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Whether you plan to take out a loan or you’re looking for investors, one cash management concept to familiarize yourself with is cost of capital. By understanding why cost of capital matters to your business, you may be able to make your business more appealing to investors or increase your chances of getting approved for a small business loan.
Keep reading to learn more about what cost of capital is and why it matters.
Key Points
• Cost of capital is the minimum return a business must earn on its investments to satisfy its debt and equity investors. It serves as a benchmark for evaluating potential projects.
• It includes the cost of debt (interest paid on borrowed funds) and the cost of equity (returns expected by shareholders), often calculated using the weighted average cost of capital (WACC).
• Factors like market interest rates, creditworthiness, and business risk influence the cost of capital. Higher risk typically results in higher costs.
• A lower cost of capital provides a competitive advantage, enabling businesses to finance growth more efficiently and improve profitability.
• Cost of capital can be used to influence investors to invest in your company or make it more appealing to lenders when you’re applying for a small business loan.
What Is Cost of Capital?
The cost of capital for a small business is the rate of return it must earn to justify using funds from lenders or investors. It reflects the combined cost of debt (like loan interest) and equity (the return expected by owners or investors). It’s an important metric to know if you’re evaluating whether a new product is worthwhile or if an investor is assessing whether to invest money in your company.
Cost of capital includes how much it costs your business to access cash, whether that’s through financing or equity. In fact, a simple formula for cost of capital is:
Overall cost of capital = Cost of debt + Cost of equity
Cost of Debt vs. Cost of Equity
Both cost of debt and cost of equity contribute to your cost of capital, but it’s important to understand the difference between them. Cost of debt is the interest rate your firm pays on borrowed funds, less any tax deductions it can take on the interest. If you plan to take out a small business loan, your cost of capital (also called hurdle rate) includes the interest you will pay on that loan over time. Trade credit you have with vendors that you pay in the short term can also qualify as your cost of capital.
Assuming that interest is the rate your company pays on its current debts and tax represents the marginal tax rate, the formula for cost of debt is:
Cost of debt = (Interest expense / Total debt) x (1 – Tax)
As for cost of equity, if your company has investors, your cost of capital includes the cost of the equity they hold. For example, if you receive venture capital in exchange for 25% equity, that 25% contributes to your cost of capital.
If your company is public and sells stock to raise capital, your cost of capital includes the cost of that debt as well as the cost of equity.
How to Calculate Cost of Capital
To calculate the cost of capital, combine the costs of borrowing money (debt) and raising money from investors (equity).
First, figure out the interest rate on loans after taxes. Then, estimate the return investors expect for funding your business. Weigh these costs based on how much of your total funding comes from each source (debt and equity). This gives you the weighted average cost of capital (WACC), which tells you the minimum return your business needs to make projects worthwhile.
Weighted Average Cost of Capital (WACC)
Cost of capital is a general term that refers to the minimum return a company needs to justify an investment. The weighted average cost of capital (WACC), on the other hand, is the most commonly used method to measure the overall cost of capital, combining the costs of debt and equity financing weighted by their proportions in a company’s capital structure.
Example of a Cost of Capital Calculation
To see how this works in action, let’s take an example.
The formula for the overall cost of capital is:
Overall Cost of Capital = Cost of Debt + Cost of Capital
Let’s consider Company ABC. Imagine that it has a capital structure with 60% equity and 40% debt. To arrive at the company’s WACC, we’ll need to weigh the components accordingly.
If the after-tax cost of debt is 4% and equity investors expect an 8% return, the WACC calculation will look like this:
(.40 x 4%) + (.60 x 8%) = 1.6% + 4.8% = 6.4%
Company ABC calculates its weighted average cost of capital (WACC) at 6.4%.
Why Is It Important to Know the Cost of Capital?
Knowing the cost of capital is essential for making informed financial decisions. It acts as a benchmark for evaluating investment opportunities, helping investors gauge whether projects are likely to yield returns exceeding this threshold to create value. It also guides businesses in choosing between financing options, such as debt and equity, by comparing associated costs.
