5.2 Cost of Capital - 5.2 Cost of Capital Explained

Key Concepts

• Cost of Equity
• Cost of Debt
• Weighted Average Cost of Capital (WACC)
• Capital Structure
• Marginal Cost of Capital

Cost of Equity

The Cost of Equity is the return that a company theoretically pays to its equity investors, for providing capital to the company. It is often calculated using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the market risk premium, and the company's beta.

Example: If the risk-free rate is 3%, the market risk premium is 5%, and the company's beta is 1.2, the Cost of Equity would be 3% + (1.2 * 5%) = 9%.

Cost of Debt

The Cost of Debt is the effective rate that a company pays on its current debt. It is typically calculated as the yield to maturity on the company's outstanding debt, adjusted for taxes (since interest expenses are tax-deductible).

Example: If a company has a bond with a yield to maturity of 6% and the corporate tax rate is 25%, the after-tax Cost of Debt would be 6% * (1 - 0.25) = 4.5%.

Weighted Average Cost of Capital (WACC)

WACC represents the average rate of return a company expects to pay to all its investors, both equity holders and debt holders. It is calculated by weighting the Cost of Equity and the Cost of Debt by their respective proportions in the company's capital structure.

Example: If a company's Cost of Equity is 9%, the after-tax Cost of Debt is 4.5%, the equity represents 60% of the capital structure, and debt represents 40%, the WACC would be (9% * 0.60) + (4.5% * 0.40) = 7.2%.

Capital Structure

Capital Structure refers to the mix of a company's long-term debt and equity. It is a critical factor in determining the WACC. A company's optimal capital structure balances the trade-off between risk and return, aiming to minimize the WACC.

Example: A company might choose to finance 60% of its operations with equity and 40% with debt, based on its risk tolerance and the cost of each type of capital.

Marginal Cost of Capital

The Marginal Cost of Capital is the cost of obtaining an additional dollar of financing. It increases as a company raises more capital, due to the rising costs associated with higher levels of debt and equity.

Example: As a company raises more debt, lenders may require higher interest rates to compensate for the increased risk. Similarly, as more equity is issued, the Cost of Equity may rise due to dilution and higher perceived risk.