It is typically expressed as a percentage (e.g., 12%) and helps to calculate the minimum return that the business needs to generate to financially justify the project. Before jumping into the cost of capital and why it is important, we need to understand what capital expenditure is, as well as its impact on businesses and economies.
Countries across the world strive to grow their economies to create a better standard of living for their citizens. Growth typically occurs when there is an increase in economic activity, such as higher consumer spending, increased production of goods and services, trade, or an increase in capital spending. Capital spending is the money spent to buy, maintain, or improve fixed assets. Some examples include buildings, vehicles, equipment, or land where there is longer term benefit, such as a railroad company investing in new railway tracks or a telecom provider rolling out a brand-new wireless network. Capital spending by governments, companies, or consumers has a huge multiplier impact on production of goods and services in an economy. For example, when a railroad company invests in a capital-intensive project like a new rail track, it not only adds to the economy by way of the direct labor and materials needed to lay the tracks, but also unlocks the economic potential of all the places the new rail connects, by providing access to new markets and enabling trade, thus multiplying the economic impact of the capital investment.
From a business’s standpoint, a combination of two funding sources – debt and equity – can be used to finance capital spending, and the cost of capital is derived from the weighted average cost of all capital sources (debt and equity). This is known as the weighted average cost of capital (WACC). Loosely speaking, cost of debt is the interest rate to service the loans taken, while cost of equity is the shareholder expectation for a return on their investment in the company’s stock. Here is an example for a WACC for a business with a capital structure with 40% equity and 60% debt; its cost of equity is 10% and after-tax cost of debt is 6%. Its WACC would be: (0.4 * 10%) + (0.6 *6%) = 7.6%.
To generate a return for investors, new projects should always generate a return that exceeds their cost of capital. Otherwise, the project would not generate a return for investors, and therefore wouldn’t make sense to undertake; also a project that costs more than it brings in wouldn’t be fiscally responsible. Businesses incur capital spending to improve their market position and long-term prospects, while governments invest in capital spending for projects like infrastructure to improve the growth of their economies. Typically, lower cost of capital helps spur capital investments, since the business has to meet a lower financial bar to satisfy investors. Consequently, finance professionals at businesses constantly endeavor to reduce their cost of capital. Understanding the cost of capital is, therefore, very important when making business decisions of any kind.
