Key Takeaways:
- Understand the meaning of overall cost of capital and why it matters for every business decision.
- Learn how the cost of capital affects a firm's valuation and how changes in capital structure can alter both cost and value.
- See how financial managers aim for an optimal capital structure to maximize shareholder wealth.
Source: Pixabay
Meaning of Overall Cost of Capital
The Overall cost of capital represents the average rate a firm must pay for using funds from all sources—equity, debt, and any other long-term financing. It's not just a theoretical metric, but a real-world benchmark: managers use it to judge whether new investments are worthwhile, and investors use it to assess the risk and return of the firm as a whole.
We calculate the overall cost of capital most commonly as the Weighted Average Cost of Capital (WACC). The formula:
WACC = (E/V) × Ke + (D/V) × Kd × (1 – Tc)
Where:
E = Market value of equity
D = Market value of debt
V = E + D (Total firm value)
Ke = Cost of equity
Kd = Cost of debt
Tc = Corporate tax rate
Think of the WACC as a hurdle rate. Any project or investment should offer a return higher than this to add value to the firm. If it doesn't, the firm risks destroying value rather than creating it.
Relationship with Firm Valuation
a. How Cost of Capital Determines Firm Value
The relationship between overall cost of capital and firm value is rooted in the basic principle: the lower the cost of capital, the higher the present value of future cash flows. This means, all else equal, reducing the WACC will increase the firm's market value. But why?
Most valuation models—whether Discounted Cash Flow (DCF) or Economic Value Added (EVA)—use the cost of capital to discount expected future returns. If the discount rate is high, future cash flows are worth less today. If the discount rate is low, they're worth more. This simple mathematical reality underscores the financial manager's constant effort to minimize WACC without taking on excessive risk.
| WACC (%) | Present Value of ₹100 in 5 years |
|---|---|
| 8 | ₹68.06 |
| 12 | ₹56.74 |
| 15 | ₹49.72 |
b. Example: Calculating Firm Value using WACC
Suppose a firm expects to generate free cash flows of ₹1,00,000 every year, indefinitely. If the WACC is 10%, what's the value of the firm?
- Formula: Value = Cash Flow / WACC
- Calculation: ₹1,00,000 / 0.10 = ₹10,00,000
If the WACC falls to 8%, the value becomes ₹1,00,000 / 0.08 = ₹12,50,000. A small drop in WACC leads to a large jump in value.
Effect of Capital Structure Changes on Overall Cost
a. Role of Debt and Equity Mix
The firm's capital structure—the proportion of debt and equity it uses—directly affects the WACC. Debt is usually cheaper than equity due to tax benefits, but increasing debt also raises financial risk. Equity investors demand higher returns when risk rises, which can offset the lower cost of debt.
b. The Trade-off: Debt Advantage vs. Financial Risk
Adding moderate debt can lower WACC by taking advantage of tax shields. But too much debt increases the likelihood of default, raising the cost of both debt and equity. There's a point where the benefit of more debt is outweighed by the extra risk it brings.
| Debt-Equity Ratio | Cost of Debt (%) | Cost of Equity (%) | WACC (%) |
|---|---|---|---|
| 0:100 | - | 12 | 12.0 |
| 30:70 | 7 | 13 | 10.5 |
| 50:50 | 8 | 15 | 11.5 |
| 80:20 | 11 | 20 | 15.8 |
Observe: WACC falls as debt increases to a point, but then starts to rise as risk becomes excessive.
Concept of Optimal Capital Structure
Definition and Practical Approach
The optimal capital structure is the mix of debt and equity that minimizes the WACC and maximizes the firm's value. It's not a fixed formula, but a careful balancing act, shaped by industry norms, market conditions, and the firm's unique risk profile. Managers seek this 'sweet spot' where the benefits of debt are fully realized, but before the costs of financial distress begin to erode value.
Why does this matter so much? Because at the optimal structure, the firm can fund new projects at the lowest possible cost, making more investments viable and increasing shareholder wealth.
Summary Table: Cost of Capital, Capital Structure, and Firm Value
| Capital Structure | Financial Risk | Cost of Capital | Firm Value |
|---|---|---|---|
| All Equity | Low | High | Lower |
| Moderate Debt | Moderate | Lowest | Maximum |
| High Debt | High | High | Lower (due to risk) |