Understanding Cost Of Capital (With Examples)

In today’s competitive business landscape, introducing new initiatives is thrilling, but it’s essential to gain stakeholder buy-in by demonstrating the potential return on investment. After all, your colleagues are committed to ensuring that their resources are directed toward worthwhile endeavors.

This is where the cost of capital becomes crucial, serving as a fundamental metric for evaluating the costs and potential benefits of new projects or investments. In this article, we will define cost of capital and provide formulas and examples to illustrate its application.

Key Takeaways

• Cost of capital represents the minimum return necessary to justify an investment.

• The weighted average cost of capital (WACC) encompasses the average cost of all capital sources, including debt and equity.

• Understanding cost of capital is vital for securing funding for new projects from investors.

What Is the Cost of Capital?

The cost of capital refers to the minimum return required to make an investment worthwhile. This is typically expressed as a percentage, indicating the potential return on investment.

For example, the cost of capital aids in assessing whether a project justifies its costs in terms of required materials and resources. Additionally, it helps investors evaluate the overall risk in relation to potential returns, allowing companies to compare different investment opportunities.

The Cost of Capital and Equity and Debt

The cost of capital is intricately linked to equity and debt, as it varies depending on how a project is financed. If a project is financed purely through equity, its cost of capital pertains only to equity, and vice versa for debt.

Most companies utilize a blend of both equity and debt, leading to a cost of capital derived from the weighted average of all capital sources, known as the weighted average cost of capital (WACC).

What Is the Weighted Average Cost of Capital (WACC)?

The weighted average cost of capital (WACC) takes into account each category of capital within a company and weighs them according to their proportionate share. This can include common stock, preferred stock, bonds, and other forms of long-term debt.

Typically, this calculation blends the weighted average of a firm’s cost of debt with the cost of equity. This metric is crucial for assessing whether a capital project is worthwhile, as it indicates the investment’s risk level.

The WACC provides a percentage that helps investors gauge expected returns. For instance, if the cost of capital is 9%, investors can anticipate a return of $0.09 for every dollar they invest. Therefore, a high WACC suggests a low-risk investment, while a low WACC indicates a high-risk investment.

How to Calculate the Weighted Cost of Capital (WACC)

Calculating the weighted cost of capital involves three key steps:

1. Calculate the company’s cost of debt.

2. Calculate the company’s cost of equity.

3. Weigh these two percentages to find the WACC.

Let’s begin with step one: calculating the cost of debt. This requires considering all the company’s borrowings and interest rates.

For instance, if a company has a credit line at 6%, bonds for acquisitions at 5%, and two long-term loans at 3%, the average would be calculated. In this case, we arrive at an average of 5%.

Additionally, interest on debt is tax-deductible. To factor this in, multiply your debt percentage by the corporate tax rate (typically around 25% in the U.S. as of 2026). The formula becomes:

Plugging in our numbers looks like this:

Now we have our cost of debt!

Next, we calculate the company’s cost of equity, which relates to beta, indicating risk compared to prevailing interest rates.

Beta measures the volatility of a company’s stock relative to the market average. A higher beta indicates a riskier investment. If a company’s stock fluctuates at the same rate as the market, its beta will be close to 1.

Let’s assume our theoretical company has a beta of 0.75, indicating slightly less volatility. Assume the average market rate is 8% and the risk-free rate is 2%.

The formula for calculating the cost of equity is:

Plugging in the numbers gives us:

Beta remains a critical factor, as it significantly influences the calculation.

Finally, we weigh our debt and equity percentages to determine the WACC. Assume the company uses 40% debt and 60% equity.

The final formula is:

When we plug in the values:

This hypothetical WACC indicates the expected return. In this instance, with a WACC of 5.25%, the company would be expected to pay investors $0.0525 for every $1 of funding.

Is that a favorable figure? It depends on investor expectations, as different individuals may seek varying returns.

Examples of the Cost of Capital in Action

1. Cost of Capital Example

   Consider a scenario where a company is weighing the decision to invest in new electric delivery vans versus upgrading its current office space for better efficiency. The renovation costs $250,000 and is projected to save the company $35,000 annually over five years. Alternatively, the company could purchase new electric vans at the same price, with an anticipated return of 25% per year.

   Applying the cost of capital to determine which investment offers a higher potential return on investment is key. The renovation yields a 14% return on investment ($35,000/$250,000), while the electric vans promise a 25% return, making them the superior choice.

2. WACC Example

   Now, let’s examine WACC in the current market. Industries with stable operations, such as utilities and rail transportation, generally exhibit a higher cost of capital. For instance, as of 2023, the cost of capital in the rail transportation sector stood at 10.5%.

   This elevated figure stems from the consistent nature of the business, which carries lower risk. In contrast, technology startups that are subject to rapid change may experience a cost of capital around 7%, reflecting their elevated risk profile.

Why Is Cost of Capital Important?

The cost of capital plays a pivotal role in enabling companies to innovate and launch new projects. It determines the opportunity cost of investment and guides the capital budgeting process. Essentially, the cost of capital represents a financial benchmark that companies must exceed to advance their desired projects.

Moreover, investors and creditors heavily rely on this metric. It informs their decisions on whether to finance a company’s new initiatives, as it highlights the risk associated with a company’s equity. If a company appears too risky, investors may opt out of financing.

Thus, understanding cost of capital is vital for launching new initiatives, ensuring companies can attract investment and secure essential funding.

Is WACC the Same as Required Rate of Return (RRR)?

WACC and the Required Rate of Return (RRR) are not identical, though WACC can inform the calculation of the RRR.

The RRR represents the minimum return an investor requires to justify an investment. If the RRR falls below a certain threshold, investors may choose not to invest. WACC assists in calculating the RRR by reflecting the company’s debt financing and equity structure.

Author

Jack Flynn

Jack Flynn is a writer for Zippia. In his professional career he’s written over 100 research papers, articles and blog posts. Some of his most popular published works include his writing about economic terms and research into job classifications. Jack received his BS from Hampshire College.