February 3, 2023

How to Calculate Your True Cost of Capital

Vividly Team
Money Matters

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.

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 the different strategies you can use to manage your cost of capital, along with some of the essential tools you need to succeed.

What Is Cost of Capital?

Cost of capital is the minimum rate of return that a company must earn on a project or investment to satisfy shareholders and lenders. For a CPG brand, cost of capital is an important factor in determining profitability and attractiveness to potential investors.

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%

How to Calculate the 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.

Formula for Calculating Cost of Capital

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!

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