Every company needs money to grow, whether it borrows from banks, issues bonds or raises money from shareholders. None of that money is free. The price a company pays for it is called the cost of capital, and it is one of the main reasons share prices react so strongly to interest rates.
What the cost of capital is
The cost of capital is the return a company must offer to attract money from lenders and investors. It has two main parts. The cost of debt is the interest the company pays on loans and bonds. The cost of equity is the return shareholders expect for taking the risk of owning the shares. Analysts often blend the two into a single figure called the weighted average cost of capital, or WACC, based on how much of each the company uses.
Why it matters
The cost of capital is the hurdle every investment has to clear. If a company borrows at 7 per cent to build a factory that earns 5 per cent a year, it is destroying value, however impressive the factory looks. If the factory earns 12 per cent, it is creating value. This is why investors pay close attention to capital expenditure alongside the cost of capital.
It also drives valuations. Analysts value companies by estimating future cash flows and discounting them back to today using a rate linked to the cost of capital. When interest rates rise, the discount rate rises, and future profits are worth less in today’s money. Companies whose profits are expected far in the future, such as fast-growing technology firms, are hit hardest.
A simple example
Imagine a company expects to make £100 million a year in ten years’ time. Discounted at 6 per cent, that future profit is worth about £56 million today. Discounted at 9 per cent, it is worth about £42 million. Nothing about the business has changed, but a higher cost of capital has knocked a quarter off the value of that future profit. This is the main channel through which higher bond yields put pressure on share prices.
How traders use it
Traders watch government bond yields, such as the US 10-year Treasury yield or the 10-year gilt, as a guide to the general cost of capital. When yields climb, they expect pressure on growth and technology shares, and on companies with lots of debt. When yields fall, those same shares often recover.
They also watch corporate borrowing costs. When the yields companies pay on new debt rise, big spending plans become more expensive, and investors become less forgiving of projects with long payback periods.
Common mistakes
One mistake is treating equity as free money because there is no interest bill. Shareholders expect a return, and if they do not get it, the share price falls. Another is assuming any growth is good growth; growth that earns less than the cost of capital reduces value. A third is ignoring how quickly the cost of capital can change when interest rates move.
The bottom line
The cost of capital is what a company pays for its money, and it sets the bar every investment has to beat. When interest rates rise, that bar rises too, which is why bond yields and share valuations are so closely linked. If you want to test how you think about these links, the free Samuel & Co Trading Trader Assessment is a sensible next step.
