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 could 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.
What Is Cost of Capital?
Cost of capital refers to the cost of running your business before you see profit. This includes how much it costs your business to access cash, whether that’s through financing or equity.
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. Any trade credit you have with vendors that you pay in the short term also qualifies as your cost of capital.
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% is 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.
What to Know About 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.
Here are seven things to know about small business cost of capital.
Recommended: What are Term Loans?
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 to helping a potential investor make the decision whether 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 agree with your investors on what percentage of the company they’ll own. Down the road, if your company is doing well and is 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.
Recommended: Small Business Grants Explained
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, or 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.
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
All this talk about cost of capital may be making your head spin, but stick with me. 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% 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.
Recommended: Applying for a First Time Business Loan
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% annually. If you use a business credit card, your interest might be 16.99% on what you’ve borrowed.
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. For example, with a business credit card, the annual percentage rate is divided by the days in your billing cycle that you carried a balance. If you pay your balance within a few days, you’ll pay significantly less interest than you would if you carried the balance from one month to the next.
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.
Recommended: Debt-to-Income Ratio
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 or how to attract potential investors to help you grow your business.
The more appealing your company is, the more likely investors will be to give you capital in exchange for equity. Stay on top of your cost of capital so you can show your business in a positive light.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
Photo credit: iStock/pixdeluxe
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOSB0224010
