The cost of capital is a key part of valuing a business under the discounted cash flow (DCF) and capitalization of earnings (COE) methods. A business valuation expert discounts the subject company's future normalized earnings using the cost of capital.
The cost of capital — also called the rate of return, "hurdle rate," or “capitalization rate” — is based on the perceived risk of the investment. Risky companies (or investments) warrant a higher discount rate and, therefore, a lower value (and vice versa).
The term "cost of capital" refers to the expected rate of return that the market requires to attract funds to a particular investment. This amount can be found using the COE and/or the DCF methods. A business can be financed with 100% equity or a blend of equity and debt financing.
In general, debt costs less than equity. Why? Debt holders receive regular economic benefits (interest and principal payments). But equity investors receive dividends only at management's discretion, and they must wait until a sale to receive any capital appreciation.
Cost of Equity
Several market-based rates can be used to estimate the cost of equity. It typically includes the following components:
- A risk-free rate, based on a long-term government bond,
- A market risk premium, based on historical returns for a stock index over the risk-free rate,
- A market size premium, based on the relative size of the subject company compared to the S&P 500, and
- A company-specific risk premium based on the subject company's financial performance, industry and other attributes.
The cost of equity is used as the cost of capital when the subject company is financed 100% with equity financing — or when the valuation expert discounts earnings available to only equity investors.
Weighted Average Cost of Capital
Conversely, when discounting the earnings available to both equity investors and creditors, experts apply a blended rate that incorporates the cost of equity and the cost of debt. This rate is often referred to as the weighted average cost of capital (WACC).
The cost of debt is fairly straightforward: It's based on the interest rate that banks charge companies for borrowing money. Interest rates have been near historic lows in recent years, so debt can be an inexpensive form of financing. But there are limits to the amount of debt financing creditors will allow, and the cost of debt gradually increases as companies become increasingly leveraged.
In addition, interest payments are generally deductible as a business expense, which further reduces the cost of debt. But, going forward, when valuing larger companies, it's important to factor in limitations on interest expense deductions under the Tax Cuts and Jobs Act. (See "Tax Law Changes Affect the Cost of Capital" at right.)
When using WACC as the discount rate in a DCF analysis, an expert can choose various capital structures. What's appropriate depends on the characteristics of the company and the standard of value being applied.
For example, an expert can apply the subject company's historical or expected percentages of debt and equity financing. This may be appropriate when valuing a minority interest that lacks the control needed to alter the company's capital structure.
Alternatively, an expert may choose an industry average capital structure. This is generally more relevant when valuing a controlling interest in the business.
What's Right for Your Business?
Small differences in the cost of capital can have a major effect on the value of your business. Contact a credentialed business valuation professional to help you get it right.