What it means
Capital is not free. Lenders require interest and shareholders require a return that compensates them for the risk of owning a business whose profits are uncertain and whose claims rank last.
A company that uses capital must earn at least what its providers require, or they will take it elsewhere; the cost of capital is that requirement expressed as an annual rate. The two components differ: the cost of debt is observable (the interest rate on the company's borrowings, or the yield at which it could borrow today, adjusted for tax because interest is deductible, so a 6% loan costs 4.5% after tax at a 25% rate), while the cost of equity must be estimated as the total return (dividends plus growth) that the share price implies shareholders require.
The standard estimate is the capital asset pricing model: the risk-free rate (a government bond yield) plus the company's beta (its sensitivity to market movements) times the equity risk premium (the excess return the market as a whole is expected to earn over the risk-free rate). A company with a beta of 1.2, a risk-free rate of 4% and a premium of 5.5% has a cost of equity of 10.6%, and alternatives such as the dividend growth model all involve judgement, so the result is usually a range.
The weighted average combines them by the proportions of debt and equity in the company's capital, at market values: a company financed 30% by debt at 4.5% after tax and 70% by equity at 10.6% has a WACC of 8.8%. Because debt is cheaper than equity, adding debt lowers the WACC, up to the point where the added financial risk raises the cost of both debt and equity enough to reverse the effect; the capital structure that minimises the WACC is the optimal one in theory, and companies target a range around it.
The cost of capital is used everywhere in financial decision-making. It is the discount rate in NPV analysis (a project whose NPV at the WACC is positive earns more than its capital costs), the hurdle rate that sets the minimum IRR for approval (often with a margin for optimism), the benchmark that separates businesses that create value (ROIC above WACC) from those that destroy it, and the capitalisation rate that converts free cash flows into a value.
It is also the rate charged for capital in economic profit or EVA calculations, which makes managers accountable for the capital they use, not only the profit they report. Refinements matter.
The company's WACC is right for projects of average risk; riskier projects (a new market, a new technology) warrant a higher rate and safer ones (a cost-saving replacement) a lower one, and divisions in different businesses should have different rates, or capital flows to the risky projects that clear a blended hurdle. The rate should be real or nominal to match the cash flows, reflect the currency and country of the investment, and be revisited as conditions change: a WACC set when rates were 1% is wrong when they are 5%.
The most common practical error is precision. The inputs are estimates, and a WACC of 8.8% is really 8% to 10%; decisions should be tested across the range, and projects that pass only at the bottom of it should be treated as marginal.
In practice
Real-world examples
Example 1
A utility with a beta of 0.6 and 55% debt at low rates has a WACC of about 5.5%, and its regulator uses a similar figure to set allowed returns.
Example 2
A biotechnology company with no debt and a beta of 1.8 has a cost of capital above 13%, which is why it rejects projects that would be attractive to a utility.
Example 3
A private company estimates its cost of capital from listed peers' betas, adds a premium for size and illiquidity, and uses 12% as its hurdle rate.
Think of it
Cost of capital is the minimum return needed to satisfy investors-your hurdle rate for investments.
Formula
Calculation
Cost of Debt (after tax) = Pre-tax interest rate x (1 minus Tax rate)
Cost of Equity (CAPM) = Risk-free rate + Beta x Equity risk premium
WACC = E / (D + E) x Cost of equity + D / (D + E) x After-tax cost of debt, with D and E at market values
Economic Profit = (ROIC minus WACC) x Invested capital
Value of a perpetual cash flow = Cash flow / (WACC minus Growth rate)
Worked example. A listed logistics company has: market capitalisation $600,000,000; debt $300,000,000 (bonds and loans) at an average pre-tax rate of 6.0%; tax rate 25%; beta 1.1; risk-free rate 4.0%; equity risk premium 5.5%.
- After-tax cost of debt = 6.0% x 0.75 = 4.5%
- Cost of equity = 4.0% + 1.1 x 5.5% = 10.05%
- Weights: equity $600,000,000 / $900,000,000 = 66.7%; debt 33.3%
- WACC = 0.667 x 10.05% + 0.333 x 4.5% = 6.70% + 1.50% = 8.2%
Sensitivity: a risk premium of 6.5% gives a cost of equity of 11.15% and a WACC of 8.9%; a beta of 1.3 gives the same 11.15% and 8.9%. The range is about 8% to 9%, and the company sets a hurdle of 9% for average-risk projects, 11% for its new-market ventures and 7.5% for replacement investments.
