What is Your Cost of Capital?

There is a cost of doing business that must serve as your benchmark for how you invest in long-term assets. This cost is called Cost of Capital. Cost of Capital is the rate you pay to those who lend or invest money into your business. You can think of Cost of Capital as the rate of return investors require for incurring risk whenever they give you money. Cost of Capital applies to long-term funding of assets as opposed to short-term funding of working capital.

Why is Cost of Capital so important? Well, you have to earn an overall rate of return on your assets that is higher then your cost of capital. If not, you end-up destroying value. So how do you calculate Cost of Capital? The most popular approach is called the Capital Asset Pricing Model or CAPM. CAPM estimates your cost of equity by taking a risk free rate and adjusting it by risks that are unique to your company or industry. Long-term government bonds are often used to estimate risk free rates while overall market premiums run around 6%.

CAPM is not perfect since it has many unrealistic assumptions and variations in estimates. For example, sources (Bloomberg, S & P, etc.) for reporting market risks of specific companies provide very different estimates. Additionally you might find simple estimates are just as accurate as CAPM. For example, simply adding 3% to your cost of debt may provide a reasonably accurate estimate of your cost of capital. You can also look at companies that are very similar to your company. In any event, you need to calculate your cost of capital since it is an extremely important component in financial management decision-making.