Three ways to think about the Cost of Capital
Many people simply refer to terms of the cost of capital as the WACC and the WACC stands for the weighted average cost of capital. More often than not when in finance we call an average of something, we typically mean a weighted average and weighted basically means, taking into account how much you’re using of each. So, if we were to take an average of debt and equity, basically we would add up the two and we divide by two. But if we were to actually take a weighted average, we would take into account what proportions of debt and equity a company’s using.
For example, the company that we’re dealing with is using a lot of equity and using very little of debt. So we cannot really just take a crude average of the cost of debt and the cost of equity, when a company may be using 98% equity and 2% debt. So you know, if we were to take a straight average, that would be 0.5 the cost of debt, and 0.5 the cost of equity, that is not what we want to do. We want to take into account how much, of each source of financing the company, is actually using. That’s why we call it the weighted average cost of capital, although some people simply refer to this as the WACC, and some people just take out the word weighted and refer to it as the cost of capital and that’s mostly what we’re going to do.
There are at least three ways of thinking about this cost of capital. One is from the point of view of investors. Remember, investors are the ones that provide the capital, so the company can invest to produce the goods and services that we like to buy. And investors do not provide the capital for free. Capital is scarce; they could provide the capital to other companies. They could provide the capital to other investments. Therefore, whenever they provide capital to a company, they are going to require a return. And as always we say in finance, a return that is required is going to be a function of the risk that you perceive that you’re bearing. So there’s going to be a positive relationship between risk and return. The higher the ratio perceived in the capital you invest, the higher the return that you are going to require. So, one-way of, of thinking about the cost of capital is investors are providing debt, investors are providing equity. They require a return on debt; they require a return on debt, on equity. And the weighted average of those required returns is basically the cost of capital. So, from the point of view of investors, the weighted average cost of capital is simply the weighted average required return, on the capital provided to the company, that the company is going to use to make the investment to produce goods and services.
Now we can actually rather flip the coin. And by flipping the coin, we basically mean looking at Cost of Capital from the point of view of the company. When the company raises that capital, they need to deliver a return. Delivering a return does not necessarily mean paying in cash, and that’s why, as we said before, the cost of capital is related to risk, not so much in terms of cash flows. There are many companies that pay no dividends, that does not mean that the providers of equity do not require any return. They may require a return that is provided, in terms of capital gains other than in terms of, of anything else. Now, we can also look at the cost of capital, sort of by flipping the coin. And, by flipping the coin, I mean that we’re going to look at this from the point of view of the company. The company actually raises capital, and it needs to pay, quote and quote every turn, it needs to deliver a return. A return again does not mean, that the cash going out of the company, you can actually invest in a company that does not pay any dividends, that doesn’t mean you’re not going to require a return. You deliver a return in terms of capital gains that is why, as we said before, always think of their required returns, as being a function of raised not as being a function of money coming out of the company.
However, when the company raises debt when the company raises equity, they need to deliver a return, and that return that they need to deliver is the cost for the company. Well, the weighted average of those costs is once again the weighted average cost of capital. So the average return required by investors, and the average cost for the company, these are like two sides of the same coin. And three, the most important way of thinking about the cost of capital, is as some people would call the hurdle rate and the hurdle rate is a minimum required return, on the company’s investments.
Why is the cost of capital a hurdle rate? For a very simple reason. Suppose that through whatever sources of financing, your average cost of raising funds is 5%. Well, you do not want to invest in anything that gives you less than 5%, otherwise, you are basically burning money. So that becomes, that 5% becomes the minimum return on which you’re going to invest and you’re not going to invest in anything from which you expect any less than that. So if your cost of raising funds, on average is 5%. You will be investing your capital in anything that you think, you expect, that is going to give you more than 5%. If you think that is going to give you less than 5%, you will basically be investing in something in which you expect a negative return. And no company actually can do that in the long term. So, eventually, you’re going to go out of business. So that is why the cost of capital is the minimum required return. That is what it costs you to raise funds, and basically, you don’t want to invest in anything. That is going to give you a return less than what it costs you to raise those particular funds.
So those three definitions of the cost of capital are important, but we’re going to be using mostly the third, that is that once we come up this number, this number becomes a beacon. This number becomes a central decision variable for the company, because you do not want to invest in anything that gives your return, or from which you expect that return lower than that cost of capital. And, that means that you know, when we, for example, evaluate a project, well, when we evaluate a project, and we calculate as we’re going to see in session five. The internal rate of return, the return we expect from the project. We will not invest in anything but gives me from what we expect anything less than the cost of capital. So one application, typical application of the cost of capital, is project evaluation in some the models to value companies. And one of those methods, one discounted cash-flow method, is called the weighted average cost of capital method. And, guess what, the discount rate in that method is precisely the cost of capital. We are not going to get into valuation, but we are going to discuss a project evaluation. Value creation.
Why is the cost of capital so important for value creation?
Well, simply because the return that you get on the capital invested must beat that cost of capital. At the end of the day, our definition of whether you are creating or destroying value will go through comparing the return that you get from the capital invested, from the cost of raising that particular capital. So, we will talk about project evaluation. We will talk about value creation. And although we will not talk precisely or specifically, in one section of the capital structure, and in particular capital structure optimization.