Online Tutorial #7: How Do You Calculate A Company's Cost of Capital?

In the tutorial on Present Value, we demonstrated that the greater the riskiness of a future cash flow, the lower its present value. One way to measure riskiness is by considering the return expected from an alternative investments with the same amount of risk. The calculation of the cost of capital quantifies this opportunity cost.

What Does Cost of Capital Mean?

More specifically, cost of capital is the opportunity cost of all capital invested in an enterprise.

Let's dissect this definition:

Opportunity cost is the loss of potential gain from other alternatives when one alternative is chosen.

All capital invested is the total amount invested in a business.

In an enterprise refers to the fact that we are measuring the opportunity cost of all sources of capital which include debt and equity.

How Do We Calculate a Company's Weighted Average Cost of Capital?

We calculate a company's weighted average cost of capital in three steps:

1. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the enterprise uses, namely debt and equity.

A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the company's debt, adjusted for the tax-deductibility of interest expenses. Specifically:

The after-tax cost of debt-capital = The yield-to-maturity on long-term debt x (1 minus the marginal tax rate in %)

We enter the marginal tax rate in cell C10 of worksheet "Inputs."

B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, we infer the opportunity cost of equity capital.

We can do this with the Capital Asset Pricing Model (CAPM). This model is based on the idea that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. This extra risk is often called the equity risk premium, and is equivalent to the risk premium of the market as a whole times a multiplier—called beta—that measures a specific security's relative risk to that of the total market.

Thus, the cost of equity capital = Risk-free rate + (Beta x market risk premium).

2. Capital structure. Next, we calculate the proportion that debt and equity capital contribute to the entire enterprise, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return.

3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.

Case Study: Domino's Pizza as of September, 2020

To demonstrate how to calculate a company's cost of capital, we will use the Domino's case study developed in the book. Readers who want to calculate the weighted average cost of capital (WACC) may wish to download the accompanying spreadsheet.

1. Cost of capital components. Domino's draws upon two major sources of capital from the capital markets: debt and equity.

A. Cost of Domino's debt capital. As of the end of 2019, Domino's had debt of $4.2 billion. Enter this figure in cell C25 of worksheet "Inputs."

We estimated that Domino's pretax cost of debt was 4.55%. You can see this from company filings or popular financial service providers.

After-tax cost of debt capital = Yield-to-maturity on long-term debt x (1 minus the marginal tax rate)

Given Domino's assumed marginal tax rate of 16.5%, the company's after-tax cost of debt equates to 4.55% x (1 - 0.165), or 3.8%. We see this calculation in cell D7 of worksheet "WACC."

Also, please note that in this example, we have used a company's actual cost of debt as a proxy for its marginal cost of long-term debt. A company's marginal cost of long-term debt may be better estimated by summing the risk-free rate and the "credit spread" that lenders would charge a company with a specific credit rating.

B. Cost of Domino's equity capital. We noted above that:

Cost of equity = Risk-free rate + (Beta x market risk premium).

To calculate any company's cost of equity capital, we need to find a reliable source for each of these inputs:

1. Risk-free Rate. We suggest using the yield on ten-year U.S. Treasury note as a proxy for the risk-free rate. That yield was 0.65% at the time of the analysis. We enter this data point in cell C4 of worksheet "Inputs."

Sources for this include:

CBS Marketwatch. Even unregistered users can use CBS MarketWatch's free bond quotes by clicking here.
CNBC. The rate is often on a banner at the top of the page.

2. Beta coefficient. We enter this data point in cell C8 of worksheet "Inputs."

There are a variety of sources available for obtaining the beta coefficient for a particular company:

Value Line Investment Survey. Paid subscribers to this service can obtain Value Line's estimates of a company's beta coefficient. Value Line can be accessed either online or offline through a paid subscription, as well as at most public libraries. Click here to see how to read a company-specific Investment Survey using Value Line. Arrow #1 points to where you can find Value Line's Beta estimate.
Yahoo. Yahoo offers free beta estimates through its Company Profile service.
Bloomberg. Free beta estimates from Bloomberg can be accessed online.
Barra. Barra publishes the Barra Beta Book monthly to subscribers. You may be able to find this resource in a good business library.

3. Equity Risk Premium. Forward looking approaches, as well as more recent historical data, suggest a market risk premium in the 4 to 6 percent range. We use 5.1%. We enter this data point in cell C7 of worksheet "Inputs."

For those interested in looking at historical equity risk premia, we refer you to the following online resources:

Aswath Damodaran. Professor Damodaran of NYU's Stern School of Business publishes an estimate of the market risk premium every month. He has also written an informative paper on the equity risk premium that he updates periodically. Each can be downloaded free of charge.

To continue with our Domino's case study, we used the following estimates for these three factors as of September 2020:

Risk-free rate of 0.65%.
Beta coefficient of 1.0
Equity risk premium of 5.1%.

Using these estimates, Domino's cost of equity capital = 0.65% + (1.0 x 5.1%), or 5.75%. We see this calculation in cell F6 of worksheet "WACC."

4. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each kind of capital contributes to the entire enterprise. This gives us the weighted average cost of capital (WACC), the average cost of each dollar of cash employed in the business.

To review, Domino's after-tax cost of debt is 3.8% and its cost of equity is 5.75%. As of September 2020, the market value of Domino's debt is equal to $4.2 billion and the market value of Domino's's equity approaches $18 billion. We enter the shares outstanding and share price for this calculation in cells C12 and C13 in worksheet "Inputs."

Thus, debt contributes 20% of Domino's capital while equity contributes the other 80%.

Domino's weighted average cost of capital is (3.8% x 20%) + (5.75% x 80%) or 5.35%. You can see this calculation in cell H12 of worksheet "WACC."