Company Cost of Capital

10 Key excerpts on "Company Cost of Capital"

• 

  eBook - ePub

  Islamic Capital Markets

  Theory and Practice

  • Noureddine Krichene(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  market refers to the universe of investors who are reasonable candidates to provide funds for a particular investment. Capital or funds are usually provided in the form of cash, although in some instances capital may be provided in form of other assets. The cost of capital usually is expressed in percentage terms—that is, the annual amount of dollars that investors require or expect to realize, expressed as a percentage of the dollar amount invested. It applies to a company, security, or project in which we are interested.

  Since the cost of anything can be defined as the price one must pay to get it, the cost of capital is the return a company must promise in order to get capital from the market, either debt or equity. A company does not set its own cost of capital; it must go to the market to discover it. Yet meeting this cost is the financial market’s one basic yardstick for determining whether a company’s performance is adequate. The cost of capital is always an expected or forward-looking return. The opportunity cost of capital is equal to the return that could have been earned on alternative investments at a specific level of risk. In other words, it is the competitive return available in the market on a comparable investment, with risk being the most important component of comparability.

  The cost of capital depends on the components of a company’s capital structure. The primary components of a capital structure include:

  • Debt capital
  • Preferred equity
  • Common equity

  Each component of an entity’s capital structure has its unique cost, depending primarily on its respective risk. The cost of capital can be viewed from three different perspectives. On the asset side of a firm’s balance sheet, it is the rate that should be used to discount to a present value the future expected cash flows. On the liability side, it is the economic cost to the firm of attracting and retaining capital in a competitive environment, in which investors (capital providers) carefully analyze and compare all return-generating opportunities. On the investor’s side, it is the return one expects and requires from an investment in a firm’s debt or equity. While each of these perspectives might view the cost of capital differently, they are all dealing with the same number.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  The Cost of Capital

  Theory and Estimation

  • Cleveland S. Patterson(Author)
  • 1995(Publication Date)
  • Praeger

    (Publisher)

  .-1 The Concept and Uses of the Cost of Capital This chapter introduces the concept of the opportunity cost of capital and re- views its use for corporate and public policy decisions. It also briefly discusses some of the difficulties involved in the estimation of its magnitude for an indi- vidual asset or firm. I. THE CONCEPT OF THE COST OF CAPITAL Most productive enterprises require a mixture of inputs to make them viable. Some of these inputs, such as labor, have clearly identifiable out-of-pocket annual costs associated with them in the form of wages, salaries, benefits, or directly assignable overheads. Others, however, take the form of capital inputs or investments. Essentially investments represent decisions to defer present consumption until a later date, and their "cost" is largely an opportunity cost rather than an out-of-pocket cash cost. We define the opportunity cost of a particular investment, A, as the expected return on the best comparable alternative, B, which is foregone as a result of the decision to commit capital to A. Although costs are normally thought of as dollars paid out, dollars not received have exactly the same effect on the ability to purchase goods. For example, assume that a firm decides to invest $100,000 in a productive asset, which promises, with certainty, to yield a payoff in constant dollars of 2 The Cost of Capital $120,000 at the end of one year. Investors usually require an inducement to defer consumption and the specific rate of return that they require for a riskless one-year investment is established by supply and demand conditions in capital markets. Let us say that it is possible to obtain a guaranteed annual return of 10% by investing in traded market securities such as one-year discount govern- ment bonds. Then the opportunity cost of investing in the project is 10%. If there are no transactions costs or taxes, this is also the project's cost of capital.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Finance for Strategic Decision-Making

  What Non-Financial Managers Need to Know

  • M. P. Narayanan, Vikram K. Nanda(Authors)
  • 2004(Publication Date)
  • Jossey-Bass

    (Publisher)

