Cost of Capital: Types and Calculation

In the fast-paced entrepreneurial world, startups increasingly recognize the shift towards profitability and building resilience. This has resulted in 93% of investors managing their cost of capital and foreseeing 2024 as a year of recovery, indicating a shift in investor sentiment towards sustainable business. Further, the median ticket size of $2.8 million in the first six months of 2024 also suggests that investors are more selective, focusing on startups with solid business models capable of navigating market challenges. 

Indian startups are gravitating towards ensuring sustainable growth over rapid expansion, with a keen focus on building robust business models that can withstand the volatility of the market. Over 77% of Indian start-ups are investing in advanced technologies, including Artificial Intelligence (AI), Machine Learning (ML), Internet of Things (IoT), and blockchain. These technologies are being utilized to achieve operational efficiency, drive growth, and enhance customer experiences. This mindset is indicative of a maturing startup ecosystem in India, where founders are increasingly focused on building scalable and resilient businesses. However, in the face of funding constraints and market uncertainties, founders also acknowledge the importance of optimizing capital costs and leveraging financing solutions. 

This article explores the various components of the cost of capital and how to make strategic decisions that deserve your attention.

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What is the Cost of Capital?

Cost of capital is the minimum rate or profit a startup must earn to meet its financing cost. Every startup incurs the cost of capital to finance its operations and business needs. Depending on the nature of the business, founders employ a mixture of debt and equity financing or even just one of these. Fundamentally, it’s a crucial metric for investors, leaders, and analysts to gauge financial risk and justify investment decisions.

The components of the cost of capital include:

• Cost of Debt: Total interest expense owed on a debt
• Cost of Preferred Stock: Dividend yield expected by shareholders  
• Weighted Average Cost of Capital: Average ROI a company pays to its debt and equity holders
• Cost of Equity: Return required by equity investors 

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Understanding the Importance of Cost of Capital for Startups 

“An investment without returns is akin to a vessel without cargo.”

In the investment landscape, potential investors assess startup projects primarily based on their perceived return on investment (ROI). To justify financial backing, investors meticulously evaluate a project's projected revenue generation capacity to ensure it can cover financing costs and deliver profitable returns. Naturally, managing finances involves carefully considering how much money a project will generate to offset the cost of financing and ultimately generate profits. 

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Let’s understand how and why it is important for startups.

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• Optimizes Capital Structure: The right capital mix increases a company’s wealth while keeping its cost of capital at its lowest. An optimal capital structure combines debt and equity to attract investors and improve their financial stability. 

• Assists in Risk Assessment: Startups often operate under unpredictable situations where evaluating risks is crucial. Higher risk means a higher cost of capital. By calculating the cost of capital, founders can assess risk and check whether an investment can yield higher returns for lenders.  

• Business Planning and Strategies: When startups include the cost of capital in their overall business plans, it helps them forecast cash flow requirements, set pricing strategies, and allocate funds accordingly. Planning finances before raising capital ensures clarity and transparency with stakeholders.

• Catalyst in Investment Decisions: The cost of capital acts as a catalyst in evaluating the profitability of an investment project, allowing startups to make sound investment decisions. 

• Measuring Financial Performance: COC (Cost of Capital) benchmarks a startup’s financial standing. Every startup's primary focus is to maximize its ROI, which creates value for investors. 

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Types of Cost of Capital

The cost of capital can be calculated through different methods, depending on the type of capital used and the associated costs. Alternatively, founders also refer to it as its types, as highlighted below: 

1. Cost of Debt

The cost of debt can be defined as the effective rate of interest that a company owes on its liabilities, such as loans or bonds. In other words, it is the expense a company incurs when borrowing funds from loans. In addition to interest rates, it includes fees and other additional charges associated with the debt. 

The cost of debt can be expressed as:

• Before-Tax-Cost of Debt: Represents the total interest payments made without tax deductions. 
• After-Tax Cost of Debt: The after-tax cost of debt is the net cost incurred by a company, including tax deductions for interest expenses. 

