Cost Of Capital Formula

The cost of Capital formula calculates the weighted average cost of raising funds from the debt and equity holders and is the total of three separate calculations – weightage of debt multiplied by the cost of debt, weightage of preference shares multiplied by the cost of preference shares, and weightage of equity multiplied by the cost of equity.

The formula explains the level of return that an investor will aim to get if they decide to invest in a project or investment opportunity. This return should be more than the cost of investing money in it, otherwise, the portfolio is not feasible.  The financial data is used to determine it, which is a tool for analysts and investors in order to evaluate the potential risk or return of any financial decision.

The cost of capital formula refers to the method of calculating the expected return from an investment opportunity based of which the investors decide to put their money on it. An investor, who might be a corporate of an individual, will grow only when the investments generate revenues that can be used to provide long term benefits, which is over and above the cost of the same. The evaluation of the value produced from such sources in the form of expected future cash inflows after deducting the cost of putting money in such sources of capital is calculated using the formula.

The equity and debt cost of capital formula is represented as,

Any return in excess of the cost of investment results in value creation that instigates a favorable decision in favor of the opportunity. Therefore, in the financial market, the use of this formula has gained vast importance, especially when the market condition is very competitive. Arriving at the value of cost of capital is not only complex but also quite challenging. A lot of analysis, assumptions, and observation is done to assess the value using overall cost of capital formula that will provide the right direction towards investment decision.

It can be observed overall that more the risk of investment, the higher the cost of capital. This is because since the lenders or owners are taking a higher risk, they should be compensated for the loss that they may have to face in case the prospect does not work. It is also the opportunity cost of putting money into that particular project instead of putting it in another comparable opportunity.

Let us learn about the steps followed in the process of equity and debt cost of capital formula calculation, as given below:

Let us take an example of a company ABC Limited to see if it can generate returns, using the overall cost of capital formula.

The company has reported a return for its last fiscal year Let us take an example of a company ABC Limited to see if it can generate returns.

First we have to calculate the following -

Total Capital:

So, Total capital = $50,000,000 + $15,000,000 + $70,000,000

• Total capital = $135,000,000

Weightage of Debt:

So, Weightage of debt = $50,000,000 ÷ $135,000,000

• Weightage of debt = 0.370

Cost of Debt:

Therefore, Cost of debt = $4,000,000 * (1 – 34%) ÷ $50,000,000

• Cost of debt = 5.28%

Weightage of Preference Share:

Hence, Weightage of preference share = $15,000,000 ÷ $135,000,000

• Weightage of preference share = 0.111

Cost of Preference Share:

So, Cost of preference share = $1,500,000 ÷ $15,000,000

• Cost of preference share = 10.00%

Weightage of Equity:

So, Weightage of equity = $70,000,000 ÷ $135,000,000

• Weightage of equity = 0.519

Cost of Equity:

So, Cost of equity = 4% + 1.3 * (11% - 4%)

• Cost of equity = 13.10%

So from the above, we have gathered the following information.

Therefore, Calculation of the Cost of Capital Formula will be -

The formula in excel will be -

Based on the above calculations, ABC Limited’s return of 10.85% is adequately higher than its cost of capital of 9.86%.

Given below are some of the important uses of the concept of cost of capital formula in financial management and in financial market.

• Understanding the cost of capital is very important as it plays a pivotal role in the decision-making process of financial management. The objective of the cost of capital is to determine the contribution of the cost of each component of a company's capital structure based on the proportion of debt, preference shares, and equity.
•  A fixed-rate interest is paid on the debt, and the preference shares are given a fixed dividend yield. Although a company is not required to pay a fixed rate of return on equity, there is a certain rate of return expected of the equity portion.
• Based on the weighted average of all the cost components, the company analyses if the actual rate of return can exceed the cost of capital, which is a positive sign for any business. Based on this, various management decisions are taken about dividend policy, financial leverage, capital structure, working capital management, and other financial decisions, etc.
• The corporates can take decision regarding designing of capital structure of the business by using the cost of capital formula in financial management, which calculate the cost of raising capital in different forms. The decision regarding the proportion of debt and equity in financing a business is important because its profitability and liquidity positions is dependent on this to a great extent.
• Since investors use it to understand the feasibility of investment in a business, an attractive investment will add to the valuation of the company and lead to an increase in its share prices. This creates a positive image of the business in the competitive financial market.

Thus, the above are some important uses of the concept. Due to the everchanging corporate and financial landscape, the use of this formula will always be of utmost importance for both company management and the stakeholders’ point of view. This will ultimately help in channelizing funds in the right direction that will add value and multiply it at the highest level possible.