Understanding the cost of capital helps a company optimize its capital structure, reduce financing risks, and enhance profitability.
Impact on Business Valuation and Investment Decisions
Simply put, investors look at cost of capital to estimate what kind of return they might be likely to get for a potential investment. A high WACC often presents a riskier proposition and a less appealing prospect.
The metric is also used in business valuation. Discounted cash flow (DCF) analysis is a common method of valuation, and it bases its estimate of a company’s present day value on the sum of projected future cash flows. WACC is used as the discount rate – to discount these back to the present, allowing for risk and the time value of money. A higher WACC could result in a lower valuation.
Role in Strategic Financial Planning
Cost of capital is important for a company to understand in the context of its investors. But the concept can also be useful when the business is thinking about a new venture, as it can use the hurdle rate to determine how much the project will need to generate in order to pay for the funds needed to start it.
Understanding cost of capital can also help a business optimize its capital structure by finding a mix of debt and equity that will keep its WACC low.
7 Things to Know About Small Business Cost of Capital
Cost of capital matters when it comes to running your business or expanding it. If you want to take on a new project, for example, calculating the cost of capital will help to determine whether the project is worth it.
But that’s not all. Here are seven things to know about small business cost of capital.
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1. It Matters to Investors
When investors are selecting a business to put their money in, they typically want a good return. The business’s cost of capital tells them the level of risk they would be taking on to attain that return. A high cost of capital signals more risk; a lower one indicates less risk.
An investor typically wants to see a rate of return that is, at a bare minimum, equal to his or her investment. But ideally, the rate of return exceeds that initial investment. Having details on your cost of capital can go a long way toward helping a potential investor decide whether or not to invest.
2. There Are Actually Two Costs to Consider
When you look at costs, there are two you’ll want to consider, depending on how your business gets capital. Cost of equity and cost of debt both factor into your cost of capital.
Let’s look at the cost of equity first. When you work with investors, you’ll have a valuation of what your company is currently worth, and you’ll work to agree with your investors on what percentage of the company they’ll own. Down the road, if your company is doing well and gets valued higher, those investors can cash out their equity and get a rate of return higher than their initial investments. The difference between what they invested originally and what they take out is your cost of equity.
Next is the cost of debt. When you take out a loan or line of credit, you pay interest and/or fees on that financing. The sum of the interest and fees is your cost of debt. Ideally, the cost of debt should prove worthwhile in the long run because the money you borrow can help you grow your business and thus make more money.
3. Weighted Average Cost of Capital May Be Relevant
In the event that your company has both debt and equity, you may need to consider what’s called your weighted average cost of capital (WACC). This calculates an average of both your cost of debt and your cost of equity together, weighted proportionally.
The distribution of debt and equity makes up your company’s capital structure, and every type of debt and equity your business has must be considered to calculate your WACC, including both common and preferred stock, loans, bonds, and other financing. The formula can look intimidating, but basically it is a way to evaluate your cost of capital, taking into account exactly how much of it is equity-based and how much of it is debt-based.
Ultimately, the higher your weighted average cost of capital, the lower your business valuation and the greater the risk to potential investors.
4. WACC Relates to Your Discount Rate
When you look at your weighted average cost of capital in relation to a particular project, you’ll probably want to consider your discount rate. This refers to the current value of future cash flows (net present value). Simply put, it’s a tool to help figure out whether anticipated future returns justify the amount of money you’d need to put into a project.
Let’s say you’re thinking about spending $1 million to expand operations in Europe. How much might that investment net you five years from now? Ideally, it should be more than your initial $1 million investment.
Similarly, an investor thinking about investing in your business will likely consider the discount rate. It provides the potential investor with insight into the risk level, as well as the opportunity cost of your business. It also accounts for the time value of money (TVM).
