The cost of capital
The minimum return investors need.
A firm earns a 9% return on a project funded at a cost of 12%. Is it better off?
The cost of capital is the return investors require for supplying funds. A project earning above it adds value; one below it destroys value. Riskier investments need higher returns.
A bank lends at 10%. Shareholders expect more than that for taking the greater risk. A firm that earns less than it costs to raise its money loses value, even if its profit is positive. So what does the money cost?
In plain wordsThe cost of capital is the return investors need in order to supply money to the firm. If a project earns less than this, the firm is worse off.
Exam definitionThe cost of capital is the required rate of return expected by providers of finance for supplying funds to a business. It is the minimum return a firm must earn on its investments to satisfy investors and maintain its market value.
| Type | Meaning |
|---|---|
| Explicit cost | The actual cost paid for raising capital, such as interest or dividends |
| Implicit cost | The opportunity cost of using funds, such as earnings kept back |
| Specific cost | The cost of one source of finance, such as debt or equity |
| Weighted average cost of capital (WACC) | The average cost of all sources, weighted by their proportions |
| Marginal cost of capital (MCC) | The cost of the next increment of capital raised |
| Factor | Effect |
|---|---|
| Risk profile | Higher business or financial risk leads to a higher required return |
| Capital structure | Debt may lower the cost, up to an optimal point |
| Dividend policy | Higher dividends may increase reliance on external funds |
| Tax rate | A higher tax rate raises the interest tax shield and lowers the after-tax cost of debt |
| Market conditions | Interest rates and investor expectations affect the cost of finance |
| Creditworthiness | A better credit rating lowers the borrowing cost |
Risk and return. The riskier the investment, the higher the return investors expect, and the higher the cost of capital. A safe lender asks for less than an equity holder.
Why it matters. It is the discount rate for NPV and IRR (Chapter 13). It guides the choice of debt and equity (Chapter 16). It informs the dividend decision, and the valuation of shares, bonds and whole firms.
Don’t think retained earnings are free. Retained profit has no interest and no issue cost, but shareholders could have used the dividend elsewhere. That forgone return is an implicit cost, and it is why the cost of retained earnings is taken as about equal to the cost of equity.
Where it breaks. The cost of equity cannot be seen in a bill; it has to be estimated, and each method (dividend growth, earnings yield, CAPM) gives a different answer. A cost of capital for the whole firm can be wrong for a project that is much riskier than the firm’s usual business.
For exams. Know the types, the factors, the significance for the four financial decisions, and the rule: accept projects earning more than the cost of capital.
Risk up, required return up, cost of capital up.
Go deeper for practitioners
A project-specific rate. A firm that makes tyres and starts an overseas venture should not use its tyre WACC for the new business. The venture’s own risk sets the right discount rate, which may be higher.
A decision. Two firms in the same trade have the same debt, but one has a better credit rating. Whose cost of capital is lower, and what difference does that make to the projects each can accept?
1. The opportunity cost of using retained earnings is called…
Not quite. The answer is “An implicit cost”. Retained profit has no direct payment, but shareholders forgo the return they could have earned on the dividend.
2. A higher tax rate makes the after-tax cost of debt…
Not quite. The answer is “Lower”. Interest is tax-deductible, so a higher rate gives a bigger tax shield and a lower cost.
3. Which statement matches the risk and return rule?
Not quite. The answer is “Higher risk, higher required return, higher cost of capital”. Investors need more compensation for taking more risk.
“Why might a firm’s overall WACC be the wrong discount rate for a project much riskier than its usual work?”
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- Cost of capital: the required return of providers of finance.
- Explicit: paid in cash. Implicit: opportunity cost. Specific: one source. WACC: all, weighted.
- Factors: risk, capital structure, dividend policy, tax, market conditions, credit rating.
- Accept projects that earn more than the cost of capital.
Risk up, required return up, cost of capital up.