Cost of capital is a necessary business expense for almost all businesses. It is a huge mistake to start a business without considering it’s costs. If this business expense is too high, your company could end up in serious debt, struggle to earn a profit, or fail due to not making profit quickly enough.
Because businesses come in different sizes and stages of maturity, it’s difficult to provide an average amount that companies spend on cost of capital. Older businesses have smaller costs of capital because investors are more willing to invest at better rates for the companies due to greater certainty that the business will succeed. For a startup or new business, there is higher risk involved, so the cost of capital is usually larger too. Fewer investors would be willing to invest in a company that isn’t established yet since it comes with greater risk.
What is Cost of Capital?
It is the cost of money a business needs to operate. There are three general ways a business owner can finance the company: equity, debt, and a combination of equity and debt. Cost of capital is sometimes called cost of equity if a company is solely financed via equity. Likewise, cost of debt is a term used when a business is solely financed through debt. Investors view cost of capital as the opportunity cost of investing in that company. They look at this value when evaluating whether or not it’s worth it for them to invest in the business. Their projected return on capital must be higher than the cost of capital.
Who Uses Cost of Capital the Most?
Business owners use cost of capital the most because capital is needed to finance their businesses. They must calculate the cost of capital when starting a business and planning a new project. Investors also take a look at cost of capital in order to make wise investments. If they are choosing between two investment options that have equivalent risk, they usually pick the one with a higher return. Cost of capital is an unavoidable part of business because lenders and investors consider it before lending or investing in the company.
How Much is Usually Spent on Cost of Capital?
You can calculate the overall cost of capital for funding in your business by using the weighted average cost of capital (WACC) formula:
WACC = E/V * Re + D/V * Rd *(1-Tc)
E/V = percentage of financing that’s equity;
E = market value of the company’s equity;
V = market value of the company’s equity + market value of the company’s debt;
Re = cost of equity;
D/V = percentage of financing that’s debt;
D = market value of the company’s debt;
Rd = cost of debt;
Tc = corporate tax rate.
The average cost of capital a company spends varies depending on industry. It usually ranges from 6%-8%, but the percentage is lower or higher in some industries. In the aerospace industry, for example, the average cost of capital is 8.86%. The tobacco industry has the highest WACC of 11.82%, and the financial services industry has the lowest WACC of 2.39%. Examples of sectors in which the cost of capital is under 6% include telecom, restaurant/dining, power, and oil/gas distribution.
3 Ways in Which You Can Decrease Cost of Capital
1. Seek alternative sources of funding for the business or an upcoming project. You don’t always have to take out a bank loan, find a venture capitalist, or receive an angel investment to secure funding for your business. Crowd funding is an alternative source of funding that can decrease your cost of capital. The way crowd funding works is you create a campaign page on a crowd funding platform with an investment goal, and individuals on the site are allowed to donate money to your campaign. It is common to offer them something small in return for making an investment, such as a t-shirt or a free copy of your new product once it’s manufactured.
2. Improve your capital structure policy. A company’s capital structure is how it funds operations and growth. Finding the best debt-to-equity ratio is the way to optimize your capital structure and in turn, improve your WACC. One thing to be aware of is that although debt financing usually offers the lowest cost due to tax deductibles, it raises the company’s risk. Also take both short-term and long-term debt ratios into consideration when evaluating your capital structure.
3. Sell debt in the form of bonds. This is helpful if your debt is increasing your WACC. Remember that bond buyers will expect a return on their investments via interest on the debt. You must offer an interest rate that is high enough to attract investors. Factor in the tax deductible too if you live in a country that offers tax deductions on bond payments like the United States.
Cost of capital represents how much your business pays for capital. It is a necessary expense in business because capital is needed for operations. Not only do you want to keep the cost of operating and funding your business low for the company’s benefit but it also looks more attractive to investors. Older and larger companies typically have an easier time securing funds for growth and benefit from a lower cost of capital as a result. Three effective ways of reducing WACC include seeking alternative forms of funding, improving you capital structure, and selling debt in the form of bonds.
Are you still struggling to reduce the cost of capital for your business? Let us know in the comments below, and we might be able to offer suggestions.
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