How to Calculate the Cost of Capital With a Practical Example for Beginners

Funds are necessary for every business, whether they are operating, growing, or investing in new opportunities. There are a variety of sources where these funds can come from, such as bank loans (debt) or investor contributions (equity). Capital cannot be used without paying a fee. Capital cost is the term used to describe this expense.

The cost of capital is the term we use to describe this return.To stay competitive and meet investor expectations, a company must obtain the lowest rate of return on its investments, which is what this signifies.

 In this article, we will explain how to calculate the cost of capital using a straightforward example that is appropriate for beginners.

What is the cost of capital?

The amount a company spends on capital, which includes borrowing through debt, raising funds from shareholders as equity, or generating income through retained earnings, is the term used to describe the cost of capital.

Easy Way to Understand:
The payment of interest is required when borrowing money from a bank. When a company utilizes funds from lenders or investors, it must compensate them through interest, dividends, or profit sharing. The objective of this payment is to provide capital funding.

Example:
A loan of 10 lakh is given to a company at a 10% interest rate. The loan comes with a 10% capital cost.
It would be a poor investment for the company if it only earns 7% from using the funds.
Making a decision that generates 15% in profit is a profitable choice.

Types of Capital

It is crucial to have a thorough understanding of the different funding sources before calculating the cost of capital.

1. Cost of Equity (Ke)

◾The return that shareholders are expected to receive is this.
◾It has an impact on the level of business risk.
To attract investors, it is necessary to have higher returns for riskier businesses.
◾Businesses that are more secure may experience lower returns.
◾In order to meet the expectations of its shareholders, a company has to pay for equity.

2. Cost of Debt (Kd)

◾This is what a company pays when paying interest on loans or bonds.
◾In general, it's straightforward to calculate and correct.
◾Interest payments make the cost less expensive because they are tax-deductible.
◾Debt's true cost is determined by the interest paid after taxes.

 3.WACC

◾WACC is what it means to have Weighted Average Cost of Capital.
◾The average cost that a company incurs to fund its operations, taking into account both equity and debt is represented by it. The cost is a direct result of the proportion of each in the company's capital structure.

◾WACC Formula:
WACC can be derived by combining (E/V)  Ke + (D/V) Kd along with (1 - Tax Rate).
Where:
E = Market value of equity
D = Market value of debt
V = Total capital (E + D)
Ke = Cost of equity
Kd = Cost of debt
Tax Rate = Corporate income tax rate

Step-by-Step Process to Calculate Cost of Capital

Below is a simple guideline for those new in their adventure:

Step 1: Determine the Cost of Borrowing

◾Check the interest rate applied to loaned money by the company.

◾Change it for taxation since tax breaks reduce the real cost of debt.

Step 2: Work out the Cost of Equity

◾Use the CAPM formula to calculate it.

◾Collect the needed numbers like the risk-free rate, beta, and market return.

Step 3: Check the Capital Structure

◾Check how much of the whole money comes from debt and how much comes from equity.

◾Find the percentage (weight) of each in the total capital.

Step 4: Calculate the WACC Formula

◾Apply the WACC equation to all the values.

◾The outcome will show you the total cost of capital for the company.

 

Practical Example: How to Calculate Cost of Capital

We should examine the following example:

◾The equity is valued at approximately 60 lakhs.
◾The debt is estimated to be 40 lakhs.
There is a total amount of capital of 1 crore.
◾Equity comes with a cost of 12%.
There is a cost of 8% for debt.
◾The percentage charged for taxes is 30%.

1 step : Determining the weight is the objective.
The value of E/V is 6/100, indicating a value of 0.60
The D/V value is 40/100, which is equal to 0.40 when divided by 100.

Step 2: Apply the formula.
WACC is calculated by combining (0.60* 12%) and (0.40* 8% (1 – 0.30)).
Divide it into smaller parts:
0.60 x 12% = 7.2%.
0.40 x 8% = 3.2%.
3.2% × 0.70 = 2.24%

Step 3: Add the results.
WACC = 7.2% + 2.24% = 9.44%.

Final answer:

To be considered worthwhile, any project or investment must have a return exceeding 9.44%, in line with the company's WACC of 9.44%.

Summary Table

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Component                                  Value

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Equity                                         ₹6,000,000

Debt                                             ₹4,000,000
Cost of Equity (Ke)                   12%
The cost of debt (Kd)               8%
Tax Rate                                    30%
WACC                                         9.44%

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Why is the Cost of Capital Important?

The cost of capital is one of the most crucial concepts in finance. It serves as a guiding tool for businesses when making strategic, investment, and financing decisions. Here are the key reasons why it matters:

1. Capital Expenditure Utilization

It helps businesses decide how to allocate funds efficiently, ensuring that capital investments generate returns higher than their cost.

2. Investment Decision-Making

Companies use the cost of capital to evaluate whether projects are profitable and worth pursuing. It acts as a benchmark for determining the cost-effectiveness of investments.

3. Business Valuation

In valuation models such as Discounted Cash Flow (DCF), the cost of capital is used as the discount rate to calculate the present value of future cash flows.

4. Optimal Capital Structure

It plays a role in deciding the right balance between equity and debt financing, ensuring that a firm minimizes its overall financing costs.

5. Performance Benchmarking

The cost of capital provides a reference point to compare a company’s actual returns. If earnings exceed the cost of capital, the firm creates value; if not, it destroys value.

Conclusion

Finance revolves around the fundamental concept of cost of capital. A business can determine the amount of return it needs to generate to cover the expense of using funds.

WACC calculation is a tool that a company can use to make informed choices about investments, projects, and financing options. Our aim is to ensure that capital is used wisely and efficiently.

The concept of financial planning, strategic decision-making, and long-term business success can be improved by individuals by comprehending it.