What is the Cost of Capital and How to Use It

“I’ve never heard an intelligent discussion about ‘cost of capital.'”

Charlie Munger

The value of any company or investment is the present value of future cash flows, whether Microsoft, our home, or a piece of art. Part of determining the present value of the future cash flows is defining the discount rate or hurdle rate to determine that present value. We do this by calculating the cost of capital or discount rate.

The cost of capital helps determine how much it will cost a company to invest in the business, and make no mistake; EVERY business must reinvest at some level to maintain its growth.

There is an opportunity cost for every investment, baseball card, or Visa. We use the cost of capital to determine those opportunity costs to help us decide whether to invest in those baseball cards or Visa.

In today’s post, we will learn:

  • What is the Cost of Capital?
  • Understanding the Cost of Capital
  • Weighted Average Cost of Capital (WACC)
  • Calculating the Cost of Capital with Real-World Examples
  • What is the Difference Between Cost of Capital and Discount Rate?
  • Investor Takeaway

Okay, let’s dive in and learn more about the cost of capital.

What is the Cost of Capital?

The easiest way to define the cost of capital is that it is the minimum rate of return that a business must earn to create value for shareholders.

The cost of capital can get bogged down in academia, but it boils down to the idea that there is an opportunity cost to invest in companies like Visa or Walmart. And what are those opportunities?

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It comes down to the money a company invests; there will be a cost associated with that investment and the kind of return the company can generate.

As usual, Warren Buffett has some great thoughts on this relationship that he shared in his 1984 shareholder letter:

Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

The above idea is Buffett’s $1 test, and here is an excerpt from an excellent article by John Huber of Saber Capital Management, outlining what Buffett is trying to emphasize:

  1. “Value creation comes from the returns that the company can generate on reinvested cash (incremental returns on capital), not just the returns they generate on previously invested capital (ROIC)
  2. Companies should only retain earnings if a dollar in the company’s hands is more valuable than a dollar in the shareholder’s hands.
  3. The only way a company achieves #2 is to earn a higher return on that dollar than shareholders could earn elsewhere (which is another way of saying companies must produce returns on capital that exceed their cost of capital).”

Understanding the Cost of Capital

The cost of capital boils down to determining the cost of investments a company must make to grow.

Those investments occur in two forms of capital:

  • Debt
  • Equity
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The cost of debt comes in the form of the company’s use of debt to raise funds for different investments. That cost relates to the interest the company pays and returns the original principle to its owner, bonds, or bank loans.

The cost of equity comes from the issuing or selling shares of the company to raise cash for investments.

Each of these forms of the capital comes with costs associated with those and opportunity costs.

As investors, we need to assess how much those costs of capital cost the company and whether they will generate greater returns over those costs of capital.

Using a simple example, which company would you want to buy?

Company A invests $1 that generates a $10 return or growth in revenues. Company B invests the same dollar and generates a $5 return or growth in revenues.

Every one of us would choose company A.

But if that dollar investment costs company A $11, then the investment destroys value, where company B’s investment only costs them $1, then they create value with its investment.

Using the cost of capital to determine the hurdle rate for our investments is how we determine the best investments.

Because many companies use a mix of debt and equity to finance their growth, investors need to determine the overall cost of capital; we use what’s known as the weighted average cost of capital or WACC.

Weighted Average Cost of Capital (WACC)

We can calculate any company’s cost of capital using the weighted average cost of capital. The formula combines both the cost of debt and the cost of equity and weighs them to blend the cost.

The WACC weighs each component of the company’s capital proportionately to reach a blended rate.

Consider that the WACC takes into account each type of debt and equity on a company’s balance sheet. For example:

  • Bonds
  • Preferred stock
  • Common stock
  • Short-term loans
  • Bank loans
  • Credit facilities (lines of credit)

For a deeper dive into WACC, please check this article out.

Weighted Average Cost of Capital Guide

The first component to explore:

Cost of Debt

The cost of debt reflects the interest paid on the debt the company holds. But because the interest expense is tax-deductible, we calculate the cost of debt after-tax.

To do a deeper dive into the cost of debt, please follow the hyperlink above.