  You recognize the need to un-derstand how the cost of capital is determined to make effective resource allocation recommendations to the CEO. ■ WACC: A General Approach to Estimating Cost of Capital Since the cost of capital of a project is determined by what in-vestors expect to earn elsewhere at the same risk as the project, the cost of capital depends in part on the risk of the project. Therefore, one way of estimating the cost of capital of a project would be to estimate the risk of the project and use that esti-mate to compute its cost of capital. However, in practice, it is quite difficult to estimate the risk of an individual project. In practice, typically, the cost of capital of a project is esti-mated by benchmarking it to a company that is publicly traded and whose risk is similar to that of the project under consid-eration. Since the benchmark company is publicly traded, we can obtain data to estimate its cost of capital; we then plausibly assume that this is the cost of capital of the project under con-sideration. The benchmark company is called a pure play of the Cost of Capital 57 project. In many cases, the pure play might be the same com-pany that is considering the project. For example, if a cement company is considering opening another cement plant in a dif-ferent location, then it can use its own cost of capital to evaluate the project. On the other hand, if a company that has produced only software is planning to produce a line of handheld orga-nizers, it might wish to use the cost of capital of other companies that produce similar devices to evaluate the project. In your case, your company’s cost of capital is a blended average of the costs of capital of all its divisions. This cost of cap-ital cannot be taken as the cost of capital of any single project from any of the divisions. Even the chemical division’s cost of capital may be inappropriate because the division might be mak-ing products with different risk profiles.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  CFIN

  • Scott Besley, Eugene Brigham, Scott Besley(Authors)
  • 2021(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Because a firm’s cost of funds is based on the returns demanded by investors, most of the models and formulas used in this chapter are the same ones we developed in Chapters 6 through 8, where we described how stocks and bonds are valued by investors and how investors’ required rates of return are determined. However, unlike the discussion in the previous chapters, which were presented from the viewpoints of investors who provide funds to the firm, the discussions in this chapter are presented from the viewpoint of the firm that uses funds provided by investors. To attract their funds, a firm must offer (pay) the returns investors want (require), which means the average rate of return that investors require on corporate securities represents a cost to the firm for using those funds. Thus, it is the investors who determine a firm’s cost of capital. required rate of return The return that must be earned on invested funds to cover the cost of financing such investments; also called the opportunity cost rate. cost of capital The firm’s average cost of funds, which is the average return required by the firm’s investors— what the firm must pay to attract funds. capital components The particular types of capital used by the firm—that is, its debt, preferred stock, and common equity. 253 CHAPTER 11: The Cost of Capital Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 11-1a Cost of Debt, r dT In Chapter 6, we showed that yield to maturity (YTM) on a bond is the average rate of return that investors require to provide funds to the firm in the form of debt.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Corporate Valuation

  Measuring the Value of Companies in Turbulent Times

  • Mario Massari, Gianfranco Gianfrate, Laura Zanetti(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  Chapter 8 Estimating the Cost of Capital

  8.1 DEFINING THE OPPORTUNITY COST OF CAPITAL

  In the previous Chapters we have discussed the calculation of the proper discount rate for cash flows by introducing formulas that are consistent with the asset and equity side standpoints and with the different definitions and derivations of the tax benefits associated with debt. All these formulas stem from two basic parameters referred to as the opportunity cost of capital of a firm with no debt ( ) and the opportunity cost of debt ( ).

  measures the rate of return that is considered acceptable by investors in the equity of a firm with no debt. The return should reflect only the risk profile associated with corporate assets regardless of the financial structure. As we are dealing with an opportunity cost, this return should be estimated taking into account the alternative returns that could be obtained from other investments characterized by similar risk profiles.

  On the other hand, measures (again, as an opportunity cost) the rate of return that is deemed acceptable by the holders of the firm debt. The risk for the underwriters of corporate financial liabilities is mostly a function of the likelihood of the firm not being able to timely fulfill its obligations along the agreed debt service schedule.

  8.2 A FEW COMMENTS ON RISK

  For economists, risky situations are usually associated with cases in which an “objective” probability (i.e., based on meaningful retrospective observations) can be attributed to a range of possible events. “Uncertain” situations, on the other hand, are characterized by the apparent inability to attribute an objective probability to a certain event.

