VALUE : The cost of capital
The cost of capital or the weighted average cost of capital (WACC) is a fundamental concept in corporate finance. It is relied on for making investment decisions and for the valuation of businesses.
The cost of capital is not just the risk of capital employed. It exists before the capital structure is even fully assembled or finalised. In fact, creditors and shareholders will determine the rate of return they require on debt and equity on the basis of the capital structure and of the risk of capital employed.
Only for calculation purposes is the cost of capital often calculated as the weighted average cost of equity and debt.
The cost of capital can be calculated by:
- using a direct method on the basis of the β of the capital employed; or
- using an indirect method where it is equal to the weighted average of the values of the cost of equity and the cost of net debt; or
- observing the value of capital employed, when this figure is available.
For a diversified company, there are as many costs of capital as there are sectors in which it operates. Similarly, every country or economic area has its own specific cost of capital, which is dependent upon the political landscape and macroeconomic risks.
For emerging countries, the methodology must be adapted to factor in both the lack of certain data (risk-free interest rate) and international parameters (the industry's β).
A company's negative net debt structure brings down the cost of its equity, but has no impact on the cost of capital which is the same as if the company had no cash.
Managers have very little margin for manoeuvre to create value by reducing their cost of capital, as if they lower the cost of capital they will most likely also lower their returns. The only hope that they have is of providing better information to the market.