Cost of capital represents the average interest rates a company secures for the use of external funds that pay for large-scale projects or operations. Estimating cost of capital is normally an activity found in corporate finance departments or capital budgeting requirements. Common methods for estimating cost of capital include basic market estimates, bond yield plus premium, and the weighted average cost of capital formula. In many ways, there is almost no end to the different methods or formulas a company can use in order to complete this project. Additionally, different market factors can affect interest rates at different times, making the end result difficult to maintain over time.
Basic market estimates are exactly what they sound like — going to different banks, lenders, and equity financiers and discovering the current interest rates charged for funds. A company can then look at the different quotes and terms for each investment type and begin estimating cost of capital for a project. This works well for small projects or those that may need money quickly especially when the company has little to no bargaining power. In most cases, however, companies do not use basic market estimates as they are too simplistic and do not provide enough technical review for use. Smaller firms may find it useful as they generally do not have the bargaining power of larger companies.
Bond yield plus risk premium is a form of estimating cost of capital for companies that have the ability to issue bonds. Bonds are a form of debt that gives investors a higher interest or claim against a company’s assets and liabilities. Under this method, the cost of capital represents the interest rate associated with the bond — such as six or seven percent — and the risk premium offered to investors is a way to induce the purchase of the bonds. For example, a company may issue bonds listed at the current market interest rate plus one percent for a risk premium. This essentially means that the bond from this company is slightly riskier than others in the market, though the reward is higher.
The weighted average cost of capital (WACC) is a bit more complex in terms of estimating cost of capital. Here, companies expect to use a mix of both equity and debt to finance new projects. The formula for WACC multiples weights against the interest rates for either debt or equity financing. The total of each individual part makes up the company’s cost of capital. Though this initially sounds simplistic, it can be quite complex and also uses tax rates in order to get an after-tax look at the effects of different interest rates.