The cost of capital is the required return that a company must earn on its investments in order to maintain the value of its stock or ownership interests. Inflation affects the cost of capital because it increases the cost of borrowing and the required return on equity investments. Here’s how to calculate the cost of capital considering inflation:
- Determine the cost of debt: The cost of debt is the interest rate that the company must pay on its debt. This rate should reflect the inflation rate, as inflation increases the cost of borrowing. For example, if the inflation rate is 3% and the company’s borrowing rate is 5%, the real cost of debt is 2%.
- Determine the cost of equity: The cost of equity is the return that investors require in order to invest in the company’s stock. This return should reflect the inflation rate, as investors will demand a higher return to compensate for inflation. One way to calculate the cost of equity is to use the Capital Asset Pricing Model (CAPM), which takes into account the risk-free rate, the market risk premium, and the company’s beta.
- Determine the weight of debt and equity: The weight of debt and equity in the company’s capital structure should be determined based on the company’s target capital structure.
- Calculate the weighted average cost of capital (WACC): The WACC is the average cost of the company’s debt and equity, weighted by their respective weights. The formula for calculating the WACC is:
WACC = (Cost of Debt x Weight of Debt) + (Cost of Equity x Weight of Equity)
For example, if a company’s cost of debt is 5%, its cost of equity is 10%, its weight of debt is 40%, and its weight of equity is 60%, the WACC would be:
WACC = (0.05 x 0.4) + (0.10 x 0.6) = 0.08 or 8%
In this example, the cost of capital has been adjusted for inflation by incorporating the inflation rate into the cost of debt and equity.