  Following the general practice, going forward we will use the terms risk and uncertainty

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Corporate Finance

  Economic Foundations and Financial Modeling

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton, Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  (1) (These weights are all non-negative and sum to 1.0.) Determining a company’s WACC is an important, albeit challenging, task for an analyst given the following: • Many different methods can be used to calculate the costs of each source of capital; there is no single, “right” method. • Assumptions are needed regarding long-term target capital structure, which might or might not be the current capital structure. • The company’s marginal tax rate must be estimated and might be different than its average or effective tax rate. Estimating the cost of capital for a company thus involves numerous, sometimes complex, assumptions and choices, all of which affect the resulting investment conclusion. 2. COST OF CAPITAL FACTORS Financial theory argues that companies should seek the optimal mix of debt and equity that results in the lowest WACC and maximizes shareholder wealth. Given differences in risk and financial risk tolerances across companies, the capital structure, cost of debt, and costs of equity vary across companies. A company’s cost of capital is influenced by the type of capital the company seeks. Because of its lower risk relative to equity, debt capital typically has a lower cost than equity capital. A company’s cost of debt, before considering the tax deductibility of interest, can be represented as the sum of the benchmark risk-free rate and a credit spread that compensates investors for the risk inherent in the company’s debt security: r d ¼ r f þ Credit spread. (2) The credit spread reflects company-specific factors such as the riskiness of the company’s business model, future profitability and growth prospects, applicable tax rates, the protective covenants in the debt securities, the company’s policy regarding debt leverage—and possible changes thereto, the maturity and callability of the debt, and the nature and liquidity of the company’s assets and operations.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Modern Management in the Global Mining Industry

  • Robin G. Adams, Christopher L. Gilbert, Christopher G. Stobart(Authors)
  • 2019(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  The estimation of expected returns requires dispassionate judgement with regard to both geological and environmental risks and expected prices. Most major mining companies have come to rely on external price forecasts, typically made by specialised consulting companies. It is my belief that a good consulting company will have the expertise and databases which will allow it to make more accurate forecasts than could be generated internally. However, even if this is not the case, shareholders will value this input, first because it is seen to be independent and second, because the use of external consultants will ensure that all major mining companies are evaluating mining prospects against a common set of criteria.

  The Capital Asset Pricing Model

  Modern business finance theory recognises that the price charged by the market for supplying finance consists of more than simply the nominal interest rate charged on any loans. Investors also supply equity, and are only willing to do so in the expectation of a return in the form of some combination of dividends and capital gains. The standard analytical framework within which these issues are evaluated is known as the capital asset pricing model (CAPM). It rests on two propositions. The first is that the cost of capital is a weighted average of the cost of debt and the cost of equity. This is usually referred to as the weighted average cost of capital (WACC), which can be expressed as follows:

  WACC = (1−T) × D × p% + E × (100% − p%) where D is the cost of debt per annum; T is the corporate tax rate faced by the company; E is the cost of equity per annum; and p is the proportion of debt in the capital structure. The second proposition relates to the premium that managers should seek over the WACC to reflect the riskiness of the company’s activities.

  The cost of debt is simply the interest rate that a company pays on its long-term bonds. However, since interest is tax deductible, the nominal interest rate must be multiplied by the tax rate to get the lower effective tax rate (e.g. an interest rate of 6% and a tax rate of 30% means an effective rate of 4.2%).