To calculate the cost of debt, we use the following formula:

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Where:

  • Interest expense = interest paid on the company’s debt (line item listed on the income statement)
  • Total Debt = total debt, including long and short-term debt from the balance sheet, including any capital leases listed on the balance sheet.
  • T = tax rate. We can find the company’s marginal tax rate by using the CTRL-F function in the company financials, searching for tax rate

We can also calculate the cost of debt by adding a credit spread to the risk-free rate (10-yr Treasury) and multiplying those results by one minus the tax rate (1-T).

Below is an example of calculating the cost of debt using Apple’s latest annual report.

  • Interest expense = $2,701 million
  • Total debt = $122,798 million
  • Tax rate = 28%

Now, we plug the numbers into the formula to get:

Apple’s cost of debt = $2,701 / $122,798 x (1-28%) = 1.51%

Simple, huh?

Typically, the cost of debt will be lower than the cost of equity. If you find a company with a higher cost of debt than equity, first check that your calculations are correct; next, run far from that investment.

Cost of Equity

Calculating the cost of equity is a touch more complicated because equity or stock investors insist on a higher return for their investments than bond investors.

That higher cost, in theory, offsets the increased risk and volatility investors receive for their investment in stocks or equities.

For a deeper dive into the cost of equity, please refer to the hyperlink directly above this section.

To calculate the cost of equity, we use the CAPM (capital asset pricing model) listed below:

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Where:

  • Risk-free rate = the minimum risk-rated return an investor will accept, typically associated with the US 10-year Treasury. We can find the rate on the US Treasury site.
  • Beta = used to estimate an investment’s risk and/or volatility. We can find beta on your favorite financial websites like Koyfin or Gurufocus.
  • Equity risk premium = the minimum rate of return an investor would accept for investing in a particular company. We can best find the most current rate on Professor Aswath Damodaran’s website.

Let’s calculate the cost of equity for Apple using the following inputs I will gather from the respective websites.

  • Risk-free rate = 1.78%
  • Beta = 1.20
  • Equity risk premium = 4.90%

And, now plugging in the numbers, we see:

Apple’s cost of equity = 1.78% + 1.20(4.90%) = 7.66%

Again, simple, huh?

The weighting of Debt and Equity

The next part of the process determines the company’s total capital weight compared to each component, debt, and equity.

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Where:

  • E = the total capital for the company, which is the current market cap
  • D = the total debt of the company, the same number we used to calculate the cost of debt
  • V = the market cap plus the total debt

To do this is simple, we:

  • Add the debt and market cap of the company, which we find on the balance sheet, by multiplying the current market price by the shares outstanding, or look it up on your favorite financial website.
  • Next, we divide the debt by the total capital and then the equity by the total capital to get percentages, which will equal 100%
  • And lastly, we multiply our weightings by our previously calculated cost of debt and equity.

For example, using Apple’s total debt and equity:

  • Total debt = $122,798 million
  • Total market cap = $2,869,610 million
  • Total capital = $122,798 + $2,869,610 = $ 2,992,408 million

Next, we will calculate the weightings for each component

Weighting of debt = $122,798 / $2,992,408 = 4.10%

Weighting of equity = $2,869,610 / $2,992,408 = 95.9%

Finally, we will plug that into our WACC formula and calculate the WACC or discount rate for our discounted cash flow model.

Apple’s WACC = (7.66% x 95.9%) + (1.51% x 4.10%) x 100 = 7.40%

The WACC calculations are the input we use in our DCF (discounted cash flow) calculations to determine the present value of the future cash flows.

Companies and management try to achieve the optimal capital structure for their business based on the cost of capital for various sources of capital.

Debt financing is more tax-efficient because of the tax benefits from interest expense; borrowing money via debt is cheaper. There is also the dividend benefit from paying those from after-tax dollars.

Companies with higher credit ratings such as Microsoft, Johnson & Johnson, Apple, Berkshire Hathaway, and Google all come with AA ratings or higher. These higher credit ratings offer the above companies the ability to borrow at far cheaper rates and give them an additional advantage.

