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Weighing up the cost of capital

A company’s cost of capital is one of the most enigmatic areas of economics – absolutely crucial to understand but absolutely impossible to pin down.

There are two basic ways that a company can obtain finance. It can either borrow it (debt) or raise it from shareholders (equity). But neither banks nor shareholders provide their capital for free, so each method has a cost. A company’s overall cost of capital is an estimate of the combination of these two costs after taking account of their relative contributions. So if a company had twice as much equity as debt, you’d count the cost of debt for a third and the cost of equity for two-thirds. It’s therefore often known as the Weighted Average Cost of Capital or WACC.

A company’s ‘cost of debt’ is relatively easy to calculate. It’s simply the interest a bank charges for the privilege of using its money. The ‘cost of equity’, by contrast, is impossible to pin down. That’s because it’s the return sought by the providers of a company’s equity capital – that is, its shareholders – and investors in the market rarely seem to agree on very much, let alone how much they’re hoping to make from a given opportunity. Before getting back to this, though, let’s take a look at why we’re even bothered about it.

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First and foremost, it’s vital for a company’s management to understand its cost of capital, as it sets a minimum benchmark against which investment decisions can be evaluated. And by extension, investors can use their view of the cost of capital as a means of assessing management’s actions.

If a company is generating a greater return on its capital (as measured by the return on capital employed, or ROCE – see last issue’s Investor’s College) than that capital is costing (generally as measured by WACC), then all is well and good and the company is said to be creating shareholder value.

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Weighing up the cost of capital / Author: Melanie