What is Cost of capital and why does it matter to your business?
When you’re deciding how to finance your business, the cost of capital is a very important consideration. It measures the cost of funds that a company pays for using debt or equity financing.
The cost of capital has many components and can be quite complex, but it’s something every entrepreneur needs to consider when making decisions about their company’s financial health. In this post, we’ll explore what the cost of capital means and why it matters for entrepreneurs like you!
1. What is the cost of capital?
Cost of capital or WACC stands for a weighted average cost of capital. This value is calculated by taking the proportion of debt financing used to finance a business and allocating its associated interest rates, as well as the proportion of equity financing used to finance the company and allocating the appreciation based on market prices. The difference between these two values is then multiplied by each other to yield the final WACC readout. The higher this number, the more expensive it is for a company to mobilize funds.
2. The different types of costs of capital.
There are two forms of cost of capital: before-tax cost and after-tax cost. The difference between the two is straightforward, but it’s important to note that you must use a company’s marginal tax rate when using the latter calculation.
In addition, many components make up cost of capital such as equity risk premium (ERP) which takes into account volatility in an economy or industry sector by comparing historical returns on stocks with those from safer assets like government bonds; bond risk premiums (BRPs), where investors demand higher interest rates on corporate debt than they do for sovereign debt because corporations carry more default risks; market beta factor (MBF), which represents how volatile a stock price will be relative to the market as a whole; cost of equity (COE); cost of debt or the interest rate on borrowed funds, and cost for preferred stock.
3. How to calculate the cost of capital for your company.
To calculate the cost of capital, you can use the following formula: cost of capital = equity value + debt value − excess cash. Equity and debt values are calculated by multiplying a company’s market beta factor (MBF) with its cost of equity and cost of debt, respectively. Excess cash is just that — any amount left over after liabilities have been deducted from assets. Once you’ve subtracted this figure from both sides, simply divide each side by total firm value to get your final cost of capital readout for before-tax purposes. Note that “cost” here refers to the interest rate on borrowed funds or return an investor demands to buy stock; it does not refer to fees associated with raising financing through venture capitalists or banks.
4. Why you should care about the cost of capital as a small business owner.
As the cost of capital is one of the key metrics to track for your business to stay financially healthy, understanding how it’s calculated and what factors impact cost can be very helpful. Failing to consider cost when making decisions about financing may lead you down a risky path that could threaten the long-term viability of your company. With this new knowledge on the cost of capital, here are some things you should keep in mind as an entrepreneur:
• You need more equity than debt if WACC is high — If the cost of capital is high, then chances are good that investors will require a greater return from their investment overall because they perceive riskier projects or businesses. This means it might make sense for entrepreneurs with higher costs of capital to use more equity than debt in financing their company, as the cost of equity is generally much higher than the cost of debt.
• You should use the right cost for your tax situation — It’s important to keep costs associated with different parts of capital separate. This means that if you’re doing a cost calculation after-tax (for instance), then it will be necessary to compare pre and post-tax values separately instead of using one value like WACC before taxes or even EBITDA.
5. Tips on determining the best type of financing for your company based on its needs and goals.
Before considering the cost of capital, it’s a good idea to assess your company’s needs and goals. For instance, if you’re looking for financing to expand production or make new hires, then the cost may not matter as much since these are long-term investments that will likely help grow your business exponentially over time. In addition, the cost is only one part of the complex decision-making process when choosing which type of financing makes sense for your company; other factors include cost/benefit analysis (e.g., how many years does it take before an investment pays off?), legal issues related to the deal with investors and more.
- Cost of capital should be high and growth expectations high
- Cost of capital should be high and cost/benefit analysis demonstrating a positive return on investment will take time
- Cost of capital should be low and cost/benefit analysis demonstrates a positive return on investment within 1 or 2 years.
Conclusion: cost of capital is necessary to keep track of for your business to remain financially healthy, cost of capital is calculated by equity value + debt value — excess cash, cost of capital = (equity value + debt value) — excess cash, cost of equity = market beta factor x cost of equity and cost of debt = market beta factor x cost of debt.
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