A firm’s cost of capital represents the cost to the firm of accessing debt and equity capital. Business decision makers use the cost of capital as a minimum “hurdle rate” when determining if a project or investment will yield value to the firm.
The cost of capital is also called the weighted-average cost of capital because it represents the total cost of debt and equity capital which the firm uses to finance its operations.
To calculate a firm’s cost of capital, we need the following: the firm’s cost of borrowing, the firm’s tax rate, the firm’s cost of equity capital, debt as a percentage of total capital, and equity as a percentage of total capital. We can then calculate the cost of capital as follows:
Cost of Capital = [D/(D+E) x Rd x (1 – T)] + [E/(D+E) x Re]
Where D is the amount of debt financing, Rd is the interest rate, T is the firm’s tax rate, E is the amount of equity financing, and Re is the cost of equity capital.
Example: Suppose a firm has $1 million in debt outstanding and $2 million in equity capital. The firm’s borrowing rate is 8%, and its tax rate is 30%. The firm’s cost of equity is estimated at 12%. What is the firm’s cost of capital?
[(1/3 x .08 x (1-.3)] + [2/3 x .12] = 0.0187 + 0.08 = 0.0987 = 9.87%
The firm’s cost of capital is 9.87%. Therefore, the firm should only pursue projects which yield returns greater than 9.87%.
The cost of capital guides business decision makers in making capital allocation decisions. By providing the minimum return necessary for projects, business managers can focus on those projects which create value for the firm.
