Cost of capital is a key metric for calculating profitability for a CPG brand. It affects your company's appeal to potential investors and determines whether you're eligible for debt financing. Calculating the cost of capital is a crucial aspect of financial management for any business. It helps companies determine the appropriate rate of return for their investments, optimize their capital structure, and make informed decisions about capital allocation.
But capital structure is a subject that baffles even the most experienced financial minds.
There are just so many moving parts — from identifying different sources of capital to calculating the ratios of equity and debt to presenting all this information in an accessible format for internal analysis…whew.
That's why we created this guide. First, we’ll help you brush up on the essentials of capital structure for CPG brands, whether you're new to financial analysis or just need a quick refresher.
Then, we'll talk about how to calculate the cost of capital, walk you through the formula for calculating cost of capital, and help you understand the different strategies you can use to manage your cost of capital.
Understanding the Cost of Capital
The cost of capital represents the minimum rate of return a company needs to generate on its investments to satisfy its investors' expectations and maintain or grow its market value. It serves as a benchmark for evaluating investment opportunities and determining the company's optimal capital structure.
There are two essential components to a company's cost of capital — the cost of equity and cost of debt.
Cost of Equity
Cost of equity is the minimum required rate of return that a company must earn on its investments to satisfy its shareholders. It measures how risky an investment is for shareholders, thus showing how much the company must offer to investors to get them to take the risk.
It's calculated using the below formula:
Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return - Risk-Free Rate of Return)
For example, let's say the risk-free rate of return is 3%, the beta for your company is 1.2, and the market rate of return is 11%. Then, we can calculate the cost of equity as follows:
Cost of Equity = 3% + 1.2 × (11% - 3%) = 10.8%
Cost of Debt
Cost of debt is the amount a company must pay to borrow money from lenders, typically expressed as an interest rate. It reflects the riskiness of the loan and serves as an incentive for the lender. The higher the cost of debt, the more risky the loan is viewed to be.
It can be calculated using the following formula:
Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)
For example, let's say that the risk-free rate of return is 5%, the company's credit spread is 2%, and the tax rate is 25%. The cost of debt for the company would be:
Cost of Debt = (5% + 2%) × (1 - 25%) = 5.5%
Calculate Cost of Capital
The most common method for calculating a company's cost of capital involves multiplying the cost of each capital source (both equity and debt) by its relevant weight by market value. The sum total of the two values gives you the Weighted Average Cost of Capital (WACC).
Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC) is a metric used to measure the overall cost of capital for a given company. It's an important part of the Capital Asset Pricing Model (CAPM) and represents the combined cost of both equity and debt capital for a CPG company.
WACC is calculated by taking the sum of the individual costs of each capital source and multiplying the result by its relevant weight by market value.
To calculate the cost of capital, you need to determine the weighted average cost of capital (WACC). The WACC takes into account both the cost of equity and the cost of debt, weighted by their respective proportions in the company's capital structure. Here's the basic formula for calculating the WACC:
WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)
Where:
E = Market value of equityD = Market value of debtV = Total market value of the company's capital (E + D)Re = Cost of equityRd = Cost of debtTc = Corporate tax rate
Let's break down the steps involved in calculating the cost of capital using this formula.
Step 1: Determine the Market Value of Equity (E)
The market value of equity can be calculated using the company's stock price and the number of outstanding shares.
Market Value of Equity = Stock Price * Number of Outstanding Shares
Step 2: Determine the Market Value of Debt (D)
The market value of debt can be calculated using the company's outstanding debt instruments' market prices, such as bonds or loans.
Market Value of Debt = Sum of the Market Values of All Debt Instruments
Step 3: Calculate the Total Market Value of Capital (V)
Add the market value of equity and the market value of debt to determine the total market value of the company's capital.
