Understanding the aspects that affect the cost of capital for your business
Estimating the cost of capital of different sources of capital investment is essential for any business in search of fresh money to keep itself afloat or to enable continued operational improvements. It allows a business owner to compare several different possible sources such as a loan, bond issuance, issuance or selling of equity, and others.
A key financial metric used in such situations is the weighted average capital cost which is often abbreviated to WACC. One way to think of it is as the expected return to the investors or as an expression of the opportunity cost for acquiring capital for a business. Importantly, the calculation of the weighted average capital cost includes taxes involved with different financial resources like stocks, retained earnings, debt, equity, etc.
Since numerous aspects affect the WACC of the business, understanding each one of them is necessary. Mentioned below are the key factors that you need to understand and consider in order to estimate capital costs.
When it comes to the economic conditions, be it of a business or the entire country, they play a major role in the price one needs to pay to get liquid capital. During times of good overall economy obtaining a bank loan can happen at relatively lower interest rates making this type of financing preferable. At the same time, however, the cost of issuing equity may also become lower which is why it is important to make comparisons based on a single metric. You can use an online WACC calculator to explore what the cost would be under different predictions for the economic circumstances – low or high interest rates and so on.
Undoubtedly, equity financing plays a major role in deciding the capital of the business. When the debt value is calculated, it is affected by the weighted average cost of the capital. The larger the debt of an enterprise, the higher will be the cost of it equity will be.
If debt is greater than the available capital, it will increase the cost of new capital as well. Since the capital structure is significant for a business, it becomes another aspect that can affect your WACC.
Every company has a dividend policy in place. Debenture holders are to be paid a sum in the form of dividends — this sum is by necessity less the total earnings of the company in a given year. When the cost of capital from other sources is high, one way to get capital relatively cheaply is by reinvesting earnings. This necessarily results in low or no dividend pay-outs.
For a business to run effectively, it requires the inflow of new funds to keep ahead of cash flow requirements as well to make investments. However, you might have to reach out to a financial institution to seek funds while also having to agree on their decided interest rate. If a financial institution finds it risky to lend money to your company, bearing relatively higher interest rates becomes inevitable for you to keep the business operations running.
How good an interest you can get has a direct impact on your business’ average cost of capital and is therefore a key component in a WACC calculation. Exploring options with several banking institutions is recommended and a comparison can be made using the weighted average cost of capital.
Income tax rates
Paying income tax is not only crucial for the business but also plays a vital role in the economy. This is because it assists the government in raising funds and even provides investments to various platforms.
Sometimes, there is even a raise in taxes by the government, and the citizens have to get along with the same. Such changes in the tax regime might alter the WACC of your business. The higher the taxes, the lower is the cost of the capital. On the other hand, the lower the taxes, the higher is the cost of the capital.