The cost of capital is the price of the cash (or money) the company pays to get, and it is a rate from the invested costs (loans and equity). Businesses get funds through loans, equity shares, or grants, and every source of funds has a different level of risk and return (or cost) that funders ask for from borrowers or investors. The company’s cost of capital is the weighted average cost of capital (WACC) sourced through loans and equity shares. The cost of loans is usually referred to as the interest rate and return on equity for the equity shares that shareholders claim from the company due to associated risks (e.g., credit, default, finance, and investment). Management strives to achieve a return on investment, which is higher than the cost of capital, to allow company profitability and sustainability. The importance of estimating the capital cost includes evaluating investment decisions (i.e., viable opportunity shows returns higher than the cost of capital), determining the value of assets and the company by discounting its future cash flows, directing the company to set financial targets, and guiding the management to decide on the optimum capital structure that supports maximizing profitability.
Step-By-Step Process
- Clarify the investment cost and capital structure outcomes.
- Obtain the loan interest rates from potential lenders.
- Review the average (WACC) for the industry.
- Work out the expected return on equity in your company using multi-methods like the capital asset pricing model (CAPM) (free return plus risk-premium return), dividends discount model (DDM), collecting the equity returns of similar businesses, or searching industry benchmarks. As a rule of thumb, the equity return is higher than the loan interest rates as the equity investment risk is much higher than credit risks.
- Use the weighted average cost of capital (WACC) to estimate the project’s capital cost. The formula is WACC = (Cost of Debt x Weight of Debt) + (Cost of Equity x Weight of Equity).
Example
If the company’s capital structure reveals (60%) loans and (40%) equity shares, the loan interest rate is (7%), and the expected return on equity is (14%), then the weighted average cost of capital becomes (9.8%).
Useful Tips
- Apply multi methodologies (e.g., as referred to above) to estimate the project’s capital costs.
- Obtain the industry’s average (WACC).
- Seek team and expert opinions.
Things To Avoid
- Avoid guesswork and assumptions without evidence.
Final Note
This article is sourced from my new book- Your Guide For Preparing An Industrial Feasibility Study.
For more information about the book: https://growenterprise.co.uk/book-your-guide-for-preparing-an-industrial-feasibility-study/
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The author: Munther Al Dawood- Industrial Enterprise Expert
Grow Enterprise 