The flip side of that view is that too much debt can be dangerous because higher leverage forces the company to pay higher interest expense levels. It reaches a tipping point, leading to default and bankruptcy if the company can’t meet its interest obligations.

Calculating the Cost of Capital with Real-World Examples

Now, let’s put our learnings into action to determine the cost of capital for the top companies in the S&P 500, or FAANG. I will look up the relevant data for each company using the website TIKR for ease of use and run them through a calculator to calculate the WACC for each company.

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A few numbers will be constant throughout the exercises, and all numbers will be in millions unless otherwise stated and based on TTM (trailing twelve months) results:

  • Risk-free rate = 1.78%
  • Equity risk premium = 4.90%
  • Marginal tax rate = 28%

First, up will be Meta (FB); sorry, I still think of it as Facebook.

  • Market cap = $898,508
  • Total debt = $13,219
  • Interest expense = $0
  • Beta = 1.28
  • Total capital = $898,508 + $13,219 = $911,727

With these eight inputs, we can calculate Facebook’s capital cost.

Cost of debt = $0 / $13,219 x (1-28%) = 0

Cost of equity = 1.78% + 1.28(4.90%) = 8.05%

Now, we can calculate the cost of capital using our WACC formula.

Weighting of equity = $898,508 / $911,727 = 99%

Weighting of debt = $13,219 / $911,727 = 1%

Facebook cost of capital = (99% x 8.05%) + (1% x 0%) = 7.94%

For the rest of the exercises, I will list the separate inputs but calculate the formulas to make them less cluttered on the page.

Amazon’s cost of capital from the following inputs:

  • Market cap = $1,527,655
  • Interest expense = $1,741
  • Total debt = $136,238
  • Beta = 1.10
  • Total capital = $1,527,655 + $136,238 = $1,663,893

Amazon’s cost of capital based on the above inputs is:

Amazon’s cost of capital = (92% x 7.17%) + (8% x 1.28%) = 6.66%

Lastly, we will tackle Google’s cost of capital using the above structure.

  • Market cap = $1,956,705
  • Interest expense = 0
  • Total debt = $26,206
  • Beta = 1.06
  • Total capital = $1,982,911

And now plugging in the variables to Google’s WACC formula:

Google’s cost of capital = (99% x 6.97%) + (1% x 0%) = 6.88%

What is the Difference Between Cost of Capital and Discount Rate?

The cost of capital and the discount rate or WACC are terms that people in finance use interchangeably. Many companies calculate the cost of capital internally to determine the viability of possible investments.

Many companies try to lay out the different costs of capital they use to tell the public what their hurdle rates are for different investments.

For a company to reinvest intelligently, they need to beat that hurdle rate; otherwise, they waste shareholders’ money.

There is also the risk of a company being either too optimistic or conservative with their cost of capital calculations, leading to either investing in poor projects or initiatives or not investing at all.

To see the bigger picture, using the cost of capital to measure our hurdle rate for a possible investment is the ideal choice.

But, we can also look at the difference between ROIC (return on invested capital) and the WACC.

Ideally, the larger the gap, the better the investment, both for the company and us.

It is always a good idea to keep both the cost of capital and the ROIC in mind when analyzing any investment because any greater investment than the returns will destroy value in the long run.

Investor Takeaway

Most management teams and investors seek investments that will help their value grow. Using the cost of capital to determine the cost of that potential investment is a great starting point.

Companies have lots of options for deploying their capital, and as Buffett argues often, that is job number one for any CEO.

They can expand their factories, build a bigger, better widget, buy out the competition, or hire more engineers to build out a particular product or service.

Before any company pulls the trigger on these investments, they determine the cost of capital for those investments. As investors, we should do the same.

Calculating the cost of capital is not difficult, even though it looks challenging on the surface; once you understand the what and why, it’s simply a matter of compiling the eight inputs you need and plugging them into the formula.

To reference, it is a good idea to look at sector WACC’s or industry WACC’s, which Professor Damodaran provides here.

Another great resource is Michael Mauboussin, professor of valuation at Columbia University; his writings and seminal article on the Cost of Capital are a must-read.

And with that, we will wrap up our discussion for today.

As always, thank you for taking the time to read today’s post, and I hope you find some value. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave

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