Cost of Capital: What It Is, Why It Matters, Formula, and Example

What Is Cost of Capital?

Cost of capital is a company's calculation of the minimum return that would be

necessary in order to justify undertaking a capital budgeting project, such as
building a new factory.

Cost Of Capital

Understanding Cost of Capital

The concept of the cost of capital is key information used to determine a

project's hurdle rate. A company embarking on a major project must know how
much money the project will have to generate in order to offset the cost of
undertaking it and then continue to generate profits for the company.

Cost of capital, from the perspective of an investor, is an assessment of the return

that can be expected from the acquisition of stock shares or any other
investment. This is an estimate and might include best- and worst-case scenarios.
An investor might look at the volatility (beta) of a company's financial results to
determine whether a stock's cost is justified by its potential return.

Weighted Average Cost of Capital (WACC)

A firm's cost of capital is typically calculated using the weighted average cost of
capital formula that considers the cost of both debt and equity capital.

Each category of the firm's capital is weighted proportionately to arrive at a

blended rate, and the formula considers every type of debt and equity on the
company's balance sheet, including common and preferred stock, bonds, and
other forms of debt.

Finding the Cost of Debt

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The cost of capital becomes a factor in deciding which financing track to follow:
debt, equity, or a combination of the two.

The cost of debt is merely the interest rate paid by the company on its debt.
However, since interest expense is tax-deductible, the debt is calculated on an
after-tax basis as follows:

The cost of debt can also be estimated by adding a credit spread to the risk-free
rate and multiplying the result by (1 - T).

Finding the Cost of Equity

The cost of equity is more complicated since the rate of return demanded by
equity investors is not as clearly defined as it is by lenders. The cost of equity is
approximated by the capital asset pricing model as follows:

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Beta is used in the CAPM formula to estimate risk, and the formula would require
a public company's own stock beta.

The firm’s overall cost of capital is based on the weighted average of these costs.

For example, consider an enterprise with a capital structure consisting of 70%

equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.

Therefore, its WACC would be:

(0.7 * 10%) + (0.3 * 7%) = 9.1%

This is the cost of capital that would be used to discount future cash flows from
potential projects and other opportunities to estimate their net present
value (NPV) and ability to generate value.

Cost of Capital vs. Discount Rate

The cost of capital and discount rate are somewhat similar and the terms are
often used interchangeably. Cost of capital is often calculated by a company's
finance department and used by management to set a discount rate (or hurdle
rate) that must be beaten to justify an investment.

Importance of Cost of Capital

Businesses and financial analysts use the cost of capital to determine if funds are
being invested effectively. If the return on an investment is greater than the cost
of capital, that investment will end up being a net benefit to the company's
balance sheets. Conversely, an investment whose returns are equal to or lower
than the cost of capital indicate that the money is not being spent wisely.

The cost of capital can also determine a company's valuation. Since a company
with a high cost of capital can expect lower proceeds in the long run, investors
are likely to see less value in owning a share of that company's equity.

What Is the Difference Between the Cost of Capital and the Discount Rate?
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The two terms are often used interchangeably, but there is a difference. In
business, cost of capital is generally determined by the accounting department.
It is a relatively straightforward calculation of the breakeven point for the project.
The management team uses that calculation to determine the discount rate, or
hurdle rate, of the project. That is, they decide whether the project can deliver
enough of a return to not only repay its costs but reward the company's
shareholders.

The Bottom Line

The cost of capital measures the cost that a business incurs to finance its
operations. It measures the cost of borrowing money from creditors, or raising it
from investors through equity financing, compared to the expected returns on
an investment. This metric is important in determining if capital is being deployed
effectively.

Valuation Of Early-Stage Startups

Understanding startup valuation

In order to receive funding from external sources such as angel investors, VCs, or
a group of investors, startups need to figure out the total amount of capital they
need. In simple terms, startup valuation works as a process to quantify the worth
of the startup or startup idea. Startup valuation is one of the most significant parts
of any fundraising process. While investing in a startup, investors exchange a part
of the equity in the company. This is where the role of startup valuation comes
into the picture. Fundamentally, the process of valuation removes the guesswork
and presents the estimated value of the startup.

Startup valuation methods

Valuation methods are significant, especially for early-stage startups when they
are at the pre-revenue stage. These startups usually do not have any hard facts
or figures to base the value of the business. Hence, there comes the need of
predefined valuation methods.

The prominent startup valuation methods are:

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Berkus method: This method is one of the simplest, created by Dave Berkus, an
American venture capital expert. This method assigns a value of $0.5 million to
various factors as the startup begins to make progress. It describes five key factors:
sound idea, prototype, quality of management team, strategic relationship,
strategic partnerships, and product rollout or sales to determine the startup value
in a range of $0-2.5 million. This method is only valid for pre-revenue companies.

