Evaluating the cost of capital is an important step for growing companies. In business terms, an expansion can be a variety of things. You could be interested in the creation of a new service or product or an acquisition of another company. No matter the project, you’ll likely need to raise money or capital to complete the expansion. But to understand the financial risk of taking on this project, companies must evaluate the cost of capital for business expansion. This is to make sure the money earned by the project will be enough to cover the cost.

What Is the Cost of Capital for Business Expansion?

To put it simply, the cost of capital is the minimum amount of financial return the company needs to justify the project. This includes figuring out the amount of money needed for the project (usually in the form of an investment) and the anticipated profits associated with it.

Calculating and Evaluating the Cost of Capital

There are a few different formulas required to calculate the cost of capital for business expansion. Your finance, accounting, or bookkeeping team can help, although there are resources online you can reference for a more detailed explanation. But we will give you a brief overview of what you need to know in order to do this calculation.

First off, your company will need to analyze the cost of debt and the cost of equity capital. These are the two main forms of capital that could be used for investment. From there, you will then calculate the Weighted Average Cost of Capital (WACC), which is based on the averages of those costs.

Cost of Debt

The cost of debt is the money that is borrowed to complete the project. In most situations, borrowed money also comes with interest, which adds another component the company must factor into their cost.

However, interest rates are tax-deductible. So even if payments are higher, they can be used to reduce the overall amount of tax they are required to pay off. Therefore, the full price of the debt won’t be as much as initially anticipated.

For example, let’s assume a company that pays 20% tax borrows money with a 3% interest rate. Taking the tax savings into consideration, they will only be paying 17% tax (since the 3% can be deducted).

Therefore, the cost of debt formula is:

Cost of Debt = Interest Rate × (1−Tax Rate)

Cost of Equity

The cost of equity is the other part of the cost of capital equation and is a little more complicated to understand. This is money the company will need to give back to its shareholders, usually in the form of dividends or increased share value. Or this could come from issuing new shares to raise money for the expansion.

The formula for calculating the cost of equity is:

Cost of Equity = Risk-Free Rate + β × Equity Risk Premium

• Risk-free rate: minimum return an investor will accept.
• β, or Beta: number used to analyze the risk or volatility of an investment
• Equity Risk Premium: additional return the investor wants for the project

  

Weighted Average Cost of Capital

Most companies will use a mix of both debt and equity to raise money for their project. Together, the cost of debt + the cost of equity = the overall cost of capital. However, it’s also important to consider the weighted average of each component.

To do this, you will use the Weighted Average Cost of Capital (WACC) formula:

• E: market value of equity
• D: market value of debt

Let’s look at this formula using a real-life example. Imagine your company is looking at undertaking a project using 70% equity and 30% debt. The cost of equity is 10% and the cost of debt (after tax) is 7%.

WACC = (0.7 x 10%) + (.03 x 7%)

Now let’s do the calculation:

9.1% = (0.7 x 10%) + (.03 x 7%)

This means that the company needs to earn 9.1% on the investment to make the project worthwhile.

What Is Considered a Good WACC?

Generally speaking, the lower the WACC the better. That’s because it indicates there’s a lower financial cost associated with the project. AKA – it’s easier for profits to meet the required return threshold.

A higher WACC is considered to be a riskier investment. However, this isn’t necessarily a bad thing. WACC is industry-specific, so what is considered high for one company may be considered low for another. This can also apply to small businesses that aren’t as financially established.

If there is a high WACC, investors will likely demand an additional return in order to compensate for the extra risk.

The Importance of Evaluating the Cost of Capital for Business Expansion

When it comes to financial planning and strategy, evaluating the cost of capital is a vital piece of information for several reasons:

• It determines if the project will be a profitable investment
• It helps the company decide whether to borrow money (debt) or sell shares (equity)
• It can predict the company’s valuation rate

However, it’s important to note that the cost of capital is just an estimation. The real amount can fluctuate depending on things like market conditions and interest rates. Therefore, the WACC should merely be used as a benchmark for determining the financial risk and success of the project.

Evaluating the cost of capital is a necessary first step for businesses considering an expansion. Without an understanding of the risks involved, you could jeopardize the growth and success of your company. Therefore, it’s worth putting in the time and effort into calculating your cost of capital to ensure you are making the best decisions for your company’s future!