The cost of capital of a company is used for figuring out if it is earning a return at a rate above its cost of funds. The rate of return used is called the return on invested capital. By seeing the spread between the return and the cost of capital, you can see if the company is creating or destroying value. One way to get started on figuring out the cost of capital is by looking at the company's annual report.
Cost of Capital
Capital is made up of debt and equity. The cost of capital is found using the the weighted average cost of capital formula. The weighted average cost of capital (WACC) is the cost of debt times the cost of debt tax break times the weight of debt in the capital structure plus the cost of equity times the weight of equity in the capital structure. Note, interest expense is deductible on an income statement while cost of equity is not. The cost of debt is easy to find. Finding the cost of equity is much harder.
There is no one right way to figure out the cost of equity for a company. Some analysts use the capital asset model formula that relies on beta to find out the required rate of return for shareholders. However, that model is unreliable. Other analysts choose a cost of equity for a company based on the historical cost of equities and adjust it for risk of the company. That is very subjective, though, and becomes more of an art than a science to finding the cost of equity.
You won't be able to determine the cost of capital from the annual report but you may be able to get a good idea. You can find the cost of debt in the annual report. All you have to do is find out how much debt the company has and its yearly interest expense. Dividing interest expense by debt will give you the cost of debt. You can find the tax rate by looking on the income statement. To find the cost of equity, you will have to perform a lot more analysis and use your judgment.
A company is in the 40 percent tax rate, has a cost of debt of 8 percent, and cost of equity of 12 percent. Its capital consists of 50 percent debt and 50 percent equity. The debt part of the formula will look like this: 50 percent for the weight of debt in the capital structure times 8 percent for the cost of debt times one minus 40 percent for the after tax cost of debt. The first part of the formula will equal to 2.4 percent. The equity part will say 50 percent for the weight of equity in the capital structure times 12 percent for the cost of equity. The second part of the formula will equal to 6 percent. Adding up the first part of the formula of 2.4 percent to the second part of 6 percent brings it to a total of 8.4 percent. The cost of capital, then, is 8.4 percent.