The cost of debt is often calculated on an after-tax basis because interest expenses are tax-deductible, which reduces the overall cost to the company. The cost of debt helps identify the overall rate paid for debt financing and is extremely useful for understanding the financial risk involved. It can be calculated as: 

Cost of Debt After Tax = (Total Interest payments / Total debt) x (1−Tax rate)

Where:

• Total Interest payments= Interest paid on the firm’s current debt

Let’s understand this through an example. 

A company has loans of Rs. 25 lakhs from source A and Rs. 15 lakhs from source B at a 5% and 4.5% interest rate, respectively. Its marginal tax rate is 20%. 

Step 01: Calculate the total interest and debt from A and B sources.  

Interest from source A = 25,00,000 * 5% = 125000

Interest from source B = 15,00,000 * 4.5% = 67500

Total Interest from both sources = 1,92,500

Total debt from both sources = Rs. 40,00,000

Step 02:  Calculate the cost of debt using its formula

Before-tax-cost of debt = 192500/ 4000000 = 0.048125 or 4.8125%

After-tax-cost of debt = 4.8125% * (1 - 0.20) 

 = 4.8125% * 0.80 = 3.85%

The net cost of debt is 3.85%. 

2. Cost of Equity

In finance, the cost of equity refers to the return a company pays to equity investors for the investment they make in a company. In other words, it is the rate of return an investor expects to earn on their investment in a company. It includes growth prospects, risk profiles, and prevailing market conditions. Investors use this cost of capital type to analyze the practicality of investing in a particular stock. 

There are several methods to calculate the cost of equity, including:

1. Capital Asset Pricing Model (CAPM)
2. Dividend Discount Model (DDM)
3. Earnings Capitalization Ratio (ECR)

The cost of equity is a trusted financial metric that sets realistic expectations for shareholders and manages capital budgeting. A higher equity cost leads to a higher discount rate, resulting in a lower valuation, while a lower equity cost increases the value of a company’s cash flows. The cost of equity helps founders and financial leaders assess how attractive investments are and is generally calculated using the CAPM formula:

CAPM (Cost of equity) = Rf + β (Rm−Rf)

where:

Rf = Risk-free rate of return

Rm = Market rate of return

β = Stock's risk measure published by investment services

Alternatively, it can also be calculated using the Dividend Capitalization Model Formula. 

Cost of Equity = (Dividends per Share / Current Market Value of Stocks) + (Dividend Growth Rate), where: 

Dividends: Regular payments to shareholders.

Market Value Stocks: Value determined by financial markets.

Dividend Growth Rate: Annual growth rate of a dividend.

Let’s understand this through an example: 

Assume: 

• Risk-free rate (Rf) = 2%
• Market rate of return (Rm) = 8%
• Beta (β) = 1.2

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Using the CAPM formula: 

Cost of Equity = 2% + 1.2% * (8% - 2%) 

= 2% + 1.2% * 6% 

= 2% + 7.2% 

= 9.2%

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Weighted Average Cost of Capital (WACC)

This method calculates the cost of capital by averaging a company’s debt and equity from all sources. It indicates the overall ROI that startups must generate to satisfy all their investors. It is the most commonly used method as it combines a firm’s overall cost of capital from debt and equity, providing a comprehensive view of the total cost of financing. 

Startups use this method to evaluate the risks of different capital sources and identify potential investment opportunities. Furthermore, WACC has the following features: 

• It indicates the return that all shareholders demand.
• Establishes the discount rate for future cash flows.
• Provides input in multiple financing processes, including capital budgeting and valuation.
• It is also called the Cost of Capital formula.

It can be calculated as:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

E: Market value of firm’s equity

D: Market value of firm’s debt.

V: Total value of capital (equity + debt)

Re: Cost of equity

Rd: Cost of debt.

T: Tax rate

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Calculation Example: Cost Capital Structure of Aero Ltd

Let’s understand the concept of cost of capital through an example.

Suppose these are the details of Aero Ltd: 

1. Equity share capital: Rs. 8,00,000 at 16% cost 

2. Retained earnings: Rs. 4,00,000 at 15% cost 

3. Preference share capital: Rs. 6,00,000 at 12% cost 

4. Debentures: Rs. 6,00,000 at 9% cost 

5. Total Cost Capital: Rs. 24,00,000

To calculate the weighted average cost of capital, we need to weigh each component of the capital structure listed above. 

