Determining the cost of capital is one of the regular tasks of auditors when carrying out business valuations. They are needed to determine the current value of a company, but also to allocate purchase prices to individual assets, carry out impairment tests or value brands. In this article, we explain how the cost of capital is made up, how to determine the weighted average cost of capital (WACC), which use cases regularly occur in practice and which errors should be avoided when determining the cost of capital.
In principle, the cost of capital always arises when equity or Debt is used for financing.
When equity is used, opportunity costs arise because potential returns are foregone. After all, the money invested can no longer be used for other forms of investment such as shares.
Investors, on the other hand, who provide Equity for the acquisition of a company, for example, demand a premium for the associated risk - the risk premium. The higher they assess the risk, the higher the premium.
The cost of Debt includes the interest you pay when you borrow money from a bank, for example. Here, too, there is sometimes a risk premium with which the bank protects itself against a possible default.
As part of a business valuation, future profits are converted into their present value by discounting them. The discount rate applied here corresponds to the cost of capital. The current value of future profits - and thus the value of the company - increases or decreases depending on the cost of capital.
The cost of capital also plays an important role in other contexts, namely whenever you want to calculate the future value of assets in general. This can be the case, for example, as part of a purchase price allocation (present value of future cash flow), but also in impairment tests (replacement value of the asset) or in brand valuation.
The weighted average cost of capital is referred to as the "weighted average cost of capital", or WACC for short. This key figure describes the average cost of a company's entire capital, i.e. both Equity and Debt.
The WACC is used to calculate the minimum return a company must achieve on an investment in order to satisfy its investors.
In order to determine the WACC, the equity and debt capital costs are first determined and then weighted:
In the context of business valuation, the CAPM is one of the most frequently used models for calculating the cost of equity. CAPM stands for "Capital Asset Pricing Model", and the underlying idea is that investors expect higher returns for riskier investments than for less risky ones.
The CAPM formula for calculating the cost of equity is: Ke = r + β * (Rm - r), where the r stands for "risk-free return", the β for the "beta factors" and the Rm for "market return".
The beta factor describes the systematic risk of a share - a risk to which all companies on the market are exposed and which cannot be eliminated through diversification. The beta describes how strongly a share moves in relation to the market as a whole:
In the context of the CAPM, the equity risk premium (MRP) describes the additional return that investors expect for the systematic risk of an investment in the market as a whole.
The equity risk premium is determined by calculating the difference between the expected market return and the risk-free return (Rm - r).
If investments are made beyond national borders, a country factor is added to the CAPM. The country risk premium expresses the return that investors expect for the systematic risk if they invest in a particular country.
The country risk premium is influenced by various factors. For example, the political circumstances in the target country, the macroeconomic situation, currency fluctuations or country-specific events such as wars or natural disasters are taken into account.
In addition to the cost of equity, the cost of debt is the second component for determining the weighted average cost of capital of a company. In practice, two common methods are used to calculate them as part of the WACC: credit spreads and the tax shield:
The credit spread method is based on the assumption that the borrowing costs are made up of the risk-free return and a credit spread. Accordingly, it is calculated by adding a credit spread to the risk-free return. The amount of this premium is subject to factors such as the company's credit rating, the term of the financing and current market conditions.
The tax shield method takes into account the tax advantage that companies gain from the deductibility of interest on borrowed capital. Borrowing costs after tax are calculated using the formula borrowing costs * (1 - company tax rate). If the borrowing costs are around 6% and the corporate tax rate is 25%, the value is 4.5%.
The credit spreads reflect the creditworthiness of a company and should therefore be regarded as a risk indicator.
With the tax shield, the effective borrowing costs are reduced by the tax deductibility of the interest.
Both methods serve as a simplified representation for determining borrowing costs. In practice, more complex models are also used, which take into account the maturity structure of the liabilities or the credit term curve, for example.
Because companies finance themselves from various sources of capital, both the cost of equity and the cost of debt must be calculated. The total cost of capital is calculated as a weighted average of the two cost types. The weighting is based on the ratio of the respective share of capital to total capital.
The Modigliani-Miller theorem is a fundamental theory in finance. It sheds light on the effects of the financing structure on the value of a company.
One of the key statements is that the choice between equity and debt financing does not affect the overall company value if there are no taxes and no transaction costs.
The value of a company can therefore only be determined by the expected cash flow and its risk. However, the assumptions made for this financial concept are rarely given and are correspondingly impractical.
In fact, debt financing is tax-privileged because the interest can be deducted from the tax base. This lowers a company's tax burden and reduces its cost of capital accordingly. Companies therefore increase their value - for tax reasons - when they take on Debt.
