The business needs to analyze operational and strategic aspects to make financial decisions, and the cost of capital is one of the essential inputs in the process of decision-making. It helps to understand if business operations are value-adding, destructive, or need attention to improve profitability. So, it’s all about measuring, controlling, and taking steps to improve the overall cost of finance.
From a technical point of view, there are two types of capital cost: the nominal and real costs of capital. Although both concepts refer to the cost of capital for the business, the difference is for inflation adjustment from the time an investment was made and a return is generated.
In a normal procedure for calculating Net present value, an accountant uses nominal cash flows – these are the cash flows that have been inflated into future values. So, these are not the real value but inflated values.
Let’s understand the concept of real value first; suppose you had invested $100 last year, and the rate of return was 10%. So, the net return on investment was $10, and the total value of the investment amounted to $110. However, it’s important to note that $10 has been generated in today’s value, not last year’s value. So, as we understand, the return of $10 has less value than $10 a year ago. Suppose inflation of the economy amounts to 2%.
So, $100 invested a year ago equals $102, and a total return generated amounts to $110. So, a deduction of $102 from the real value with the $110 results in the $8, which is the real return as investment and return have been stated in real values. So, the real rate of return on the investment is $8/$102=7.8%. That’s the real rate of return, or this is the rate that increased our purchasing power with the investment. Let’s further dive into the details of the concept.
Definition of the Real Cost of Capital
The cost of capital adjusts (eliminates) inflationary impacts on the environment. In other words, the inflation rate is adjusted, giving a real cost rate.
So, the real cost of capital is the cost of capital that has been adjusted in line with inflation. In other words, it’s the cost of capital that adjusts the impacts of inflation in making financial analyses. To calculate the real cost of capital, first, we need to calculate the nominal cost of capital and a just element of the inflation.
The businesses finance their expansion and operations with debt and equity. Raising finance via debt or equity requires the business to pay the cost. Generally, debt is considered a cheaper source of finance because payment of the interest on the debt is tax allowable. Further, it does not lead to a dilution in the control of shareholders.
Likewise, they are given preference if the business goes into liquidation. Hence, the overall risk of debt financing is limited in comparison to equity, which leads to a lower rate of return or lower cost of capital.
On the other hand, financing via equity is perceived to incur higher costs because it leads to dilution of control and sharing of business ownership. Suppose if the business only used equity to finance its operations, the cost of equity is considered the cost of capital.
Likewise, if the business only uses only debt as a source of finance (theoretically), the debt cost is considered the cost of capital. However, if the business uses both debt and equity as a source of finance, the weighted average cost of debt and equity is considered the cost of capital which is normally termed as WACC. The following formula is used in the calculation of WACC.
WACC = [(E/V) x Ce] + [(D/V) x Cd x (1 – Tax rate)]
It’s important to note that the formula has different inputs to calculate WACC. These inputs include total equity, total financing amount, return on equity, total debt value, return on debt, and tax rate to adjust the cost of debt.
All the given figures are actual and include elements of inflation. So, the calculated WACC with the formula does not represent a real cost, and we need to adjust inflation to get the real cost of capital.
Suppose the calculated WACC of the business is 11%; this is the nominal rate it includes inflation due to incorporated inflation in the cost of equity and cost of debt. Further, the real inflation rate in the economy amount to 2%.
We use Fisher’s equation to convert the nominal rate to the real rate.
The real rate of interest = nominal rate – inflation rate
The equation simply eliminated the impact of inflation. So, we can put our data in the given equation as follows,
Real rate of interest = 11% – 2%
The real rate of interest = 9%
So, 9% is the real cost of capital that investors and lenders should consider as input in the business or their return. Further, from a business perspective, the current return earned by the business can be compared with the real cost of capital to assess performance with more accuracy.
Another perspective for the cost of capital is the rate of return, where the real cost of capital is more important from a financial analysis point of view. That’s because investors frequently use the rate of return in different economies. For instance, the inflation rate is different for the United States and different for Australia.
So, it does not seem logical to compare the business’s financial performance/rate of return in two different geographical locations with the nominal rate of return. Hence, the real cost of capital can be useful as inflationary impacts for both the countries are adjusted, and real performance is compared for the companies.
NPV Uses the Nominal Rate of Return or Real Return
NPV normally uses the specific level of inflation to forecast future cash flows. The expected cash inflows and cash outflows generally include specific/project level inflation. So, when the rate of return is calculated on the net outflow/inflow, it results in a nominal rate of return.
The cost of capital, when seen from other perspectives, is the rate of return for the investors. The businesses aim to control the cost of capital by managing operations and enhancing efficiency. Generally, the businesses use the nominal cost of capital that includes the impact of inflation.
However, to assess adjusting inflation or maintaining the purchasing power of the return, investors eliminate an element of the inflation from the nominal rate by using Fisher’s equation. This results in the real rate of return or real cost capital.
So, the real rate of return is an actual return that increases the actual purchasing power of the money. For instance, the nominal rate of return for the investment is 10%. And you get $110 on the investment of $100.
However, an additional $10 received today is not equal to $10 a year ago when the investment was made. Hence, we need to adjust the nominal return with the real inflation to get the real rate of return or cost capital in real terms.
Frequently asked questions
What’s the major difference between nominal and the real cost of capital?
The major difference is that the nominal rate is calculated based on inflated cash flows. It means inflations are inclusive of it. On the other hand, the real cost of capital eliminates inflation from the cash flows.
What’s Fisher’s theory, and how it’s related to inflation?
Fisher’s theory explains the relation between nominal rate, real rate, and inflation. As per the theory, the real inflation rate is calculated by deducting the rate of inflation from the nominal rate of return.
Why is it important to understand the difference between nominal and real rates?
For everyone, it’s important to understand the difference between nominal and real rates. Its importance is due to its use in daily life. For instance, if you visit a bank and they tell you that the interest rate is 4%.
The quoted rate is the nominal rate and includes inflations. Suppose the current level of inflation in the economy is 1%. It means the real return is 3% (4%-1%).
So, your purchasing power increases with the 3% as an additional 1% has been adjusted for inflation.