Finance officers, when deciding whether or not to raise funds by borrowing, or when evaluating the likely returns from potential investments, have a keen interest in knowing precisely the firm's Cost of Capital.

Professionals in finance, banking, and investing measure the cost of raising funds in several different ways, most of which carry a name including "Cost of."

Popular Cost of Terms and Metrics

Six 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 stock market investors demand, because they will bear the risks of ownership. COE usually appears as an 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. A Cost of Funds Index (COFI) refers to a Cost of Funds rate the government sets 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.

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 by investing instead in an alternative venture with the same risk. As a result, Cost of Capital is essentially the opportunity for 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 discounting future cash flow. Note that financial specialists will want to see a discounting study when the entity proposes investments, actions, or business case scenarios that cover two or more years. 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, could sell bonds with a yield somewhere between 4% and 5%. As a result, this percentage served as the Cost of Capital for those 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.

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 average (arithmetic 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 usually appears on on an after-tax basis when the firm takes the tax deduction from funding costs.

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:

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 discounting cash flow (DCF), 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.

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:

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 the debt it acquires.

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 buys with funds it borrows. 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).

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: (1) Using the Dividend Capitalization Model, and (2) Using Capital Asset Pricing Model.

Calculating COE With the Dividend Capitalization Model

One approach to calculating Cost of Equity refers to equity appreciation and 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 will 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 COE From Capital Asset Pricing Model CAPM

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

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

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.

The term Cost of Funds, like the Cost of Borrowing (above) might seem to apply to several other terms in this article. In practice, however, 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 necessary 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 that a Federal Home Loan Bank establishes for their territory.