About Cost of Capital and WACC
Updated: Sep 1
Cost of capital is the total cost that a company incurs to raise funds to finance its operations and growth. It is the cost of all the sources of capital, including debt, equity, and any other forms of financing. The cost of capital is an important concept for companies, as it helps evaluate investment opportunities and make decisions about how to allocate capital.
To quantify the cost of capital, a company typically calculates a weighted average cost of capital (WACC) based on the relative proportions of each type of capital used. The WACC is calculated as follows:
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
where: E = market value of the company's equity
V = total market value of the company's equity and debt
D = market value of the company's debt
Re = cost of equity
Rd = cost of debt
Tc = corporate tax rate
The first term of the equation represents the cost of equity, which is the return that investors expect to receive for investing in the company's stock. The second term represents the cost of debt, which is the interest rate that the company pays to borrow money. Because interest expense is tax deductible (the benefit of leverage), we also factor in the tax shield effect (the reduced cost of debt) into our WACC consideration.
The weights used in the equation represent the relative proportions of each type of capital in the company's capital structure. By calculating the WACC, we can determine the overall cost of the capital that it uses to fund its operations and growth.
It's important to note that the cost of capital can vary depending on a number of factors, such as market conditions, the company's credit rating, and the perceived risk associated with the investment opportunity. As such, the cost of capital is an estimate and may change over time.