Composite Cost of Capital

What Is Composite Cost of Capital?

Composite cost of capital is a company's cost to finance its business, determined by and also referred to as "weighted average cost of capital" or WACC. 

Composite cost of capital is calculated by multiplying the cost of each capital component by its proportional weight. A company's debt and equity, or its capital structure, typically includes common stock, preferred stock, bonds, and any other long-term debt.

Understanding Composite Cost of Capital

Companies have a variety of options available to raise money to make investments and fund their operations. They include selling equity by issuing shares of company stock, selling debt, borrowing money in the form of bonds or loans that must be paid back at a later date, or a mixture of the two.

A high composite cost of capital signals that a company has high borrowing costs. A low composite cost of capital, on the other hand, implies the opposite.

Example of Composite Cost of Capital

Company ABC yields returns of 22% and has a composite cost of capital of 12%. In other words, it generates 10% returns on every dollar the company invests — or creates 10 cents of value for each dollar spent.

Company XYZ, on the other hand, registered returns of 11% and a composite cost of capital of 17%. Based on these numbers, it would appear that XYZ is losing 6 cents for every dollar spent.

How Composite Cost of Capital Is Used

Companies

Company management relies on composite cost of capital internally to make decisions. Based on the resulting figure, directors are able to determine whether the company could profitably finance a new expansionary project.

The goal is to identify whether an investment is worthwhile and not liable to generate less than it cost.

Investors

Important

While the cost of issuing debt is fairly straightforward, the cost of issuing stock has more variables.

Securities analysts frequently consult WACC when assessing the value of investments. For example, in discounted cash flow (DCF) analysis, the WACC can be applied as the discount rate for future cash flows in order to derive a business's net present value (NPV).

WACC may also be used as a hurdle rate against which to gauge return on invested capital (ROIC) performance and is essential to perform economic value added (EVA) calculations.

Special Considerations

The average investor might have difficulty computing composite cost of capital. WACC requires access to detailed company information, and certain elements of the formula, such as cost of equity, are not consistent values and may be reported differently.

As a result, while composite cost of capital can often help lend valuable insight into a company, it must also be treated with caution. In most cases, investors are advised to use this metric alongside others to determine whether or not to invest in a stock.