How to calculate the cost of capital

If you’re taking on loans or grants to grow your business, you’ll need to know how much to budget to pay it all back. Learn more about how to calculate the cost of capital in this article.

We’ll walk you through the key aspects of analysing your business’ capital and how to manage it so you can budget better and keep on top of your financial obligations. Discover:

• What is ‘capital’, and why does capital have a cost??
• How to calculate the cost of capital for your business
• Factors that affect your cost of capital
• Why it’s important to keep your cost of capital in mind
• Track your capital more efficiently with Countingup

Financial terms shouldn’t be a hurdle for new business owners. That’s why we want to empower new entrepreneurs to meet the challenges of business. Read on to find out more about calculating the cost of capital and how Countingup can help you manage it better.

In business contexts, ‘capital’ refers to money your business has available for daily operations and growth. There are several types of capital, but in this article, we’ll focus on debt and equity capital as they come with costs associated with securing them. 

Capital is important because it helps businesses grow, allowing them to buy equipment, hire staff, develop products or offers, and more. If you’d like to learn more about the importance of capital and advice on securing capital for your business, read our article What is the cost of capital?

Cost of capital is calculated according to the following formula:

Cost of capital = Cost of debt + Cost of equity

The first part of our calculation is more straightforward; the ‘cost’ of your debt in this situation is the interest you pay on your loans or credit cards from your borrowing. 

Fortunately for businesses, interest can be deducted from your taxes and will help reduce the overall cost of your capital. We need to include this for our calculation to be accurate, so cost of debt uses the following formula:

As an example, if your business has two loans, £10,000 at 6% and £5,000 at 5%, and you pay 20% as a basic rate taxpayer (or substitute 19% if you run a limited company), your cost of debt will be:

If you’re a sole trader, this will be the only calculation you’ll need to use as your business can’t offer equity investments and so won’t have any additional cost you’ll need to manage.

Equity in your business is the money given to your company by investors. As a result, this part of the cost of capital calculation is only relevant to limited companies. 

The ‘cost’ in this example is the rate of return that your investors receive in the form of dividends. For this reason, your cost of equity can be this percentage alone. As an example, if your company has a total of £50,000 of equity invested and an expected return rate of 5%, your cost of equity would be 5%. 

However, to work out the pounds and pence amount, use the following formula:

Cost of equity = Total equity invested x expected return rate

Using the same example as before:

Cost of equity = 50,000 x 0.05

Cost of equity = £2,500 (or 5%)

There are numerous factors that can affect your cost of capital. Below is a non-exhaustive list that you can begin to plan around and compensate for when financing your business: 

• Tax rate your business operates in (different margins if you’re a sole trader and the forthcoming increases for limited companies) as it affects your cost of debt
• The assets your business holds that help it source secured financing loans
• The strength of your business plan and pitch to investors or lenders
• The performance of your business and the return expectations of your shareholders

Calculating the cost of capital is important for small businesses as it can help you decide whether certain business decisions are truly valuable. Critically, the gains in profit you make have to be higher than the cost of capital in order for the investment to be worth it.

In researching your options on different sources of capital (loan type, interest rate and equity sale), you can begin to weigh your options to determine which route will maximise your profits. Learn more about managing expenses at your business’ stage, whether you’re starting or growing a new venture.

Calculating your cost of capital is a vital financial step that can save you money and grow your business faster. 

While these calculations can be useful, they’re also time-consuming chores that take time and consideration to complete. That’s why thousands of UK business owners use the Countingup app to save time on their financial admin and focus on growing their business. 

Countingup is the business current account and accounting software in one app. It automates time-consuming bookkeeping admin for self-employed people across the UK.

With automatic expense categorisation, receipt capture tools and cash flow insights, you can confidently keep on top of your business finances and save yourself hours of accounting admin, so you can focus on doing what you do best. Find out more here.