Companies don’t get to use the money they raise from investors for free. The cost of capital, or weighted average cost of capital, is what a company must pay for the funds. Measuring cost of capital matters because a firm that doesn’t produce a return greater than the cost of capital may not be able to generate enough money to grow.
Weighted Average Cost of Capital
To calculate cost of capital, first determine the total capital invested, which equals the market value of equity plus the firm’s total debt. The formula for cost of capital is equity as a percentage of total capital multiplied by the cost of equity, plus debt as a percentage of total capital multiplied by the cost of debt.
Suppose equity is 40 percent of capital and the cost of equity is 15 percent. Debt is 60 percent of capital and the cost of debt is 10 percent. You have 40 percent times 15 percent plus 60 percent times 10 percent. This works out to a cost of capital of 12 percent of total capital invested.
Know Your Terms
Analysts usually use after-tax yield to maturity as the cost of debt, but may substitute after-tax current yields when YTM can't be determined. Equity value is the market value of stock or the book value if market value is unavailable. Cost of equity is an estimate that can be based on various analytical models such as dividend growth and capital asset pricing models.