The cost of capital is determined in different areas. The objective is always the same: you want to know today what value certain assets will have in the future. This is why we speak of a future-oriented valuation, which is used in these cases, for example:
The cost of capital plays a key role in determining the value of a company. This is because they represent the interest rate at which a company can borrow money. If a company has a high cost of capital, it has to pay more interest than if it has a low cost of capital. Accordingly, the cost of capital reduces or increases the company's profit - and thus influences its value. Determining the cost of capital enables
Overall, determining the cost of capital enables an objective business valuation that supports important business decisions.
In the event of a company takeover, buyers and sellers endeavor to determine a fair value for the various assets such as real estate, machinery or patents.
Purchase price allocation involves allocating the purchase price to the individual assets. There are various methods for this, such as the comparative value method, the income approach or the cost approach.
The cost of capital is important in the context of purchase price allocation, as it is used to discount future income in income-based methods. They influence the present value of future cash flows as they take into account the value of money over time. If the cost of capital is high, the present value decreases, which leads to a lower valuation of the individual asset.
Impairment tests are an important part of a business valuation to determine the possible impairment of assets. The cost of capital is important for determining the recoverable amount, which is compared with the carrying amount in impairment tests:
First, the carrying amount is determined, which corresponds to the original purchase price of an asset. The recoverable amount is then calculated as the highest selling price that could be realized for the asset on the current market. If the carrying amount is below the recoverable amount, there is no impairment; if the carrying amount is below the recoverable amount, there is an impairment.
The cost of capital is required to calculate the recoverable amount. The most frequently used calculation methods include
If the cost of capital is high, the recoverable amount is lower. This is because the future cash flows are discounted more heavily. Accordingly, the recoverable amount is higher if the cost of capital is low. In this case, future cash flows are discounted to a lesser extent.
This affects the impairment test to the extent that high costs of capital make an impairment more likely and, conversely, low costs of capital make an impairment less likely.
Brands are among the most important assets in many companies. Accordingly, the value of a brand is often determined, which can be done using a brand value method or the discounted cash flow approach, for example.
The cost of capital plays a particularly important role in the DCF method. The aim here is to determine the present value of a brand's future cash flow, for example via future profits, licenses or marketing costs. The cost of capital is used to discount future cash flows to today's present value. Accordingly, higher costs of capital lead to a lower brand valuation than lower ones.
Basically, the WACC concept was developed to determine the total costs of a company - in other words, it is a business valuation method.
Accordingly, using the WACC as a discount rate for individual assets is always appropriate if the cash flows allocated to the asset are comparable with a company - in terms of risk profile, term and currency.
The WACC is less suitable for impairment tests for financial assets that fall under IAS 36. This is because the WACC version for impairment tests differs from that for business valuations in these points:
In practice, these differences can lead to considerable discrepancies between the two versions.
The cost of capital has a major influence on the valuation of companies as well as in other areas such as investment decisions, risk management and financing.
Errors in determining these should be avoided, as they would have serious consequences. First and foremost, this includes wrong decisions regarding purchases or investments or excessively high financing costs.
A number of points should therefore be taken into account when determining the cost of capital:
A vast amount of data is required to calculate the cost of capital. Determining this "manually" is extremely cumbersome, which is why it is advisable to access existing databases that provide all the necessary information.
As a user, you have a choice here. There are very large databases from international providers that go far beyond applications such as determining the cost of capital - and have a corresponding price tag. Alternatively, smaller specialist providers offer extensive pools that are tailored precisely to this area of application - and require a significantly lower investment to use.
You can find an overview of the various providers and their databases in our separate article Cost of capital databases - overview for auditors.
The cost of capital plays a central role in business valuation. They are an important factor in determining the fair value of a company and influence various decisions in areas such as investments, financing and risk management.
Various factors must be taken into account when determining the cost of capital. These include the risk-free return, the equity risk premium, the company's credit rating and the financing structure.
Various methods can be used to calculate the cost of capital, for example the CAPM, the DCF method and the WACC. The choice of method should take into account the specific circumstances of the company and the intended use of the cost of capital.
Errors in determining the cost of capital can have serious consequences (incorrect business valuation, suboptimal investment decisions or high financing costs). To avoid this, it is important to choose the appropriate method, take all relevant factors into account and critically review the results.
Determining the cost of capital is a complex but important part of business valuation. By taking a careful and conscientious approach - and above all by using the right data - companies can reliably determine the cost of capital and thus make informed decisions.
We support you in researching the data — e.g. putting together the peer group — with a short training session on how to use the platform. We are happy to do this based on your specific project.
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