The ratio between debt and equity in the cost of capital calculation should be the same as the ratio between a company’s total debt financing and its total equity financing. The cost of capital should correctly balance the cost of debt and the cost of equity. This is also known as the weighted average cost of capital or WACC.
Key Takeaways
- The ratio between debt and equity should be the same as the ratio between a company’s total debt financing and its total equity financing.
- The real cost of debt is equal to interest paid minus any tax deductions on interest paid.
- The most common method used to calculate cost of equity is the capital asset pricing model or CAPM.
- Companies can use the weighted average cost of capital to determine the feasibility of starting or continuing a project.
Cost of Debt
Companies sometimes take out loans or issue bonds to finance operations. The cost of any loan is represented by the interest rate charged by the lender. A one-year $1,000 loan with a 5% interest rate “costs” the borrower a total of $50 or 5% of $1,000. A $1,000 bond with a 5% coupon costs the borrower the same amount.
The cost of debt doesn’t represent just one loan or bond. It theoretically shows the current market rate the company is paying on all its debt. The real cost of debt isn’t necessarily equal to the total interest paid by the business, however, because the company can benefit from tax deductions on interest paid. The real cost of debt is equal to the interest paid minus any tax deductions on interest paid.
Important
The dividends paid on preferred stock are considered a cost of debt even though preferred shares are technically a type of equity ownership.
Cost of Equity
The cost of equity is complicated to estimate compared to the cost of debt. Shareholders don’t explicitly demand a certain rate on their capital in the way bondholders or other creditors do. Common stock doesn’t have a required interest rate.
Shareholders do expect a return, however, and shareholders will dump the stock and harm the company’s value if the company fails to provide it. The cost of equity is therefore the required return necessary to satisfy equity investors.
The most common method used to calculate cost of equity is the capital asset pricing model or CAPM. This involves finding the premium on company stock that’s required to make it more attractive than a risk-free investment such as U.S. Treasurys after accounting for market risk and unsystematic risk.
Weighted Average Cost of Capital
WACC considers all capital sources and ascribes a proportional weight to each of them to produce a single, meaningful figure. The standard WACC equation is:
WACC=%EF×CE+%DF×CD×(1−CTR)where:%EF=% Equity financingCE=Cost of equity%DF=% Debt financingCD=Cost of debtCTR=The corporate tax rate
A firm’s WACC is the required return necessary to match all the costs of its financing efforts and can also be a very effective proxy for a discount rate when calculating net present value or NPV for a new project. Companies can use WACC to determine the feasibility of starting or continuing a project. They may compare this value with unlevered project costs or the cost of the project if no debt is used to fund it.
What Is Unsystematic Risk?
Unsystematic risk is commonly associated with stocks but it represents the specific risks of a company as well. It’s also referred to as company-specific risk. It includes factors that a company doesn’t have 100% control over such as product recalls, market share, and sales. Diversification can help control unsystematic risk in both investing and company management.
What Are Unlevered Project Costs?
Unlevered project costs are commonly referred to as unlevered cost of capital. It’s a measurement of how much of a return on investment a company needs to finance operations without taking on debt to do so. It’s the big picture: the required return on investment for a company with no debt.
What Is the Difference Between Common and Preferred Stock?
Companies sell shares of stock to raise capital. Both types of shares typically confer an ownership percentage in the company. Investors can acquire voting rights.
Return on a common shares investment often doesn’t come until and unless the shares are sold for a profit, however. Companies must typically pay ongoing dividends to preferred shareholders.
The Bottom Line
The ratio between a company’s debt and equity should ideally be the same as the ratio between its debt financing and equity financing. Debt financing comes from incurring debt. Equity financing comes from selling shares in the company. Companies often use the weighted average cost of capital to determine whether beginning or continuing a project is feasible. Interest rates and dividends paid must be considered.