Ultimate Guide to Calculating Your Cost of Capital & Making Growth-Driven Decisions
Do you ever feel like you're running your startup on fumes? Ideas are overflowing, your team is hustling, but that initial seed funding feels like it's shrinking faster than a free trial period. You're not alone. This is an all-too-common scenario, and many startups find themselves burning through cash without a clear understanding of their financial runway. With nearly half (48%) of Australian startups failing within their first four years, this sobering statistic underscores why it’s important to understand your Cost of Capital (CoC).
It's not the flashiest financial metric, but founders as well as investors can use CoC to evaluate whether they are making smart investments and maximising returns. Put simply, your CoC is the minimum acceptable return you need to generate on an investment to justify the cost of financing it. Consider it a benchmark you use to separate promising projects from those that might drain your resources.
This article will equip you with the knowledge to calculate your CoC and unlock its potential to help you make data-driven decisions that fuel growth and avoid costly missteps.
How to calculate Cost of Capital
The concept of Cost of Capital is pretty straightforward, but putting it into practice requires some financial manoeuvring. While the calculation of CoC is often done by financial professionals, understanding the process is valuable for startup founders.
Since most startups often use a mix of debt and equity financing to fuel their growth, calculating CoC means you need to take a weighted average of your cost of debt and cost of equity, based on the proportion of each used in your capital structure.
Formula: Weighted Average Cost of Capital (WACC) =(Cost of Debt x % Debt Weight) + (Cost of Equity x % Equity Weight)
Let’s break this down step-by-step.
Step 1: Calculate cost of debt
The cost of debt represents the interest and other costs you pay to borrow money. It's essentially the price paid to lenders (debt holders) for using their capital — this could be a loan from a bank, a convertible note, or even equipment financing. Here's a more detailed breakdown on how to calculate cost of debt for your startup:
1. Gather your borrowing information:
Find all your loan agreements, credit card statements, and convertible note documents. Look for the annual percentage rate (APR) or interest rate associated with each debt source.This is the percentage of the loan you pay back on top of the principal amount in a year.
2. Calculate average interest rate:
There are two ways to do this:
- Simple average: Add up the interest rates from all your debt sources and divide by the number of sources.
- Weighted average (more accurate): Multiply the interest rate for each debt source by the outstanding balance of that debt. Then, add up these values and divide by the total debt amount.
Example: Let's say you have a business loan with a balance of $10,000 at an interest rate of 8%, plus a credit card with a balance of $2,000 at an interest rate of 15%.
Simple average: (8% + 15%) / 2 = 11.5%
Weighted average: [(8% x $10,000) + (15% x$2,000)] / ($10,000 + $2,000) = 9.8%
3. Factor tax benefit (if applicable):
Debt interest payments are typically tax-deductible, which translates to tax savings for your company. If your accurate cost of debt. The figure you need to look at here is your company’s marginal corporate tax rate — you can find this information from your accountant or tax advisor.
Once you have calculated your average interest rate and gathered your tax rate, use them in the Cost of Debt formula below:
Cost of Debt = Average Interest Rate x (1 - Tax Rate)
Example: Let's say your startup's weighted average interest rate is 9.8% (as calculated above) and your corporate tax rate is 30%(or 0.30).
Cost of Debt: 9.8% x (1 - 0.30) = 6.86%
Taking into account the 30% tax rate, your effective cost of debt would be 6.86%. This means that for every $100 you borrow, you're essentially paying $6.86 in interest after considering the tax benefit.
Step 2: Calculate cost of equity
This step involves estimating the return on equity that investors expect. We essentially need to put ourselves in the shoes of investors and try to understand what rate of return they would require to be incentivised to invest in your company. Here, we'll consider three key factors that influence their expectations:
Risk-free rate: In Australia, this can be directly referenced by the current Cash Rate Target set by the Reserve Bank of Australia (RBA) and represents the (near) risk-free benchmark rate for the Australian dollar. You can find the latest Cash Rate Target on the RBA website.
Beta (β): This measures how volatile your company's stock is compared to the overall market. A beta of 1 indicates your stock moves inline with the market, while a beta above 1 suggests higher volatility (riskier for investors). Since most startups aren't publicly traded, you can estimate your beta based on similar public companies in your industry listed on the Australian Securities Exchange (ASX).
Market return: This reflects the additional return investors expect for investing in stocks (riskier) compared to government bonds(considered risk-free). You can estimate this value using historical market data or industry benchmarks for startup investments in Australia.
