The cost of capital is the lowest rate of return the companies should earn before generating value. Before earning profits, a company must generate sufficient income to cover the cost of capital it uses to fund the operations.
The cost of the capital contains both costs of debt and the cost of equity. A company’s cost of capital depends upon the method the company chooses to fund the business operations which is also known as the capital structure. A company may rely solely on debt or on equity of a mix of the two to fund its operations.
As a choice of financing, the cost of capital is a critical and important variable for the companies for financing the projects. As the cost of capital determines the capital structure, companies usually look for an optimal mix of debt and equity to form the cost of capital.
Investors use the cost of capital as a metrics to evaluate companies for potential investments. The cost of capital is also an important metric because it is used as the discount rate for the company’s free cash flows in the DCF analysis model.
The cost of capital is an important factor in the calculation of a company’s capital structure. Determining the capital structure is a tricky process because determining an ideal mix of debt and equity needs a lot of ideas about their potential effects. Moreover, both debt and equity have their advantages and disadvantages that must be considered while using them in the capital structure of a company.
Debt is a cheaper source of financing than equity, and companies can benefit from their debt financing by expensing the interest on existing debt. It helps the companies to reduce their taxable income. The reduction in taxability due to debt expenses is known as tax shields.
Tax shields are crucial for a company because they help to preserve the cash flows of the company and therefore impact the total value of the company.
Although debt financing is easier, at some point, debt issuance is overtaken by the issuance of equity. For a company that already has lots of debt, adding new debt will increase its chances of default. Increased risk increases the cost of debt because new investors will ask for a risk premium to cover the additional risks. In addition, a higher risk of debt will take the cost of equity up, as shareholders will need additional assurance for covering the increasing debt.
Although it is costlier, equity financing is more attractive to investors because they do not carry the risk of default. It can also help in raising a larger amount of capital. However, as equity financing reduces the control of current shareholders over the business, it is not a preferred choice of all companies.