Understanding the Cost of Capital: Why It Matters for Your Business (Or, Why You Should Care)
How much is the cost to fund your business?
I had a friend who was consolidating a nearly empty 4% milk into a half full 1% milk into a single carton, only to have someone congratulate her on creating 3% milk.
Just as that is not quiet right, it’s also valid on funding. How much and at what cost will give you an overall idea how much interest you are paying for the whole works. And it’s not an average.
So, What’s the “Cost of Capital” Anyway?
Imagine that money grows on trees. You’d think this is great until you realize that these trees need constant watering, fertilizing, and are mysteriously prone to pests that only come out at night. Cost of capital is basically the “watering” required to keep your business’s financial tree thriving. It’s the price tag on the funds you use to keep your business running—whether it’s a loan, investment, or even your own savings.
Why Should I Care About It?
Let’s say you walk into your business thinking, “I want a shiny new office with a popcorn machine, standing desks, and a slide from the second floor to the first. And a massive fish tank with rare tropical fish.” Cool, right? Sure, but this is where the cost of capital comes in.
Think of it as contemplating the real cost. If you are borrowing money as debt and have investors, those combined funds have a cost, which should know before diving into that (likely ill-fated) fish tank project. This will help you figure out if your business can afford it.
The cost of capital is like that honest friend who tells you, “Maybe just go with the popcorn machine.” It helps you know if you’re spending wisely or if you’re going all-in on an idea that won’t bring in more revenue.
What Makes Up the Cost of Capital?
Now, before you zone out, hang in there—this part is actually interesting. The cost of capital comes in two main flavors:
Debt – When you borrow money, you pay interest. Say 8% annually, added as Rd in the equation below. That interest is your cost of debt. Think of it as the toll you pay on the highway of business growth. You can also deduct this from revenue, unlike equity, as seen in the Tc of the equation below.
Equity – This one’s a bit trickier. If you take on investors, they’ll want a return on their investment, and since they are retirees and could put in the stock market but gave it to you, they want you to pay them back PLUS 12%. This would be entered in the Re of the equation below. The cost of equity is basically the “thank you” they expect, even if they say they’re just in it for the journey. Spoiler alert: they’re not.
The WACC formula explained.
Mix them together, and voila—you get the “weighted average cost of capital” (WACC), which is, in finance terms, a fancy smoothie made of debt and equity costs. The WACC is like your business’s financial benchmark: it tells you the minimum return you need to keep your investors and bankers smiling instead of looking at you like they want their money back.
Why Ignoring It is a Recipe for Trouble
Not caring about your cost of capital is like deciding to take a long road trip without checking how much gas is in the tank. Sure, you might get there—eventually—but you’ll probably have a few breakdowns along the way.
If your business doesn’t make at least what it costs you to finance it, you’re essentially paying out more than you’re making. Eventually, you’ll end up “growing” a debt collection tree, and spoiler alert: they don’t give you fruit.
How to Use Cost of Capital Without Boring Yourself to Tears
Think of cost of capital like your internal compass. It tells you whether your business decisions are as smart as they seemed when you first thought of them. Here’s a little checklist:
Check Your Projects – If a new project doesn’t promise a return higher than your WACC, it’s time to shelve it (or downsize your expectations).
Evaluate Growth Opportunities – Are you scaling up? Great! Just make sure you’re scaling in a way that keeps your returns higher than your costs. Growing at a loss is a quick way to get stuck in a hamster wheel of debt.
Make Your Investors Happy – If you’re courting investors, know your cost of capital. They’ll want to see that you understand it, or they’ll start getting that look in their eyes that says, “How do I sell this stock?”
TL;DR - It's Your Business's Bottom Line Guard Dog
In short, the cost of capital is like that friend who drags you away from a bad investment or ill-advised purchase, reminding you that your future self might not appreciate an impulsive splurge. By keeping an eye on it, you make sure every dollar you bring in is doing more for you than it costs you to get it.
And hey, next time someone starts talking about “WACC,” you’ll know they’re not just making weird bird sounds. Instead, you can nod knowingly and say, “Yeah, we’re keeping an eye on that around here.” (And maybe order that popcorn machine—it’s a solid investment.)