Applications:
- Project appraisal: a new warehouse costing $40,000,000 with expected cash flows of $6,000,000 a year for 15 years. At 8.2%: present value $6,000,000 x 8.46 = $50,740,000; NPV $10,740,000. At 9%: $48,360,000; NPV $8,360,000. Approved; it clears the range.
- Economic profit: invested capital $850,000,000; operating profit after tax $85,000,000; ROIC 10.0%; economic profit = (10.0% minus 8.2%) x $850,000,000 = $15,300,000 a year. The company creates value, modestly.
- Divisional rates: the freight division (stable, contracted) has comparable betas around 0.8, giving a cost of equity of 8.4% and a divisional WACC of about 7.1%; the logistics technology start-up division has comparable betas around 1.6, giving a cost of equity and WACC (all equity-funded) of 12.8%. Using the group rate of 8.2% for both would over-fund the technology division's projects and under-fund the freight division's.
- Capital structure: at 45% debt, the pre-tax cost of debt would rise to 7% (5.25% after tax) and the beta to about 1.3, giving a cost of equity of 11.15% and a WACC = 0.55 x 11.15% + 0.45 x 5.25% = 6.13% + 2.36% = 8.5%, higher than the current 8.2%. The current structure is near the optimum.
- Valuation: free cash flow $70,000,000, growing 3%: value = $70,000,000 / (8.2% minus 3%) = $1,346,000,000 enterprise value; less debt $300,000,000 leaves equity of $1,046,000,000, against a market capitalisation of $600,000,000. Either the market is discounting the company or the growth and cash flow assumptions are optimistic.
Rate change: two years later the risk-free rate is 5.5%. Cost of equity rises to 11.55%; the cost of debt on refinancing to 7.5% (5.6% after tax); WACC to about 9.6%. The warehouse project's NPV at 9.6% would be $46,700,000 minus $40,000,000 = $6,700,000, still positive, but marginal projects approved at 8.2% now destroy value, and the company raises its hurdles.Case study
Seen in the real world
This is a fictional, illustrative scenario. A conglomerate used a single hurdle rate of 10% for every project in every division, set by its treasury a decade earlier and never revisited. Its consumer products division, a stable business with comparable betas of 0.7, rarely proposed projects that cleared 10% and had been starved of investment; its resources division, with betas around 1.5, proposed many that cleared it and had received most of the group's capital. Returns told the story: consumer products earned 13% on its shrinking capital base, resources earned 9% on its growing one, and the group's overall return on capital had fallen from 12% to 9.5%.
A new chief financial officer built divisional costs of capital: 7.5% for consumer products, 12% for resources. Applied retrospectively, half of the resources projects approved in the previous five years would have been rejected, and a pipeline of consumer products projects returning 8% to 10% would have been approved. The group reversed its capital allocation over three years, sold two resources assets, and its return on capital rose to 11.5%. The chief financial officer's board paper made the point in a sentence: a single hurdle rate had sent the group's money to its riskiest businesses because they were the only ones that could promise to beat it.
Watch out
Common mistakes
- Using a single company-wide cost of capital for projects and divisions of different risk, which over-funds risky projects and starves safe ones.
- Treating the WACC as precise. The inputs are estimates; use a range and test decisions across it.
- Leaving the cost of capital unchanged as interest rates and market conditions move, so that hurdle rates become detached from what capital actually costs.
Questions
People also ask
What is the difference between the cost of capital and the hurdle rate?
The cost of capital is the estimated return providers of capital require. The hurdle rate is the minimum return the company sets for approving projects, usually the cost of capital adjusted for project risk and sometimes with a margin for optimism.
Why is the cost of equity higher than the cost of debt?
Shareholders bear more risk: they are paid after lenders, their returns are not fixed, and they lose everything in a failure. They require a higher return to compensate, and unlike interest, their return is not tax-deductible to the company.
How do I estimate the cost of capital for a private company?
Use the betas of comparable listed companies, unlevered and relevered for the private company's debt; add premiums for size and illiquidity where appropriate; and take the cost of debt from the company's actual borrowing rate. The result is a range, typically higher than for a listed peer.