is often a debate on the time horizon for which beta should be measured (5 years to 15 years).
The beta of companies in the hospitality and tourism sector would fluctuate very widely after Covid 19 outbreak. Similarly, for sectors, such as financials, that were most affected by the 2008 meltdown, the discrepancies in beta are much larger and often approach 1.0, implying beta-induced errors in the cost of capital that could be as high as 6%. It also clearly indicates that the measurement period significantly influences the beta calculation and, thereby, the final estimate of the cost of equity.
6. Project risk adjustment-
Finally, after determining the weighted-average cost of capital, corporates need to adjust it to account for the specific risk profile of a given investment or acquisition opportunity. The way to do it is to look at companies with a business risk that is comparable to the project or acquisition target.
Most businesses are not adjusting their investment policies to reflect the decline in their cost of capital. This is resulting in businesses forgoing many viable projects. This is one of the big reason why despite record-low borrowing costs and record-high cash balances, capital expenditures worldwide are projected to be flat. It indicates that most businesses are not adjusting their investment policies to reflect the decline in their cost of capital.
Business leaders and financial advisers must evaluate and deeply brainstorm investment time horizons, cost of capital, and project risk adjustment. And it is also high time for nonfinancial corporate directors to understand how the companies they oversee evaluate investments.
