Health of your business: How much does your capital actually cost?
Amongst all the key inputs for a business, it is the cost of capital that is not only the least understood, but is also the most difficult to determine accurately.
How much of each component should be used depends on the riskiness of the business and availability of funding, besides the relevance of each type. Broadly, Equity is less risky with respect to cash flow commitments but is much more expensive compared to Debt.
Debt on the other hand while being cheaper, results in a liability or obligation that must be serviced. This introduces cash flow risks independent of the business’s degree of success, or in other words you pay it back whether the business does well or not. Interest on Debt though is tax deductible, unlike equity.
Here, we discuss the cost-related aspects of each form of capital and how the capital structure determines what the Cost of Capital is for your business. Let’s start with the question of why determining an accurate Cost of Capital is important.
The most important use of Cost of Capital is in determining what projects to invest in. The Cost of Capital becomes a ‘Hurdle Rate’ for the business, which means that you would not accept any proposal that does not provide a return higher than this rate. The other primary use of Cost of Capital is in helping measure business performance in a more objective and thorough manner. For example, if you measure business performance by say margins analysis, it would not show how well you are using your capital. Alternatively, even a comparative measure like Return on Equity or Return on Capital will not provide a measure of whether the rate you are earning is adequate.
As a first step, lets define Cost of Capital. The overall Cost of Capital of a firm is represented by the WACC or Weighted Average Cost of Capital, shown by the formula:
The proportions E/V and D/V are taken at long term ratios of equity and debt to total capital.
Cost of Debt (Rd) is the rate at which the firm can borrow long term funds and is considered after taking into account the tax deductibility of interest. Hence, if you can borrow at 12% and your average tax rate is say 30%, then your net cost of debt is 8.4% (12 x (1-30%)).
Calculating Cost of Equity (Re) involves use of models like Capital Asset Pricing Model (CAPM). While this model involves complex calculations and has many nuances, very simply it helps compute what rate of return a business in a particular industry should earn in addition to the return on a risk-free asset such as a government bond. A simple estimate of Re would be to use a base of 15%, which is the long-term rate of return on equity investments, and adjust it for the riskiness if your industry sector. Hence, a stable trading business would have a required rate of return just below the average of 15%, while a business involved in developing complex products with high failure rates would have a required rate of return well above 15%.
Once you have determined a reasonably accurate Cost of Capital, you are now well positioned to understand the implications of raising more capital and also measuring your performance in a more thorough manner to understand whether the business is making enough returns. For example, if you earn a RoE of say 18%, which would be considered very healthy, but your Cost of Capital is 21% then you are not doing well enough.
For the long term health of your business, make it a habit to determine costs of any and every input into the business, the largest of which is clearly Capital.