We today return with our series of articles aimed at helping investors better understand financial statements and metrics. We hope to help investors make better investment decisions by facilitating a deeper understanding of financial metrics and financial statements. We shall today look into the cost of capital and understand what it means.
Sources of Capital
A company has various sources of capital at its disposal. The sources of capital are typically classified as debt and equity. The firms have a choice to raise funds from either of the sources, but each source comes with an associated cost of capital.
Cost of Capital
Cost of capital is the price a company has to pay to get access to capital from various sources. The cost of debt means the interest rate that a company agrees to pay, whereas the cost of equity means the dividends and capital appreciation that the investor expects. A debt investor’s expectations are different from those of an equity investor resulting in different costs of capital for the firm.
A company will raise capital from different sources and in different proportions to make up the total capital of the firm. To get a realistic cost of capital we must consider the proportions as well as cost associated with each individual source of capital. The best measure of cost of capital is therefore WACC (weighted average cost of capital), as it considers the proportion of capital raised from each source in relation to the associated cost of capital.
Calculating WACC for Amazon
To get a clear understanding let’s calculate the WACC for Amazon (NASDAQ:AMZN) based on the numbers filed in the company’s latest quarterly results for the quarter ended September 30, 2013. We calculate the weighted average cost of capital or WACC for Amazon below.
|Last tweleve months interest||130M|
|Tax (in millions of $)||-12|
|Pre-tax income (in millions of $)||-43|
|Cost of debt (interest/debt)||4.3%|
|After cost of debt [Cost of debt*(1 - tax rate)]||3.07%|
|Risk free rate of return (10 yr US treasury bond yield)||2.99%|
|Market rate of return (10 year Nasdaq returns)||7.73%|
|Cost of equity||11.38%|
Amazon is using two sources of funding, long term debt and Shareholder’s equity. Hence the WACC for Amazon will have a weightage and cost associated with each of the two components. We get the after tax cost of debt for Amazon as 3.07% and cost of equity as 11.38%. We use the capital asset pricing model (CAPM) to arrive at the cost of equity. It is important to note that 'beta of a stock', which is an integral part of CAPM, measures the volatility of a company's stock vis-a-vis the market. The higher the beta of a stock the higher is the stock's volatility. The final value of WACC is derived from the proportion of total capital (Debt: $3.04 billion & Equity: $9.09 billion) financed by debt and equity and the respective cost of capital associated with these sources.
In conclusion, we would like to state that determining a firm’s cost of capital is a critical part to estimate the value generated by it. The WACC must be compared against the returns generated by a firm in order to understand value created by it. We shall cover the comparison of WACC against a firm’s returns in subsequent articles in this series. You can read our earlier articles in this series below.
- How companies cheat on income statement
- How to read a balance sheet beyond the numbers? part I: Assets
- How to read a balance sheet beyond the numbers? part II: Liabilities
- 'Cash is a fact, Profit is an opinion' Understanding the cash flow statement
Keep reading to ‘demystify’ finance. You are welcome to add your comments in the comments section below.
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