Making a business successful is simply down to ensuring you earn more than your costs. An easy way to check this in a company is by comparing the cost of the capital employed by the company with the return made on that capital. This allows you to see how much value (if any) management is adding.
The cost of capital is made up of the cost of the company’s debt and the cost of its equity. The cost of debt is relatively simple in that it refers to the interest rate the company has to pay to borrow money (the riskier the company, the higher this is).
The cost of equity is trickier to work out. It depends not on dividends payable, but on several other variables that combine to quantify the opportunity cost of investing in the equity given the inherent risks involved. The average cost of debt and the cost of equity – weighted depending on the percentage each represents in the capital structure – are referred to as the weighted average cost of capital, or WACC.