Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Cost of Capital Main Page
The cost of capital is used in various calculations such as net present value and economic value added (EVA). Definitions of the cost of capital range from fairly simple to relatively complex. Two examples are provided below.
According to Dierks and Patel1 the capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested. The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing risk.
Fera provides a more precise definition2. The risk of a company is measured with the weighted average cost of capital or WACC. WACC is the after tax cost of debt plus the cost of equity. The cost of debt is based on the current yield of the company’s debt.
Cost of Debt = (Marginal borrowing rate)(1-Tax rate)
Using the capital asset pricing model (CAPM), the cost of equity is:
Cost of Equity = Risk free rate + (Beta)(Market risk premium)
The risk free rate is based on the 30 year U.S. treasury bond. The market risk premium (MRP) is the premium that investors require for investing in a portfolio of investments that is of higher risk than the U.S. government. Beta is a measure of the relative riskiness of an individual company as compared to the market. A beta of 1.0 means that the risk premium associated with an individual company equals that of the market in general. Beta estimates are computed for publicly traded companies by various sources such as Merrill Lynch or Value Line.
Using the measurements above, the weighted average cost of capital is:
WACC = (% of debt)(Cost of Debt) + (% of Equity)(Cost of Equity)
For an example see the Fera summary listed below.
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1 Dierks, P. A. and A. Patel. 1997. What is EVA, and how can it help your company? Management Accounting (November): 52-58. (Summary).
2 Fera, N. 1997. Using shareholder value to evaluate strategic choices. Management Accounting (November): 47-51. (Summary).