Scorecard method: This method uses the valuation assigned to an already angel-
funded company. It begins with finding a company of a similar stage operating
in the same geography and same domain. After getting the average pre-money
valuation of that company, the startup is thoroughly analyzed to find its strengths
and weaknesses. It is given weightage to various factors such as the size of the
opportunity, technology/ product, management strength, competitive
environment, marketing, funding requirement, etc.

Risk factor summation method: This method works as a combination of the Berkus
and Scorecard method while emphasizing the risk factors. Various types of risks
associated with the investment are categorized to assign grades to each
category. The major risk categories include management, stage of the business,
sales and marketing risk, funding requirement, competition, technology, litigation,
international, and reputation risk, and potential lucrative exit.

Venture capital method: This startup valuation method emphasizes the exit or the
terminal value of the startup. In this method, the investors consider the expected
future returns of the startup. It is one of the most effective methods which makes
it is easier to estimate a potential exit value once certain target milestones are
achieved.

First Chicago method: This method was first developed by and consequently
named for, the venture capital arm of the First Chicago Bank. It is a business
valuation approach used by venture capital and private equity investors. This
method combines elements of both multiple based valuation and cashflow
based methods, First Chicago helps the investors to understand how viable and
ambitious the startup plan is. This method focuses on three different scenarios:
best case, normal case and worst case.

Valuation methods

In order to evaluate a company, one must have an initial understanding of it.

Therefore, at Venture Valuation, we pursue a holistic evaluation approach. All
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 valuations are based on a careful consideration of both hard facts and soft
factors. We apply a thorough risk assessment of factors which include:

 Management
 Market
 Science and technology
 Financials / funding phase

Discounted Cash Flow (DCF)

Method: The discounted cash flow method takes free cash flows generated in the
future by a specific project / company and discounts them to derive a present
value (i.e. today’s value).

The discounting value usually used is the weighted average cost of capital
(WACC) and is symbolized as the ‘r’ in the following formula:

DCF = Calculated DCF value

CF = Cash Flow
r = Discount rate (WACC: Weighted average cost of capital)

Uses: DCF calculations are used to estimate the value of potential investments.
When DCF calculations produce values that are higher than the initial investment,
this usually indicates that the investment may be worthwhile and should be
considered.

Risk adjusted NPV

Method: The risk adjusted net present value (NPV) method employs the same
principle as the DCF method, except that each future cash flow is risk adjusted to
the probability of it actually occurring.
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The probability of the cash flow occurring is also known as the ‘success rate’.

Uses: Risk adjusted NPV is a common method of valuing compounds or products

in the pharmaceutical and biotech industry, for example. The success rates of a
particular compound/drug can be estimated, by comparing the probability that
the compound/drug will pass the various development phases (i.e. phases I, II or
III) often undertaken in the drug development process.

Also known as: rNPV, eNPV (e=estimated/expected)

Venture Capital method

Method: The venture capital method reflects the process of investors, where they
are looking for an exit within 3 to 7 years. First an expected exit price for the
investment is estimated. From there, one calculates back to the post-money
valuation today taking into account the time and the risk the investors takes.

The return on investment can be estimated by determining what return an

investor could expect from that investment with the specific level of risk attached.

Uses: The Venture Capital method is an often used in valuations of pre revenue
companies where it is easier to estimate a potential exit value once certain
milestones are reached.

Market comparables method

Method: The market comparables method attempts to estimate a valuation

based on the market capitalization of comparable listed companies.

Uses: The market comparables method is a simple calculation using different key
ratios like earning, sales, R&D investments, to estimate the value of a company.

Also known as: Multiples

Comparable Transaction method

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Method: The comparable transaction method attempts to value an entire
company by comparing a similar sized private company in a similar field, and
using different key ratios. The price for a similar company can either come from
an M&A transaction or a financing round.

Uses: The comparable transaction method is a simple calculation estimating the

value of a target company based on comparable investments or M&A deals.

Decision Tree analysis

Method: Decision trees are used to forecast future outcomes by assigning a

certain probability to a particular decision.

The name decision tree analysis comes from the ‘tree’ like shape the analysis
creates where each ‘branch’ is a particular decision that can be undertaken.

Uses: Decision trees are used to give a graphical representation of options,

strategies or decisions that can be undertaken to reach a particular goal or
“decision”.

Reference:
https://www.investopedia.com/terms/c/costofcapital.asp

https://www.entrepreneur.com/en-in/starting-a-business/valuation-of-early-
stage-startups/366948
https://www.venturevaluation.com/en/methodology/valuation-methods

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