What it means
A company is funded by a mixture of loans and owners' money. Lenders expect interest, and shareholders expect a return through dividends and growth.
Each source has its own cost, and the composite cost of capital pulls them into a single figure. Equity is usually more expensive than debt because shareholders take more risk than lenders and are paid last if things go wrong.
Debt is cheaper, and the interest on it is normally deductible for tax, which lowers its effective cost further. Using the after-tax cost of debt is therefore standard in the calculation.
Each source is weighted by its share of total funding, usually measured at market values where possible. A company funded 60% by equity and 40% by debt gives equity a weight of 0.6 and debt a weight of 0.4.
The weighted costs are added to give the composite rate. The rate is used as a hurdle for decisions.
A project that is expected to earn less than the composite cost of capital destroys value, while one that earns more creates it. It is also the usual discount rate for valuing a business using discounted cash flows.
The result is only as good as its inputs. The cost of equity cannot be read from a statement and must be estimated, often with a model such as the capital asset pricing model, so two analysts can produce different answers.
Debt costs, tax rates and funding mix also change over time and should be refreshed. A common refinement is to use a target funding mix rather than today's, since a company plans to stay near a certain structure over the long run.
Using a different composite rate for a riskier project is also sensible, because one blended rate does not suit every investment.
In practice
Real-world examples.
Example
A manufacturer is considering a new $2,000,000 production line that is expected to earn 11% a year. The CFO compares that to the company's composite cost of capital of 9.6%. The project clears the hurdle with room to spare, and the board approves it.
Example
A retail chain takes out a large new loan to buy back shares. The cheaper debt replaces expensive equity, which lowers its composite cost of capital at first. The treasurer warns that more debt also raises the risk, and lenders may demand higher interest later.
Example
A valuation analyst values a software business by discounting its forecast cash flows. She builds the discount rate from the company's funding mix, using a composite cost of capital of 10%. Changing that rate to 11% cuts the value, which shows the board how sensitive the price is.
Formula
Calculation
Composite cost of capital = (E / V x Cost of equity) + (D / V x Cost of debt x (1 - Tax rate))
A company has equity of $600,000 and debt of $400,000, so total funding is 600,000 + 400,000 = $1,000,000, giving weights of 60% and 40%. The cost of equity is 12%, and debt costs 8% before tax with a tax rate of 25%. The after-tax cost of debt is 8% x (1 - 0.25) = 6%. The composite cost is (60% x 12%) + (40% x 6%) = 7.2% + 2.4% = 9.6%.Case study
Seen in the real world.
Summit Packaging is a fictional company used as an illustrative example. It plans two projects: an automation upgrade costing $1,500,000 that is expected to earn 13%, and a branding campaign costing $900,000 expected to earn 8%. The finance manager calculates a composite cost of capital of 9.6% using a funding mix of 60% equity and 40% debt.
The automation project exceeds the hurdle and is approved, while the campaign falls short and is sent back for redesign. A year later interest rates rise, the cost of debt increases to 9%, and the finance manager updates the figure to about 10%. The illustrative lesson is that the hurdle rate must be refreshed as conditions change.
Watch out
Common mistakes.
- Using the pre-tax cost of debt. Interest is usually tax deductible, so the after-tax cost is the right figure.
- Weighting by book values when market values are available. Market values reflect what investors would actually require today.
- Treating one rate as right for every project. A risky venture deserves a higher hurdle than a routine replacement.
Questions
People also ask.
Is the composite cost of capital the same as WACC?
Yes, WACC stands for weighted average cost of capital and is the more common name. Both describe the same blended funding cost.
Why is equity more expensive than debt?
Shareholders carry more risk because they are paid after lenders and their returns are not fixed. They therefore demand a higher expected return.
Can a company reduce its composite cost of capital?
It can by adjusting its funding mix, negotiating cheaper loans or lowering its risk. Taking on too much debt, however, raises risk and can push costs back up.
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