Cost of Capital

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A Refresher on Cost of Capital by Amy Gallo

You’ve got an idea for a new product line, a way to revamp your inventory

management system, or a piece of equipment that will make your work easier.

But before you spend the company’s hard- earned money, you’ve got to prove to

your company’s leaders that it’s worth the investment. You’ll likely be asked to

show that the return on the investment will be better than your company’s cost

of capital. But are you sure you know exactly what that is? And how your company

uses it?

To learn more about this commonly used business term, I spoke with Joe Knight,

author of the HBR TOOLS: Return on Investment and co-founder and owner of

www.business-literacy.com.

What is the cost of capital?

“The cost of capital is simply the return expected by those who provide capital

for the business,” says Knight. There are two groups of people who may put up

the capital needed to run a business: investors who purchase stock and debt

holders who buy bonds or issues loans to the company. Any investment a

company makes has to earn enough money that investors get the return they

expect and debt holders can be repaid.

You may be wondering if this is the same as discount rate and the terms are

sometimes used interchangeably, explains Knight. Though there is typically a

distinction. “At most companies, the cost of capital is a mechanical calculation

done by the finance people. Then the management team takes that number and

decides on the discount rate, or hurdle rate, that you have to exceed to justify an

investment,” he says.

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In many businesses, the cost of capital is lower than the discount rate or the

required rate of return. For example, a company’s cost of capital may be 10% but

the finance department will pad that some and use 10.5% or 11% as the discount

rate. “They’re building in a cushion,” says Knight, which is not a bad thing. And

how much they pad it will depend on their appetite for risk. A risk-averse

company might raise the discount rate even further, as high as 15-20%. But if the

business is looking to stimulate investments, they might lower the rate, even if

just for a period of time.

What do companies typically use it for?

There are two ways that cost of capital is typically used. Senior leaders use it to

evaluate individual investments and investors use it to assess the risk of a

company’s equity.

Let’s look at that first instance. “A wise company only invests in projects and

initiatives that exceed the cost of capital,” says Knight. So once the finance

department, CFO, or treasure department has determined what the rate is,

managers know that is the number to beat if they want to win support for their

projects or proposals. “If you make investments that don’t get a return that

exceeds the cost of capital, you’re encouraging investors to go elsewhere,”

explains Knight. “You’re basically saying that we’re not getting the return you

expected.” Therefore it’s important that managers — often with the help of

finance — take a close look at potential projects to make sure they exceed the

cost of capital

Now for the second instance. Although this use is less common, investors will look

at an aspect of the cost of capital — the beta or volatility (more on this in the next

section) — which will help them understand if a stock is a risky investment or not.

How do you calculate the cost of capital?

In reality, few managers will ever make this calculation. “This is the job of finance

professionals,” says Knight, “and to the average manager what goes into

determining the cost of capital can often be opaque.” Here’s a brief overview

(based on the example in Knight’s book, Financial Intelligence):

The first step is to calculate the cost of debt to the company. This is pretty

straightforward. You take all of the money that the company has borrowed and

look at the interest rates you’re paying. So if the company has a credit line with a

rate of 7%, a long-term loan at 5%, and bonds that it uses to make acquisitions at

3%, you add that all up and calculate the average. Let’s say it’s 6%. Then because

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interest on debt is tax deductible you multiply it by the corporate tax rate (which

is usually around 30% in the U.S.). The formula looks like this:

Cost of debt = average interest cost of debt x (1 – tax rate)

So you take your 6% and multiply it by (1.00-.30). In this case the cost of debt =

4.3%.

Now, set that number aside and move over to the equity calculation. This is a

much more theoretical number and takes into account beta (risk) and prevailing

interest rates.

The formula looks like this:

Cost of equity = risk-free interest rate + beta (market rate – risk-free rate)

Beta measures the volatility of the company’s stock compared to the market. The

higher the beta, the riskier the stock is, according to investors. If a stock rises and

falls at close to the same rate as the market, the beta will be close to 1. If it tends

to rise and fall more than the market, it might have a beta closer to 1.5. And if it

doesn’t fluctuate as much as the market, like a utility for example, it might be

closer to 0.75.

The market rate is the expected return on the stock market right now. There is

typically lots of debate about this number but generally it falls between 10-12%.

The risk-free rate is the return you’d get on a risk-free investment, such as a

treasury bill (somewhere between 1-3%). This figure can also be debated.

Let’s assume that that the company’s beta is 1,that it uses 2% for the risk-free

rate and 11% for the market rate, then you’d get the following calculation:

2% + 1 (11% – 2%) = 11%

Note how important the beta can be. For example, if the company’s beta was 2

instead of 1, the cost if equity would be 20% instead of 11%. That’s quite a

difference.

Now the next step is to take your two percentages – the cost of debt (4.3% in the

example above) and the cost of equity (11%) – and weight them according to the

percentage of debt and equity the company uses to finance its operations. Let’s

assume the company uses 30% debt and 70% equity to run its business. So you’d

do the following final calculation:

(0.3 x 4.3%) + (0.7 x 11%) = 8.99%

This is the company’s WACC.

Keep in mind that this is a number used to evaluate future investments so there

is a lot of projecting going on. “You’re using the current structure of interest rates

and business conditions to calculate a future return and there’s an implicit

assumption that your current beta will be the same going forward. In a volatile

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market, that’s never true,” explains Knight. It’s hardly an exact figure and is, in

fact, a very theoretical calculation. “Like everything in finance it’s based on a lot

of estimates and assumptions. It may look like a hard, fixed number — but it’s far

from that.”

What mistakes do people make when using cost of capital?

The biggest mistake managers make, according to Knight, is taking the number at

face value. “Sure, some grouse about the number, claiming that it’s too high and

it limits the investments that they can reasonably make, but most just take the

figure handed to them by finance.” This is problematic because the cost of capital

has a big influence on what you’re able to do. “It’s not something you should just

accept. You should absolutely challenge it,” says Knight.

He recommends asking your counterpart in finance: What did you use for cost of

equity? How did you come up with cost of debt? Or why do we use 12% as the

market rate? “You can miss a lot of opportunities when you have to hit a higher

standard,” Knight says, so it’s worth asking tough questions and seeing if you can

negotiate the rate. What you want the rate to be will depend on the type of

project you’re taking on. For example, if you’re a manager proposing a whole new

R&D software for a new product that you’ve never done before, you want to

use a high number, probably higher than your WACC, to show that this type of

risky investment is worth it. But if your order processing system is breaking down

and you need a new one, you can use a lower rate since this is part of the nuts

and bolts infrastructure for running your business. After all, if you don’t have an

order processing system, you’ll be out of business.

Another mistake managers make is to pad the number. “They like to bump it up

to be safe,” explains Knight. If the corporate cost of capital is 12%, then a manager

might think, I’m going to use 15% to be on the safe side. But the number likely

already includes a cushion. Don’t up it again or you will be making things

unnecessarily hard on yourself.

When finance tells you that your new project or initiative needs a return that

beats the company’s cost of capital, it’s helpful to know what that figure is and

how it’s calculated. Armed with this information, you’ll be able to better make

the case that your idea is worth the company’s investment.