In my previous posting, I explained the concept of risk and return. Another key building block in finance is the concept of “cost of capital”.
Capital is a resource for a business, in the same way that labor, raw materials and other inputs are resources for a business.
The cost of using this capital depends on the risk profile of the type of capital.
However, this raises the question: What is the overall cost of capital for a firm?
There are two types of cost of capital; the opportunity cost of capital and the actual cost of capital.
The opportunity cost of capital for a firm is determined by the overall risk profile of the firm. This is the minimum total return the firm should expect to earn for providers of capital. The more risk the firm is exposed to, the higher the opportunity cost of capital.
The opportunity cost of capital can be expressed as a weighted average of the expected rates of return for the different types of capital used to finance the business. This is also referred to as the weighted average cost of capital (WACC).
Where kE is the cost of equity, kD the cost of debt, E the market value of the firm’s equity, and D the value of the firm’s debt.
As an example, if a business is financed for 75% by equity capital and 25% by debt capital, the cost of equity is 10% and the cost of debt is 6%, the opportunity cost of capital can be expressed as:
9% = 75% x 10% + 25% x 6%
Note that the cost of equity and the cost of debt do not determine the opportunity cost of capital for a firm. It is the other way around; the opportunity cost of capital and the weights of each type of capital in a firm’s capital structure determine the cost of equity and the cost of debt.
If our example firm had been financed by 100% equity, the cost of equity would have been 9%:
9% = 100% x 9%
If our example firm had been financed by 80% debt and 20% equity, the cost of equity and cost of debt would have been:
9% = 20% x 25% + 80% x 5%
The reason why the cost of equity has increased so much is because of the high level of debt. Since interest has to be paid first before shareholders are paid any dividends, the returns to the shareholders are much more volatile with high debt levels. As a result of the much higher risk, the shareholders expect a much higher return.
Note that we have assumed that the cost of debt does not change. In reality, it does change, but much less than the cost of equity. The cost of debt really increases when the percentage of debt capital starts to get very high. The reason is that at high debt levels, the likelihood of default becomes very high and hence the cost of debt increases dramatically.
If it was not for one small tax anomaly, this would be the end of the cost of capital story.
The tax anomaly is that interest payments are tax deductible. Interest payments are deducted from EBIT and then the tax amount is calculated over whatever earnings are left (EBT). However, cash dividends to shareholders are not tax deductible.
Consider the following two simple income statements:
| Income Statement | Without tax advantage |
| Revenue | 200 |
| Operating expenses | (100) |
| EBIT | 100 |
| Tax (50%) | (50) |
| Interest expenses | (30) |
| EAT | 20 |
| Income Statement | With tax advantage |
| Revenue | 200 |
| Operating expenses | (100) |
| EBIT | 100 |
| Interest expenses | (30) |
| EBT | (70) |
| Tax (50%) | (35) |
| EAT | 35 |
In the first case (no tax advantage for debt financing), the total return to debtholders is 30 and the earnings that remain for the shareholders is 20. This is a total return for the providers of capital of 50.
In the second case (with tax advantage for debt financing), the total return to debtholders is still 30, but the earnings that remain for the shareholders is now 35. This is a total return for the providers of capital of 65.
In the second case, the shareholders receive the tax advantage, which is called the tax shield.
These two income statements represent exactly the same operating results, but the total returns to the providers of capital are very different.
Let’s say that according to the opportunity cost of capital, this firm should earn 50 for the providers of capital. This means that in the scenario without the tax advantage for debt financing, the firm needs to earn 200 in revenues, but in the scenario with the tax advantage for debt financing, the firm only needs to earn 70 in EBIT to achieve the same total return to the providers of capital:
| Income Statement | With tax advantage |
| Revenue | 170 |
| Operating expenses | (100) |
| EBIT | 70 |
| Interest expenses | (30) |
| EBT | 40 |
| Tax (50%) | (20) |
| EAT | 20 |
This is where the actual cost of capital comes in. The actual cost of capital is simply the opportunity cost of capital adjusted for the tax advantage for debt financing:
Where TC is the marginal tax rate for the firm.
In theory, it would make sense for a firm to have as much debt financing as possible. However, in reality, once you reach a certain level of debt financing, the likelihood of debt default becomes so high (and the cost of debt increases so much), that the benefits of more debt financing are cancelled out by the cost of debt default.
If there was no tax advantage for debt financing, there would only be one cost of capital; the opportunity cost of capital, which would depend only on the overall risk profile of the business.
As a non-finance manager, it is unlikely you will be calculating your own cost of capital. Normally, an estimate for the cost of capital will be provided by the Finance Department of your firm. However, it is important to have a basic understanding of the opportunity cost of capital and the actual cost of capital, especially since the cost of capital plays an important role in value creation and investment decisions.
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I am Mark Holleman. Thank you for taking the time to visit my business blog!
3. February 2011 at 4:39 pm
hi there, great wordpress blog, and a good understand! just one for my book marks.