The cost of capital (Ke) is the cost that a company incurs to finance its investment projects through its own financial resources.
Although it is not a directly observable cost, it is a very relevant concept. Although we might think that financing ourselves with our own resources has no cost, this is incorrect. For example, if we carry out a capital increase, we could obtain resources without the need to return them (as is the case with debt), but in return the shares may be diluted.
To avoid what we reflected in the previous case, investors will demand a return from the company to compensate for that loss in the company’s participation.
Also, we must not forget that shareholders will want to make money. Therefore, it could happen that they require a dividend.
Capital cost characteristics
The main features are:
- Cost not directly observable.
- Greater calculation complexity than the cost of debt.
- Generally calculated based on the Financial Asset Valuation Model (CAPM).
- The lower the risk of the assets, the lower the cost of capital.
Cost of capital formula
The formula for calculating the cost of capital (Ke) is as follows:
- Rf: It is the risk-free rate.
- Bl: It is the market return.
- (Rm – Rf): It is the market premium.
- Bl (Rm – Rf): It is known as the company’s premium.
Importance of cost of capital
The valuation of the cost of capital is of vital importance for the survival of a business or a company. It is calculated through the relationship between the average of all financial resources used to carry out investments or projects and the weight that each resource has in total resources.
Ke = Cost of capital ( equity )
E = Market value of capital.
V = Market value of debt + Market value of equity.
Its monitoring, as we mentioned, must be rigorous, it also contributes to:
- Improve the efficiency of the company since it optimizes the cost-benefit ratio.
- It allows to analyze the financial model of the company through the analysis of its own sources of financing and source of external financing.
- Detect the needs of the company and its profit margins.
- Analyze the unit cost of production.
Capital investment is very important for the company to be able to produce and function, but it is also just as important to analyze its cost. Far from financial engineering and the complex models that are used for its determination, we can say that the valuation of the cost of capital is simpler than many analysis formulas that can be found in books.
We can say that it is the cost of financing to produce capital. In this, we can include the interest rates charged for access to credit and the cost of financing to access it. Market risk is another variable to take into account, given that the higher the risk, the investors will demand a higher return on their investments and this will translate into a higher cost for the company, the cost of equity and the opportunity cost In order to access more capital, make investments in a larger volume with a higher profit margin that allows covering the entire mass of fixed costs.
Example of calculating the cost of debt
In this example, suppose that this company has issued 1,000 shares, its market value is 6 euros, and it is expected to pay a constant dividend of 4% per year on the nominal value.
To calculate the cost of capital of this company, we must first know the nominal value of the share, that is, the quotient between the capital stock and the number of shares:
Nominal value = Share capital / N ° shares = 4,500 / 1,000 = 4.50 euros
On the other hand, the formula for the cost of capital is as follows:
Ke = Do / Po = 4.50 * 0.04 / 6 = 0.03 = 3%
The cost of capital of this company is 3%.
Where Do is the constant rate of increase of dividends over the nominal value and Po is the price of the company.