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Cost of Capital, Cost of Borrowing, and SimilarTerms
Explaining Definitions, Meaning, Example Cost Calculations

 

When acquiring capital assets such as factory machinery, the company's cost of capital may be a significant factor in deciding whether to purchase outright with cash or to purchase with borrowed funds.

Corporate officers, owners, and investors all take a keen interest in borrowing costs.

What is the Cost of Capital? What Do Similar "Cost Of" Terms Mean?

The primary meaning of Cost of capitalis merely the cost an entity must pay to raise funds. The term can refer, for instance, to the financing cost (interest rate) a company pays when securing a loan.

The cost of raising funds, however, is measured in several other ways, as well, most of which carry a name including "Cost of."

Defining "Cost of" Terms

Seven similar-sounding terms have the following definitions:

1. Cost of Capital

This term refers to the price an organization pays to raise funds, for example, through bank loans or issuing bonds. Cost of capital usually appears as an annual percentage.

2. Weighted Average Cost of Capital WACC

WACC is the arithmetic average (mean) capital cost that weights the contribution of each capital source by the proportion of total funding it provides. "Weighted average cost of capital" usually appears as an annual percentage.

3. Cost of Borrowing

Cost of borrowing refers to the total amount a debtor pays to secure a loan and use funds, including financing costs, account maintenance, loan origination, and other loan-related expenses. "Cost of borrowing" sums appear as amounts, in currency units such as dollars, pounds, or euro.

4. Cost of Debt

Cost of debt is the overall average rate an organization pays on all its obligations. These typically consist of bonds and bank loans. "Cost of debt" usually appears as an annual percentage.

5. Cost of Equity COE

Cost of equity COE is part of a company's "capital structure." COE measures the returns demanded by stock market investors who will bear the risks of ownership. COE usually appears as an annual percentage.

6. Cost of Funds

This term refers to the interest cost that financial institutions pay for the use of money. "Cost of funds" usually appears as an annual percentage.

7. Cost of Funds Index (COFI)

A Cost of Funds Index (COFI) refers to an established Cost of Funds rate for a region. In the United States, for instance, a regional COFI might be set by a Federal Home Loan Bank.

Explaining and Calculating Cost Of Terms in Context

Sections below further explain and illustrate the cost of capital concept and similar terms in context with related ideas and example calculations.

 

Contents

Related Topics

  • For more on nature of interest, compound interest, and interest calculations, see the article Interest
  • The article Liabilityexplains accounting for borrowing and other debt liabilities
  • For more on the several meanings of the term capital, see the article Capital

 

"Cost of" Metric 1
Two Definitions for Cost of Capital

A firm's Cost of capital is the cost it must pay to raise funds—either by selling bonds, borrowing, or equity financing. Organizations typically define their own "cost of capital" in one of two ways:

  1. Firstly, "Cost of capital" is merely the financing cost the organization must pay when borrowing funds, either by securing a loan or by selling bonds, or equity financing. In either case, the cost of capital appears as an annual interest rate, such as 6%, or 8.2%.
  2. Secondly, when evaluating a potential investment (e.g., a significant purchase), the Cost of capital is the return rate the firm could earn if it invested instead in an alternative venture with the same risk. As a result, Cost of capital is essentially the opportunity cost of using capital resources for a specific purpose.

Using Cost of Capital

In many organizations cost of capital (or, more often weighted average cost of capital WACC) serves as the discount rate for discounted cash flow analysis. Note that financial specialists will want to see a discounting study when the entity proposes investments, actions, or business case scenarios. WACC also appears sometimes as a hurdle rate, or threshold return rate, that a potential investment must exceed to receive funding.

The Cost of capital percentage differs significantly between different firms or organizations, depending on such factors as the entity's creditworthiness and prospects for survival and growth. In 2016, for example, a company with an AAA credit rating, or the US Treasury, can sell bonds with a yield somewhere between 4% and 5%. As a result, this percentage is mostly the cost of capital for these organizations. At the same time, organizations with lower credit ratings, whom the bond market views as "speculative," might have to pay 10% - 15%, or more.

"Cost of" Metric 2
Weighted Average Cost of Capital WACC

A firm's cost of capital from various sources usually differs somewhat between the different sources of capital. "Cost of capital" may vary, that is, for funds raised with bank loans, the sale of bonds, or equity financing. As a result, Weighted average cost of capital (WACC) represents the appropriate "cost of capital" for the firm as a whole. WACC the arithmetic average (mean) capital cost, where the contribution of each capital source weighs in proportion to the proportion of total funding it provides. 