Total Market Value of Capital = Market Value of Equity + Market Value of Debt
Step 4: Calculate the Cost of Equity (Re)
There are several methods to calculate the cost of equity, with the most common being the Capital Asset Pricing Model (CAPM). The CAPM formula is as follows:
Cost of Equity = Risk-Free Rate + (Beta * Market Risk Premium)
Where:
Risk-Free Rate = The return on a risk-free investment, such as a government bondBeta = The stock's sensitivity to market movementsMarket Risk Premium = The expected return on the market minus the risk-free rate
Step 5: Calculate the Cost of Debt (Rd)
To calculate the cost of debt, you can use the yield to maturity (YTM) on the company's debt instruments, such as bonds or loans. The YTM represents the interest rate the company would pay if it issued new debt today.
Step 6: Determine the Corporate Tax Rate (Tc)
The corporate tax rate is the percentage of the company's taxable income that is paid in taxes. This rate varies depending on the jurisdiction and the specific tax laws that apply to the company.
Step 7: Calculate the Weighted Average Cost of Capital (WACC)
Using the WACC formula mentioned earlier, calculate the weighted average cost of capital by plugging in the values you've determined for the cost of equity, cost of debt, and the corporate tax rate.
WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)
Capital Cost Formula
The formula for calculating a company's Weighted Average Cost of Capital is as follows:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
- E: Market value of firm’s equity
- D: Market value of firm’s debt
- V: Total value of capital (equity + debt)
- E/V: Percentage of capital that’s equity
- D/V: Percentage of capital that’s debt
- Re: Required rate of return
- Rd: Cost of debt
- T: Tax rate
The higher a company's WACC, the more risky and volatile an investment is viewed to be.
Tips for Managing Your Cost of Capital
The higher the cost of capital, the riskier the investment in a company is perceived to be. If your cost of capital is too high, individual investors and financial institutions may think twice before putting money into your company's growth.
Thankfully, there are a few steps you can take to make sure that your cost of capital stays within reasonable limits:
- Increase your equity percentage by issuing more stock to investors.
- Reduce debt from financial institutions to keep debt-to-equity ratios in check.
- Maintain adequate cash reserves to cover loan payments and other obligations.
- Utilize cost-cutting measures in your supply chain to achieve operational efficiency.
- Leverage tax incentives and government programs to reduce the cost of capital.
- Regulate expenses by managing the amount of money spent on trade promotions.
How Trade Spend Affects Capital Structure
Trade spend is usually the second-largest item in a CPG company's P&L statement. Brands globally have been known to invest up to 20% of their annual revenue in trade.
With numbers like that, it's no surprise that being ignorant about your trade spend can have a massive impact on a company's capital structure. In fact, financial institutions have been known to thoroughly analyze trade expenses when determining eligibility for debt financing.
If trade expenses go uncontrolled, they can easily lead to a higher debt-to-equity ratio that eventually raises your company's cost of capital. All of this makes investment in your company's stocks riskier, discouraging potential shareholders from investing in your brand. So, the cycle continues, trapping you in an ecosystem of bad debt.
CPG Brands Need More Visibility Into Their Trade Spend
Strategically managing trade spend can help reduce your cost of capital by ensuring adequate cash reserves and reducing debt from financial institutions. This, in turn, improves your debt-to-equity ratio, leading to more investments and better financial health for your company.
However, managing trade presents a significant challenge for most CPG brands. Without the right tools, it’s very hard to collect and visualize trade spend data. In fact, most companies file away trade promotions simply as "the cost of doing business."
But a company's second-largest yearly expense is too important to be left out in the dark. You need better data and insights to make sure that the money you're putting into trade is consistently leading to the expected volume of sales and revenue.
Enter Vividly. Our platform is designed to use AI to offer more data and detailed insights into your company's trade expenses. With a bouquet of features designed to help plan, forecast, reconcile, and analyze trade, we flip the switch on your company's trade promotion strategy to eliminate all uncertainty from the process.
We have helped our clients achieve a 90% reduction in deduction-processing labor and increased their planning accuracy by over 20%. Want to learn more about how we can help your business reduce your cost of capital through detailed analysis of your trade expenses? Schedule a demo today!