Let’s work out the cost of equity with an example:
Imagine you’re a SaaS startup offering marketing automation software. The current risk free rate is 4.0%, and based on industry analysis, you estimate your beta to be 1.5 (indicating 50% more volatility than the market). The historical market risk premium for Australian SaaS startups is estimated at 10%.
Use these values in the Cost of Equity formula below:
Cost of Equity = Risk Free Rate + Beta (Market Return - Risk Free Rate)
Cost of Equity = 4.0% + (1.5 *(10% - 4.0%))
= 4.0% + (1.5 * 6.0%)
= 4.0% + 9.0%
= 13.0%
Based on this example, your estimated cost of equity would be 13.0%. This means that to attract investors, your SaaS startup would need to demonstrate the potential for returns that are at least 13.0% higher than what they could get from a (near) risk-free investment like government bonds.
Step 3: Calculate weighted average cost of capital
Now that cost of debt and cost of equity have been calculated, we can determine the weighted average cost of capital (WACC), which reflects the overall cost of financing your startup. It considers both the cost of debt and the cost of equity, weighted by their relative proportions in your capital structure. For example, if your startup is funded 30% by debt and 70% by equity, the weights would be 30% and 70% respectively.
Let’s apply the Weighted Average Cost of Capital (WACC) formula below:
WACC = (Cost of Debt x % Debt Weight) + (Cost of Equity x % Equity Weight)
Using the values we’ve calculated before, let's assume your startup has a cost of debt of 6.86% (from Step 1 example), a cost of equity of 13.0% (from Step 2 example), and a capital structure of 30% debt and 70% equity.
WACC = (6.86% x 0.30) + (13.0% x0.70)
= (2.06% + 9.10%)
=11.16%
Based on these values, your startup's cost of capital on average is 11.16%. Meaning, this is the minimum rate of return you should expect to generate on your investments to satisfy both your debt holders and your equity investors.
How to quickly estimate your Cost of Capital
While the WACC formula provides a more accurate picture, there are a few shortcuts you can use to get a ballpark estimate of your CoC:
Industry benchmarks: Look for research reports or industry publications that provide average CoC for startups in your sector. This can be a good starting point, but keep in mind it may not account for your specific company's risk profile or capital structure.
Rule of thumb: A simplified approach is to take the average of the current interest rate on business loans and the expected return rate for angel investors in your region. This is a rough estimate, but it can be helpful in the early stages of your startup journey.
Remember, these are just quick estimations and it’s always advisable to consult a financial professional for more precise calculations and strategic financial decisions.
Using Cost of Capital to make growth-driven decisions
Capital is the lifeblood of any young company, but investing in every opportunity can be a recipe for disaster. Investors expect companies to use their money wisely, and if a company's projects or overall performance don't deliver returns that beat their cost of capital, it suggests inefficiency.
Let’s look at a few ways CoC can empower founders to make better growth-driven decisions:
Investment evaluation: Ditch the guesswork. Use CoC to identify investments that deliver strong returns, exceeding your minimum acceptable threshold.
Capital allocation: Debt or equity? CoC helps you weigh the cost of capital against the benefits of each financing option.
Pricing strategy: Don't undercharge! Set prices that cover expenses and generate profit exceeding your CoC.
Merger & acquisition decisions: Go beyond financials and look at the target company's CoC. Post-merger synergies that lower your combined CoC strengthen the acquisition case.
Validate growth strategy: Compare your projected returns to your CoC. This reveals if your growth strategy is on track for long-term financial health.
By consistently exceeding your CoC, founders are not just maximising returns for their business; they’re also demonstrating financial responsibility and building long-term value for investors.
Optimising Cost of Capital for SaaS startups
SaaS startups thrive on innovation, which means they need capital — but traditional funding options often come with a higher cost of capital and dilution of your ownership stake.
What if we told you there’s another way? Kashcade offers R&D tax incentive lending specifically designed for startups and other innovative Australian companies. Our model works by bringing forward your next R&D tax incentive refund to today, providing access to capital that may attract a lower CoC compared to traditional funding options.
For startup founders, this means:
Retained ownership: You keep control of your vision and decision-making.
Flexible repayments: With no monthly repayments, repay the loan only once your R&D refund is paid out by the ATO.
Access capital on demand: Get funding part-way through the financial year, then draw on additional funds later as needed.
Funding that scales with your refund: Over time, access more as your R&D refund accumulates further.
Ready to unlock growth without dilution?
- Use our funding calculator to get an estimate of how much funding might be available to your company.
- Connect with the Kashcade team to discuss your specific needs and see if our financing solutions are the right fit for you.