Running a business isn’t like managing your household finances. Yet a lifetime of conventional fiscal wisdom has taught many a business owner that debt is a dirty word. Borrowing can be the fuel that propels your business to new growth. Nonetheless, it’s important to borrow from a position of financial strength and understanding.
Before you apply for any credit, you need to understand the cost of the capital you’re trying to raise. Here we’ll look at how to identify and calculate the cost of capital and provide an illustrative example so that you understand this principle in real terms.
What is the cost of capital?
When we think of the cost of capital, we often think of financing business growth through capital investments that require borrowing. However, cost of capital doesn’t just refer to the costs associated with borrowing.
Broadly speaking, cost of capital refers to gauging your company’s ability to cover your asset and liability expenditures while also turning a profit. In its simplest terms, it’s the minimum return that businesses need to earn before value is generated.
Businesses need to be able to identify the cost of capital in order to borrow without compromising their operational cash flow, and to ensure that they have the liquid capital free to make capital investments that could fuel future growth.
Investors and business lenders also need to be able to define the cost of capital to determine whether it’s worth lending to a business.
Cost of capital vs opportunity cost
When it comes to identifying the cost of capital, the question at hand is usually “Can I afford to finance this?” Opportunity cost looks at the cost of capital from the other side. It asks “Can I afford not to finance this?”
Opportunity cost is the cost of the investment / opportunity you miss out on over the cost of the investment / opportunity you choose. It is fairly easy to calculate – it’s just a case of subtracting the return on your chosen investment from the return on the investment you had to forego.
Investing in a new piece of equipment, taking on a new member of staff, or opening up another branch will all require you to identify the cost of capital. But it’s also worth weighing the cost of capital against opportunity costs if you should miss out on the investment.
Calculating the cost of capital
Now that we know what the cost of capital is, how can you calculate it in order to take advantage of the next opportunity that comes along? This can be complicated if you’re combining debt and your own equity to finance a venture.
There is a formula to help you calculate the cost of capital:
Calculate the cost of the debt: Average interest cost of debt x (1 – tax rate).
Next we need to work out the cost of equity: Risk-free interest rate + beta (market rate – risk-free rate). Beta measures the market volatility of your stock compared to the market.
Weigh the cost of debt against the cost of equity in proportion to the percentage of debt and equity you will use to finance your venture.
This gives you your weighted average cost of capital (WACC).
An example of cost of capital
What might the cost of capital look like in real terms?
Let’s say a retail chain wants to renovate its premises. This has the potential to draw more foot traffic while also increasing employee productivity. The renovation costs £50 million and is projected to save £10 million in operational costs over the next five years.
Alternatively, the business could buy high-risk bonds in another company. This has a projected return of 12% per year.
Which is the best opportunity?
We can use the cost of capital and opportunity cost formulae to figure this out. In this case, the renovation carries a 20% ROI which exceeds the 12% ROI from the bonds.
We can help
If you’re interested in finding out more about the cost of capital, cost of opportunity, or any other aspect of your business finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.