Here’s a simplified example. You have $100 and want to invest it in a savings account that offers 5% interest per year. At the end of the year, you would have $105. Because your ending balance is more than what you started with, you might consider that a worthwhile investment. Of course, when you’re investing in a business, your returns won’t necessarily be so clearcut.
Weighted average cost of capital is a type of discount rate, and it’s the one investors will likely be keen to examine when they consider investing in your business. An investor may have a specific discount rate in mind that must be reached to move forward with an investment.
5. Cost of Capital Can Help You Evaluate Financing Options
Having an understanding of your business cash flow and the cost of the investment opportunities your company offers is essential, both for you and for any investors.
From your perspective, understanding the cost of capital, particularly the cost of debt, can help you decide whether taking out financing is worthwhile. If what you pay in interest or fees outweighs what you could see in increased revenues, it’s not worth it. On the other hand, if paying, for example, 5.00% interest on a loan could help you realize a 15% growth in revenue, the cost of debt may be justified.
This information is also valuable to investors. The equity you receive from an investor should be used to deliver the expected rate of return. (That will also be beneficial to you, since you are also an equity owner in your company.) If you aren’t able to deliver the expected rate of return, any shareholders you have will likely sell their shares of your company’s stock, which will devalue your company.
That’s why it’s important to have a plan for how you’ll spend the investment capital you receive.
6. You May Be Able to Control Your Cost of Debt
There are many small business financing tools to choose from, and each comes with a different cost of debt. If you take out a loan, you may pay 6.00% annually. If you use a business credit card, your interest might be 16.99% on what you borrow.
Carefully consider your financing options and your ability to repay the loan. The faster you repay it, the less you’ll pay in interest or fees.
The bottom line is that financing can be helpful, but be mindful of how much you pay for it over time. Keeping down the unnecessary cost of debt can help you keep your cost of capital lower.
7. It’s Not an Exact Science
As you’ve seen, determining weighted average cost of capital can look complex and technical. But in fact, there’s no guarantee that an investor will receive a given discount rate for his or her equity. Many factors contribute to the return your business may see, including market conditions, how many competitors are in your industry, how your business is run, and more.
Calculating cost of capital is a way to provide an educated guess on what sort of return an investment might bring, but it’s definitely not set in stone.
The Takeaway
With a solid understanding of what cost of capital means, you can make smarter financial decisions. You can determine what type of loan or financing to take out and how to attract potential investors to help you grow your business.
The more appealing your company looks, the more likely investors will be to give you capital in exchange for equity. Staying on top of your cost of capital can help you show your business in a positive light.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is an example of cost of capital?
An example of cost of capital is a company with 60% equity and 40% debt. If equity investors expect an 8% return and the after-tax cost of debt is 4%, the company calculates its weighted average cost of capital (WACC) at 6.4%, and that metric can be used to guide investment decisions and evaluate profitability.
What does cost of equity mean?
Cost of equity is the return investors expect for owning a company’s stock. It represents the compensation shareholders require for the risk of investing in the business and is used in valuation and capital budgeting to assess whether an investment or project is worthwhile.
How can I calculate the cost of capital?
To calculate the cost of capital, combine the costs of debt and equity financing using the weighted average cost of capital (WACC) formula. Adjust the cost of debt for tax benefits, and calculate the cost of equity using a model like the Capital Asset Pricing Model (CAPM). Weigh both costs by their proportions in the capital structure.
Why is cost of capital important for small businesses?
Looking at what its cost of capital is can be valuable for a small business for several reasons. Cost of capital can serve as a benchmark for the company as it evaluates its capital structure and contemplates taking on future debt or offering more equity. It’s also important to the business because potential investors can be more likely to consider this metric before deciding whether or not to invest in the company.
What factors influence a company’s cost of capital?
A company’s cost of capital is influenced by interest rates, market conditions, business risk, capital structure (debt vs. equity), creditworthiness, industry stability, tax rates, and investor expectations. Factors like company size, growth prospects, and economic conditions can also affect how much return lenders and investors require.
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