Cost of Capital Calculator

To calculate the cost of capital, follow these steps:

1. Calculate the cost of debt

The cost of debt is given to you in the contractual terms of debt you take - whether that is a bank loan, venture debt, or another type of debt. If you have multiple sources of debt, you should weight your cost of debt % by the size of each debt.

You will then calculate the after-tax cost of debt, which reflects the expense a company incurs for borrowing funds, adjusted for tax savings on interest payments.

kd = Interest rate on debt (Rd) x (1 − Tc)

Where

• kd = After-tax cost of debt
• Tc = Corporate tax rate

2. Calculate the cost of equity (Re)

If you are a startup - you can use mid-range cost of equity like 35%. Startup equity investors usually have a much higher expected return than a general investor in the market, due to the high risk of investing in startups. However that expected return, also know as the cost of equity, varies significantly depending on the startup, industry, stage, size and other factors - often in the range of 15-60%.

For established companies, you can use the CAPM formula - the capital assets pricing model. CAPM estimates the return shareholders expect, factoring in market risk:

Re = Rf + β (Rm − Rf)

Where:

• Rf = Risk-free rate (e.g., government bond yield)
• β = Stock’s sensitivity to market movements
• Rm = Expected market return

3. Determine the capital weights (%)

Calculate the proportion of debt and equity in the company’s capital structure:

Weight of debt (D/V) = Total debt / Total capital (debt + equity)

Weight of equity (E/V) = Total equity / Total capital (debt + equity)​

4. Multiply each capital cost by the corresponding capital weight

Now, calculate the weighted costs of debt and equity:

Weighted cost of debt = D/V x kd

Weighted cost of equity = E/V x Re

5. Sum the capital structure WACC

The final step is to sum the weighted costs of debt and equity to determine the weighted average cost of capital:

WACC = Weighted cost of debt + Weighted cost of equity

The calculated WACC is a clear and accurate representation of the company’s cost of capital, which is a benchmark for evaluating investment opportunities.

What is the cost of capital?

Cost of capital is a financial metric that quantifies the return a company needs to generate to meet the expectations of its investors and lenders. It represents the price of funding business operations or investments, whether through debt, equity, or a mix of both. Essentially, the cost of capital acts as a benchmark for decision-making, helping businesses determine whether an investment is worth pursuing based on its expected returns.

From a practical perspective, the cost of capital varies depending on the type of funding:

• Debt: The cost of borrowing money, often influenced by interest rates and adjusted for tax benefits.
• Equity: The returns shareholders demand, reflecting the risk they assume in their investment.

Cost of equity vs. cost of debt

The key differences between the cost of equity and the cost of debt are that equity represents ownership and comes with higher expectations for returns, while debt involves fixed repayments with tax advantages. In more detail:

Cost of equity

• Represents the return shareholders expect on their investment.
• Is traditionally calculated using the Capital Asset Pricing Model (CAPM), which factors in market risk and the company’s volatility.
• Can be hard to identify when evaluating startups - for early stage startups, venture capital firms might project a cost of equity between 15 to 60% - and this number is highly variable
• Is often higher than the cost of debt because equity investments come with more risk since shareholders bear losses if the company underperforms.

For example, if a company’s expected return is 10%, this is the cost of equity.

Cost of debt

• Reflects the interest payments a company makes on borrowed funds.
• Is generally lower than the cost of equity, as debt is less risky for investors (e.g., lenders are repaid before shareholders in case of liquidation).
• Even more cost-effective after-tax adjustments since interest payments reduce taxable income.

What is the weighted average cost of capital (WACC)?

The weighted average cost of capital is the blended cost of a company’s equity and debt, weighted by their respective proportions in the capital structure. Think of it as your company’s financial balancing act. It’s the average rate of return you need to generate to keep both your lenders and investors happy.

WACC combines the costs of debt and equity into a single percentage. This percentage is essentially what it costs your company to fund its operations through a mix of debt (loans) and equity (shareholder stakes).

The formula for WACC is:

WACC = (E / V x Re) + (D / V x Rd x (1−Tc))

• E = Market value of equity
• D = Market value of debt
• V = Total value of capital (E + D)
• Re = Cost of equity
• Rd = Cost of debt
• Tc = Corporate tax rate

Tips to improve your cost of capital

Here are a few actionable tips to help optimize your capital structure:

Raise your credit

A higher credit rating signals reliability to lenders, resulting in better borrowing terms. Focus on maintaining strong cash flow, reducing liabilities, and ensuring timely payments to achieve a favorable rating.

Consider taking debt in place of equity

Leverage your company’s financial health and market standing to negotiate debt financing, which may allow you to access lower rates as compared to the cost of equity. Lenders are often willing to offer favorable terms to businesses with a proven track record of stability and growth.

Pay debt on time

Consistently making payments on time builds trust with lenders and suppliers. A solid repayment history can lead to better financing opportunities and improved credit terms in the future.

Manage your inventory

Streamline inventory management to minimize excess stock and optimize working capital. Effective inventory practices can free up resources and reduce storage costs, which combine for improved operational efficiency.

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Cost of capital FAQs

What is a good cost of capital?

A "good" cost of capital depends on the industry and the specific business. Generally, a lower cost of capital is better since it indicates the company can fund operations and investments at a lower expense. For example, mature industries like utilities often have lower costs of capital, while tech startup fundraising may have higher costs due to increased risk and volatility.

What has the lowest cost of capital?

Debt typically has the lowest cost of capital compared to equity. It’s less risky for lenders—they receive fixed interest payments and are prioritized during liquidation. Additionally, the tax deductibility of interest payments further reduces the cost of debt for businesses.

What are the three costs of capital?

The three primary components of the cost of capital are:

1. Cost of debt: The effective interest rate a company pays on borrowed funds, adjusted for tax benefits.
2. Cost of equity: The return shareholders expect on their investment.

Weighted average cost of capital (WACC): The combined cost of equity and debt, weighted by their proportion in the company's capital structure.