WACC is not the same thing as the "cost of debt," because WACC can include sources of equity funding as well as debt financing. Like "cost of debt," however, the WACC calculation is usually shown on an after-tax basis when funding costs are tax deductible.

Calculating the Weighted Average Cost of Capital

Calculating WACC is a matter of summing the capital cost components, multiplying each by its appropriate weight. For example, in simplest terms:

WACC = (Proportion of total funding that is equity funding ) x (Cost of equity)  
                   + (Proportion of total funding that is debt funding) x (Cost of Debt)
                            x (1 – Corporate tax rate)

Using Weighted Average Cost of Capital

In brief, WACC is the overall average interest rate an entity pays for raising funds. In many organizations, WACC is the rate of choice for discounted cash flow (DCF) analysis for potential investments and business cash flow scenarios. However, financial officers may use a higher discount rate for investments and actions that are riskier than the firm's prospects for survival and growth.

"Cost of" Metric 3
Cost of Borrowing

The term Cost of borrowing might seem to apply to several other terms in this article. In business, and especially in the financial industries, however, the term refers to the total cost a debtor pays for borrowing. Cost of borrowing usually appears as an amount in currency units such as dollars, euro, od pounds.

When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Calculating Cost of Borrowing

Cost of borrowing may include, for instance, interest payments, and (in some cases) loan origination fees, loan account maintenance fees, borrower insurance fees, and still other fees. As an example, consider a loan with the following properties:

Loan properties
Amount to borrow (loan principle): $100,000.00
Annual interest rate: 6.0%
Amortization time: 10 Years
Payment frequency: Monthly
Annual borrower insurance $25.00

Such a loan calls for 120 monthly payments of $1,110.21. Therefore, the borrower who makes all payments on schedule ends up repaying a total of 120 x $1,110.21, or $133,225. The borrower will also pay $200 for loan origination, $600 in account maintenance fees (120 x $5), and $250 in borrower insurance. The cost of borrowing, therefore, calculates as:

Cost of borrowing calculation
Total repayments: $133,225.20.00
Less principal repaid: ($100,000.00)
Total interest payments:: 33,225.20
Loan origination fee: 200.00
Account maintenance: $600.00
Borrower insurance fees: 250.00
The total cost of borrowing: $34,255.20

Over the last few decades, lending institutions everywhere have started facing increasingly stringent laws requiring disclosure of Cost of borrowing figures. These laws call for potential buyers to be informed in clear, accurate terms before they sign loan agreements.

"Cost of" Metric 4
Cost of Debt

An organization's Cost of debt is the effective rate (overall average percentage) that it pays on all its financial obligations. Typically, most of these consist of bonds and bank loans. Cost of debt is a part of a company's capital structure (along with preferred stock, common stock, and "cost of equity").

Note that "cost of debt" appears as a percentage in either of two ways: Firstly, before-tax, and secondly, after tax. In cases where interest expenses are tax deductible, the after-tax approach is generally considered more accurate or more appropriate. The after-tax cost of debt is always lower than the before-tax version.

Calculating Cost of Debt

For a company with a marginal income tax rate of 35% and a before-tax cost of debt of 6%, the after-tax cost of debt is as follows:

After-tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate)
                                  =  (0.06) x (1.00 – 0.35)
                                  =  (0.06) x (0.65)
                                  =  0.039 or 3.9% 

Using Cost of Debt

As with "cost of capital," "cost of debt" tends to be higher for companies with lower credit ratings—companies that the bond market considers riskier or more speculative. Whereas "cost of capital" is the rate the company must pay now to raise more funds, cost of debt is the cost the company is paying to carry all debt it has acquired.

Cost of debt becomes a concern for stockholders, bondholders, and potential investors for "high-leverage" companies (i.e., companies where debt financing is large relative to owners equity). High leverage is riskier and less profitable in a weak economy (recession, for example), when the company's ability to service a massive debt load may be questionable.

The cost of debt may also weigh in management decisions regarding asset acquisitions or other investments bought with borrowed funds. The additional cost of debt in such cases reduces the value of investment metrics such as return on investment (ROI) or internal rate of return (IRR).

"Cost of" Metric 5
Cost of Equity COE

A company's Cost of equity (COE) is a measure of the returns that the stock market requires for investors who bear ownership risks. "Cost of equity" is part of a company's capital structure. Note that the capital structure also includes preferred stock, common stock, and "cost of debt."

A high cost of equity indicates that the market views the company's future as risky. As a result, the firm must show higher return rates to attract investors. A lower cost of equity indicates just the opposite. Not surprisingly, "cost of equity" is a central concern to potential investors applying the capital asset pricing model (CAPM), who are attempting to balance expected rewards against the risks of buying and holding the company's stock.  