Using the formula, WACC = (E/V x Re) + ((D/V x Rd) x (1 – T)), we get:

For equity share capital:

(8,00,000/ 24,00,000 × 0.16) = 0.053

For retained earnings:

(4,00,000/ 24,00,000 × 0.15) = 0.024

For preference share capital:

(6,00,000/ 24,00,000 × 0.12) = 0.03

For debentures:

(6,00,000/ 24,00,000 × 0.09) = 0.023

WACC = 0.023 + 0.03 + 0.024 + 0.053 = 0.13%

WACC = 13%

In this example, Aero Ltd's weighted average cost of capital is 13%, indicating that the company needs to earn a return of at least 13% or more on its investments to justify the cost of its capital structure.

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How Does Cost of Capital Help in Investment Decisions

The cost of capital influences investment decisions. Startups can leverage this to evaluate investment projects based on price, benefits, and risks. It is much more convenient for founders to determine whether a project is financially viable to generate returns, helping them allocate resources to the most profitable projects. 

It includes factors such as:

Capital Budgeting: It’s a process that founders use to evaluate potential investments. It involves estimating cash inflows and outflows, identifying investment opportunities, and selecting projects to improve their startups’ financial health. 

Payback Period: This is when a startup generates enough cash flows to recover the investment amount. It is calculated by dividing the initial investment by the annual cash inflow. A more extended payback period signals higher risks, while a shorter one indicates a quicker ROI. 

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Factors That Affect the Cost of Capital 

Several factors influence the cost of capital, including the following:

• Market Conditions: The current economic conditions can significantly impact the cost of capital. Stock market fluctuations, interest rates, and market stability primarily affect the price of equity capital, as these factors influence investor sentiments and valuations. The volatile nature of the stock market has a more significant impact on equity financing than debt financing. Hence, startups must consider economic indicators while framing financing strategies. 

Picture this: During periods of economic growth, interest rates may rise, leading to a higher cost of borrowing. Meanwhile, during a recession, lower interest rates may reduce the cost of debt with a simultaneous increase in risk. If founders raise capital during economic slowdowns, investors may expect a higher return due to increased uncertainty.

• Credit Rating: While it is true that the higher a startup's credit rating, the lower its loan interest rates, it does not generally apply to early-stage startups. Most new companies do not have a formal credit rating established yet. Instead, their interest rates depend on the creditworthiness of the founder or the collateral they can provide. Nonetheless, a high credit score always leads to favorable financial outcomes! It helps secure loans at a lesser interest rate than companies with a low credit score. Over time, as the company builds its credit reputation, its credit rating will become one of the factors to consider while securing loans and strengthening investor relationships.

• Tax Regulations: Tax laws and other regulations can significantly impact the after-tax cost of debt and influence capital structure decisions. Companies strive to attain an optimum financing mix based on the cost of capital of various funding sources. For example, debt financing is more tax-efficient than equity financing since interest expenses are tax-deductible.  

• Inflation: A sudden decrease in the purchasing power of money due to inflation may make it challenging for companies to keep up with the increased cost of capital. A rise in inflation may also make it extremely difficult to finance new projects or operations, eventually increasing the cost of capital. Acknowledging the potential impact of inflation when planning financial strategies is considered a great practice.  

• Market Sentiment: Investor sentiment can alter a startup’s cost of equity. A positive sentiment will lower the capital cost, while a negative sentiment will increase it. For instance, during a bear market, risks are high, which leads to investors demanding higher returns, ultimately increasing the cost of equity. On the contrary, during a bull market, investor optimism booms, making it the best time for startups to pitch for equity finance with lower returns. 

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Key Takeaways

The cost of capital helps startups make informed financial decisions, which is critical for aligning projects with strategic objectives. Moreover, it demonstrates investment potential to stakeholders. Accurate calculations of the cost of capital can guide investment strategies, mergers, acquisitions, and capital restructuring. 

Recur Insight: Optimizing the capital structure isn’t a one-time task. Startups should revisit and adjust their debt-to-equity mix based on evolving market conditions and business needs. This helps them enjoy a competitive advantage! 

If you’re looking to optimize the debt component of your capital structure, Recur Club is here to assist! Connect with our capital experts to help you with your startup’s growth journey.