Dental Practice Finance:
Cost of Capital

When you’re looking to buy or sell your practice, you’ll often find the term “cost of capital” buried in a valuation. Let’s demystify this concept along with other related terms.

Cost of Capital (often abbreviated CoC) is a term often found in dental practice valuations formulas and is often denoted as \(r\). This \(r\) is used because CoC plays the more general role of required rate of return in those formulas. Here’s the simplest form of these formulas:

$$ \bold{\text{Practice Valuation}} = \frac {\text{Expected Next Year Income}} {r} $$

In this context, required return (and thus CoC) expresses the financial return prospective buyers of a practice expect to receive. The way CoC does this is by discounting the future income expected from a practice to arrive at its valuation. Because CoC discounts future income in this way, yet another similar term, discount rate, is often used to refer to the same concept as CoC.

When a practice has debt holders (for example, a bank when it finances a practice), additional terms will be used because debt holders and practice owners have differing expectations on their returns. Cost of Debt (often abbreviated CoD, in formulas r_D) is used to refer to the return debt holders require and is essentially the interest rate a practice can borrow at from a bank. Cost of Equity (often abbreviated CoE, in formulas r_E) refers to the required return practice owners demand, and when a practice has no debt is equivalent to CoC. When a practice has debt, valuations blend the CoD and CoE to arrive at a combined CoC, often referred to as the Weighted Average Cost of Capital (often abbreviated WACC and pronounced as “whack”).

All said, practice valuation is truly more art than science, and knowing the meaning and usage of the Cost of Capital terms enhances your ability to negotiate. For that, it’s worth getting a better sense for what drives Cost of Capital higher or lower.