The cost of capital is a key factor in determining a company's valuation. When the cost of capital is high, investors are likely to see less value in owning a portion of that company's capital. The Weighted Average Cost of Capital (WACC) is used to measure the combined cost a company pays for its debt and capital. If the WACC exceeds the company's returns, the company pays investors more than it earns, which can lead to its demise. It is important to analyze the cost of capital and make sure it does not exceed the returns.
When the cost of capital is 20%, the company will be destroying value, even if growth seems profitable. The WACC is an integral part of a discounted cash flow assessment and is a vitally important metric for financial professionals to master. The cost of debt is generally well-defined, and the formula for WACC uses total liabilities and the market value of capital. A high WACC usually indicates greater risk associated with a company's operations, as it pays more for the capital that investors have invested in the company. If the incremental capital invested in growth initiatives does not exceed the company's cost of capital, then it will not be profitable. In extreme cases, issuers whose costs have exceeded their ability to pay their coupon requirements could face bankruptcy, hurting the price of bonds for debt holders.
