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The average cost of capital is the amount of money a company must pay in order to secure debt or equity financing. For example, bond coupons are the interest payments a company makes to investors holding this instrument. The cost of capital for equity represents dividends on preferred stock or the share price growth rate on common stock. To figure the average cost of capital, a company can add the bond coupon amounts and dividend payments together and divide by the total amount secured in for financing.
For example, assume a company issues bonds with a coupon rate of $1,000 US Dollars (USD) and issues preferred stock with dividend payments of $500 USD. Both figures represent annual payments. The total amount secured for outside financing is $20,000 USD. The annual average cost of capital is 7.5 percent (1,000 + 500 / 20,000). Therefore, if the company agrees to a three-year plan for this financing option, it will have a total cost of capital of 22.5 percent (7.5*3) on the $20,000 USD. Companies offset the cost of capital by investing the $20,000 USD into business operations that will generate more sales revenue and profits. This helps pay for the cost of capital.
Companies calculate their average cost of capital as this figures is an operating expense. Starting new business operations or purchasing new major operational assets typically requires external funds. Large organizations or publicly held companies typically have several financing options. Therefore, determining the average cost of capital is important as each type of loan or equity funds will have different impacts on their company.
Another common formula for calculating the average cost of capital is the weighted average cost of capital (WACC) formula. This is a common finance formula that adds weight to each portion of debt and equity financing used in the process. The $20,000 USD represents $12,500 USD in bonds and $7,500 USD in preferred stock. WACC focuses on the interest rates paid for external financing. The interest rates for each financing type are 10 percent for bonds and 7 percent for equity, respectively. The WACC for this project is 8.9 percent annually (((12,500/20,000)*.10) + ((7,500/20,000)*.07)). This focuses solely on interest rates, which are a common cost of capital used for other finance formulas.
Most companies compare their cost of capital to the return on investment from various projects. This allows for owners and managers to have a quick figure to compare with each new business opportunity. For example, projects with a return of investment less than 8.9 percent will be rejected in favor of projects over 8.9 percent.