Accounting Handbook: Explaining the term “Cost of Capital”

The term “Cost of Capital” is an accounting and finance concept used to measure the cost of capital invested in a business or project. This is especially important in evaluating business performance and financial management. Let's find out information about this term with Bizzi!

What is the cost of capital?

This term can be understood from two angles:

  • Enterprise - user of capital: is the estimated cost that the business must spend to use that capital.
  • Investor - provider of capital: is the return value that investors or creditors (bondholders) expect to receive when providing capital for businesses.

To put it more simply, the cost of capital is the “price of using money”. Economists say that the essence is the opportunity cost of using that capital to invest in businesses.

To meet capital needs, businesses or business people must mobilize from many sources. These sources are classified into two main categories, namely debt capital and equity capital. Each different type will have a different cost of capital.

What is the cost of capital used for?

Suppose, you are faced with a question: "Should I buy more new machines to increase the productivity of the factory?". There will be many other related questions raised. Among them, it is certainly indispensable for the first key element – “where is the money”?

For any corporate finance manager, calculating and estimating the cost of capital is very important. The main objective is to have a basis for decision-making to raise new capital for an investment project. Accordingly, businesses need to know the marginal cost of new capital - that is, the average cost of capital for each additional dollar of new capital - in order to choose the most appropriate and optimal capital mobilization.

In addition, considering the cost of capital can help managers gain visibility when considering the choice of a long-term capital mobilization strategy of the enterprise.

Characteristic

  • The cost of capital fluctuates based on the laws of the market, because “capital” is also a commodity. In other words, the cost of capital is not always subjectively determined by the business, but is determined on the basis of the supply and demand for capital in the market.
  • The cost of capital is considered on the basis of the risk level of the investment project. The law of "high risk - high return" - if the investment project has a higher risk, the higher the required rate of return of the investor, so the cost of capital will increase and vice versa.
  • The cost of capital reflects an investor's required return now, not in the past.
  • The cost of capital is usually measured by the ratio %.
  • The cost of capital includes the inflation premium and the real interest rate demanded by investors.
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Considering the cost of capital helps managers gain visibility when considering long-term capital mobilization strategies.

What factors determine the cost of capital?

As discussed above, the cost of capital is largely determined by the market, and is influenced by both subjective and objective factors:

Group of objective factors

  • Market interest rate: When the market interest rate is high, the required rate of return of investors is also high, so the cost of capital of the enterprise is also high and vice versa.
  • Corporate income tax policy: Loan interest is included in the cost of reducing taxable income, thereby helping to reduce the amount of income tax that businesses have to pay. Therefore, interest on loans brings tax benefits. If the tax rate is high, the tax benefit is large, reducing the cost of borrowing capital and vice versa.

Group of subjective factors

  • Investment policy: If the enterprise invests in assets with a high level of risk, the required rate of return of investors is also high and vice versa.
  • Financing policy: When businesses mobilize a lot of loans, it will increase financial risks for investors' capital, which leads to an increase in the company's cost of capital.
  • Dividend policy: The company's dividend policy determines the size of reinvested profits more or less. If the dividend payment is limited, the enterprise has more reinvested resources, and it is limited to raising capital from outside, so the cost of capital is higher. Because the cost of equity is higher than the cost of debt.

Types of cost of capital

Cost of using loan capital

For borrowed funds, such as bonds, the cost of capital will be the periodic interest charged on the face value of the bond. In general, the costs of using debt capital are relatively easy to determine because the enterprise and creditors have agreed on this cost from the outset.

Cost of equity

Equity is formed by contributing capital, offering shares (usually for joint stock companies) or using retained earnings. For equity, the cost of capital is not easy to determine because the returns the business pays to shareholders are not committed in the first place – except in the case of preferred shares. Therefore, the cost of equity is often determined from the investor's perspective, based on the "expected rate of return", and is calculated using the capital asset pricing model - CAPM.

How is the cost of capital calculated?

Formula to calculate cost of capital

The cost of capital is calculated as a weighted average of the cost of each good. Specifically:

WACC = (E/V) * Re + (D/V) * Rd * (1 – Tc)

In there:

  • Re: Cost of Equity
  • Rd: Cost of debt use
  • E: Total market value of equity
  • D: Total market value of debt
  • V: Total value of long-term capital of the enterprise
  • Tc: Corporate income tax
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How is the cost of capital calculated?

Meaning of cost of capital

  • Evaluate financial decisions: provides important information for companies and investors to make decisions about financial resource allocation. This helps determine how to finance or invest in a company's projects and capital structure.
  • Evaluate investment opportunities: assist companies and investors in assessing various investment opportunities. By converting future cash flows into present value through discounting, the cost of capital helps make decisions about investing in the most profitable projects.
  • Budget management:  Play a role in setting the company's budget. It helps management use the company's financial resources to achieve business goals and minimize capital costs.
  • Measure progress: Combining project progress with capital use, the cost of capital can be used to measure the progress of a project or investment. It helps to determine whether the project is progressing as planned and delivering the expected financial benefits.
  • Optimizing capital and debt: provides useful information for companies wishing to expand their business. It helps to optimize the use of capital and maintain the lowest level of debt to satisfy shareholders' wishes

The above is information related to the term "The cost of capital". Managing the cost of capital is very important to ensure the efficient use of capital, optimize profits and increase value for the business. Understanding the terminology will help managers make sound decisions about the use of capital, weighing the risks and benefits of each project or business. Hope the content that Bizzi provides can help your work.

>> See more: What is Bootstrapping? 

>> See more: Explain the term “Account Payable”

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