Analysts commonly use two similar approaches to estimating "cost of equity":

Calculating Cost of Equity With the Dividend Capitalization Model

One approach to calculating Cost of equity refers to equity appreciation and dividend growth.

Cost of equity = (Next year's dividend per share
     + Equity appreciation per share) / (Current market value of stock)
       + Dividend growth

For example, consider a stock whose current market value is $8.00, paying an annual dividend of $0.20 per share. If those conditions held for the next year, the investor's return would be simply 0.20 / 8.00, or 2.5%. When the investor requires a return of, say 5%, one or two terms of the above equation must change:

  • If the stock price appreciates 0.20 to 8.20, the investor would experience a 5% return:(0.20 dividend + 0.20 stock appreciation) / (8.00 current value of stock).
  • When, instead, the company doubles the dividend (dividend growth) to 0.40, while the stock price remains at 8.00, the investor also experiences a 5% return.

Calculating Cost of Equity From theCapital Asset Pricing Model CAPM

Cost of equity = (Market risk premium) x ( Equity beta) + Risk-less rate

Consider a situation where the following holds for one company's stock:

Grande Company Common shares
Market Risk Premium: 4.0%
Equity beta fort his stock: 0.60
Risk-free rate: $1,800

Using these CAPM data and the formula above, Cost of Equity is as follows:

Cost of equity = (4.0%) x (0.60) +  5.0%  =7.4%

In the CAPM, beta is a measure of the stock's historical borrowing usually price changes compared to changes in the market as a whole. A beta of 0 indicates the stock tends to rise or fall independently from the market. A negative beta means the stock tends to rise when the market falls, and the stock tends to fall while the market rises.  A positive beta means the stock tends to rise and fall with the market.

"Cost of" Metric 6
Cost of Borrowing

The term Cost of borrowing might seem to apply to several other terms in this article. As used in business and especially the financial industries, however, the term refers the total cost a debtor will pay for borrowing, expressed in currency units such as dollars, euro, pounds, or yen.

When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Calculating Cost of Borrowing

Cost of borrowing may include, for instance, interest payments, plus (in some cases) loan origination fees, loan account maintenance fees, borrower insurance fees, and still other fees. As an example, consider a loan with the following properties:

Loan properties
The amount borrowed (loan principle): $100,000.00
Annual interest rate: 6.0%
Amortization time: 10 Years
Payment frequency: Monthly
Annual borrower insurance $25.00

Such a loan calls for 120 monthly payments of $1,110.21. Thus, the borrower who makes all payments on schedule ends up repaying a total of120 x $1,110.21, or $133,225. The borrower will also pay $200 for loan origination, $600 in account maintenance fees (120 x $5), and $250 in borrower insurance. Analysts calculate the cost of borrowing as follows:

Cost of borrowing calculation
Total repayments: $133,225.20.00
Less principal repaid: ($100,000.00)
Total interest payments:: 33,225.20
Loan origination fee: 200.00
Account maintenance: $600.00
Borrower insurance fees: 250.00
The total cost of borrowing: $34,255.20

Declaring Cost of Borrowing

Over the last few decades, lending institutions everywhere have begun to face increasingly stringent laws requiring them to disclose the total cost of borrowing figures to potential borrowers, in clear, accurate terms, before signing loan agreements.

"Cost of" Metric 7
Cost of Funds / Cost of Funds Index COFI

The term cost of funds,like the cost of borrowing (above)might seem to apply to several other terms in this article, but in practice, the proper use of the name refers to the interest cost that financial institutions pay to use funds.

Besides interest expenses, the cost of funds may also include any non-interest costs required for the maintenance of debt and equity funds. As a result, the non-interest parts of "cost of funds" may consist of such things as labor costs or licensing fees.

Whereas other kinds of businesses raise funds that ultimately support more product production or service delivery in one way or another, financial institutions make money primarily by making funds available to individuals, firms, or institutions. Funds for this purpose bring a cost—the cost of funds.

Two Definitions For Cost Of Funds

  • For banks or savings and loan firms, cost of funds is the interest they pay to their depositors on, for example, certificates of deposit, passbook savings accounts, money market accounts, The bank uses depositor funds for loans it issues, but the use of those funds comes with a cost.
  • For a brokerage firm, cost of funds represents the firm's interest expense for carrying its inventory of stocks and bonds.

Using Cost Of Funds Index

A bank's cost of funds reflects the rates it charges for adjustable rate loans and mortgages. And, banks set interest rates for borrowers referring to a cost of funds index (COFI) for their region. In the United States, for instance, banks set variable mortgage interest rates referring to the COFI established for their territory by a Federal Home Loan Bank.

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