Companies calculate their cost of capital to determine the required return needed to make a capital budgeting investment worthwhile. Managers will invest only in projects or other assets that will produce returns in excess of the cost of capital. For this purpose, the cost of capital is known as the "hurdle rate."
Companies finance their operations with various proportions of debt and equity. Each source of funds has a different cost that reflects its seniority and risk level relative to other sources. For example, a loan secured by physical assets, such as buildings and equipment, has a lower cost compared to the return required for equity capital contributions. Stockholders do not have any legal claims on the assets of the company and must depend on future profits and dividends to receive a return on their investments. While companies are obligated to make interest and principal payments on loans, they are not required to pay dividends to shareholders. Therefore, a common stockholder has no assurance that he will ever receive a return on the investment.
The weighted average cost of funds is a summation of the blended costs of each source of funds. This weighted average cost of capital, or WACC, is calculated by multiplying the proportion of each source of funds by its cost and adding the results.
The cost of debt financing is adjusted because interest costs are tax deductible. The after-tax cost of debt is "1 minus the corporate tax rate." If the marginal tax rate for the company is 36 percent, then the after-tax rate applied to the interest cost for calculating the WACC is "1 - 36 percent" or 64 percent.
The cost of equity is a little more difficult to calculate. Essentially, the cost of equity is whatever rate the stockholders say it should be. Shareholders assume a level of risk whenever they invest funds in a business. If investors perceive that future profits of the company are uncertain, they will demand a higher return on their investment. Unlike debt commitments, the company is not obligated to pay its stockholders anything. Therefore, shareholders demand an additional return for being willing to assume the risk that they may never see any return on their investments.
Let's consider an example of the cost of funds calculation. Suppose the debt and equity structure of a company and its tax rate are as follows:
- Corporate tax rate: 36 percent
- After-tax rate: 1 minus 36 percent = 64 percent
- Long-term debt: $100,000 at a fixed interest rate of 8 percent
- Preferred stock: $75,000 with a dividend rate of 3 percent
- Common stock: $200,000 with a required investor return of 12 percent
- Total debt and equity: $375,000
The calculations for the proportions are the following:
- Long-term debt: ($100,000/$375,000) X 64 percent X 8 percent = 1.3 percent
- Preferred stock: ($75,000/$375,000) X 3 percent = 0.6 percent
- Common stock: ($200,000/$375,000) X 12 percent = 6.4 percent
- Adding up: 1.3 + 0.6 + 6.4 = 8.3 percent
The weighted average cost of capital is therefore 8.3 percent.
Companies try to find the optimal mix of debt and equity financing. Long-term debt has the advantage of being more tax efficient because interest costs on loans is tax deductible. On the other hand, dividends paid on preferred and common stock are not tax deductible and are paid with after-tax dollars.
While borrowing more money may lead to a lower WACC, a high debt-to-equity ratio can result in riskier leverage, causing lenders to demand higher interest rates to compensate for the increased risk of default.
On the other hand, raising more equity capital to reduce financial leverage could lead to reduced ownership control. More investors would mean that they have more of a voice in how management runs the business.
Small business owners have to find that balance of debt and equity that allows them to control their businesses and, at the same time, keep the cost of capital down.