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  The Cost of Capital

  • E. Porras(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  30 The Cost of Capital The time value of money and investment criteria We have already mentioned that a dollar today is preferable to a dollar in the future. With time, money loses value because the purchasing power of its holder diminishes as prices increase. However, once a lender commits her resources, she would need to worry, not only about inflation, but about the danger of losing her savings and the alternative uses of the money she is forgoing when selecting a specific investment. Therefore, because investors are rational and aim to maximize economic utility, it is important to determine both the ade- quate return for an investment and the best allocation of resources. Given that resources are finite, the cost of capital can be used as a criterion for choosing among potential funds sources and uses. In this sense, a corpo- ration or individual faces two decisions: where to invest and where to raise funds. Hence, to determine the optimal allocation of the savings alternative investments should be ranked. To do this, the cash flows produced by these alternative options must be set up on the same time framework so that the different opportunities are comparable. This is accomplished by ‘discount- ing’ or ‘bringing to present value’ the future cash flows and by comparing the results of the analysis to some acceptance criterion. We shall provide a few examples to illustrate how this is done by using the most common cri- teria: payback period, internal rate of return, net present value, and profit- ability ratio. The payback period (PP) rule answers the question ‘how long does it take to recover an investment with the cash flows the outlay produces?’ It is calculated by adding the negative cash flow of the initial investment to the positive net cash flows that materialize during the life of the venture. For example, let us say we are analyzing an opportunity that requires an initial outlay of five hundred dollars and produces two hundred a year over five years.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  Incidentally, if we assume that the firm is subject to the 40 per cent marginal tax rate, then the after-tax increase in the cost of capital for the firm would be × − = 0.012 (1 0.4) 0.007 2 , or 0.72 per cent. S O L U T I O N S T O S E L F-S T U D Y P R O B L E M S THE COST OF CAPITAL 464 13.1 Explain why the required rate of return on a firm’s assets must be equal to the weighted average cost of capital asso-ciated with its liabilities and equity. 13.2 Which is easier to calculate directly, the expected rate of return on the assets of a firm or the expected rate of return on the firm’s debt and equity? Assume that you are an out-sider to the firm. 13.3 With respect to the level of risk and the required return for a firm’s portfolio of projects, discuss how the market and a firm’s management can have inconsistent information and expectations. 13.4 Your friend has recently told you that governments effec-tively subsidise the cost of debt (compared to equity use) for companies. Do you agree with that statement? Explain. 13.5 Your firm will have a fixed interest expense for the next 10 years. You recently found out that the marginal income tax rate for the firm will change from 30 per cent to 40 per cent next year. Describe how the change will affect the cash flow available to investors. 13.6 Describe why it is not usually appropriate to use the coupon rate on a firm’s bonds to estimate the pre-tax cost of debt for the firm. 13.7 Jakarta Timber has not checked its weighted average cost of capital for four years. Firm management claims that since Jakarta Timber has not had to raise capital for new projects since that time, they should not have to worry about their current weighted average cost of capital since they have essentially locked in their cost of capital. Critique that statement. 13.8 Ten years ago, Electricité de France issued preference shares with a price equal to the par amount of €100.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Cost of Capital

  • Shannon P. Pratt, Roger J. Grabowski(Authors)
  • 2008(Publication Date)
  • Wiley

    (Publisher)

  The goal is to analyze the appropriate cost of capital and earn a greater return. This sounds easy; it is not. One study found that 61% of acquisition programs did not earn a sufficient return (cost of capital) on the funds invested. 8 Any acquisition or merger can be viewed as three distinct streams of expected cash flows. First, in a typical acquisition, the acquiring company will make investments beyond those cap- tured in the expected cash flows of the acquired business. Typically there are integration costs that need to be expended to get the two businesses operating together. The variability of those cash out- flows is negligible, and the appropriate cost of capital should be as low as the after-tax cost of the debt that will be used to finance the acquisition. Second, the risk of the ‘‘stand-alone’’ cash flows that will be realized from the business the ac- quired company already had should be analyzed consistent with the methods we have presented here- in. If the target company is publicly traded, you can use the returns realized on that firm’s stock. For example, assume you will use the Capital Asset Pricing Model (CAPM) to estimate the cost of equity capital. The tools available to directly estimate the company’s beta (e.g., ordinary least squares re- gression of company excess returns against the excess returns of the Standard & Poor’s [S&P] 500) measure the overall company levered beta. But the overall capital structure and the cost of debt capi- tal may change as a result of the merging of the companies. If the target company is a closely held business, you must estimate the risk of the business using the methods we have described in previous chapters. For example, you can locate pure plays, compa- nies specializing in a very narrow business line that parallels the business of the target.

  Sign up to read

  Learn more about book