How to Calculate the Cost of Capital
It is often necessary to calculate the cost of capital when you are trying to make decisions concerning investments or lending. You may also need to show your current cost of capital if you are trying to elicit investments for your company. This is to say that your lenders will want to know your financial standing in order to estimate if the cost to them is even remotely worth the risk.
There are several specific business models that can be used, but for business valuations the cost of capital is the RISK associated with any investments or valuation related to the business. The HIGHER the cost of capital the larger the risk and the lower will be the present value of the business.
This calculation of the cost of capital may sound simple, but it is complex due to all of the elements involved. For instance, the bank or loan interest rate is NOT the business Cost of Capital, but is only the cost of debt.
If you want to use true numbers, you must take into account six elements:
- The risk free rate
- The rate of equity
- The rate for the size of the company
- The rate of the specific company’s industry
- The rate for the specific company which can include 10 to 20+ elements. The number depends on which formula is selected.
- Economic conditions
If you do not include all these elements, then errors can occur. These errors can be significant. If you company is valued at $5-15 million and an error of 10% in the cost of capital occurs the value can be off by over $1 million to $5 million or 20% to 33%. It is always best to have a certified valuator assist you in your valuation and the important cost of capital calculation.