Cost of Capital
Cost of capital refers to the expense a company incurs to finance its operations through equity and debt. It represents the return that investors expect to receive for providing capital to the company. Calculating the cost of capital helps businesses make decisions about investments and financing, as it provides a benchmark for evaluating the potential returns of various projects.
7 Key excerpts on "Cost of Capital"
eBook - ePub- Clive Marsh(Author)
- 2012(Publication Date)
- Kogan Page(Publisher)
...Generally, these types of debate are more significant to a large company. Summary The Cost of Capital is the rate of return that a company has to pay to gain and retain funds from investors, who will take into account their risk in investing. It is the opportunity cost of investment capital or the marginal rate of return required by investors. When calculating a weighted average Cost of Capital in a low-geared company, the rate for the cost of equity that is included in the calculation might not be a factor to which the overall rate is particularly sensitive. You need to decide how sensitive investment appraisals are in your own organization to estimate a precise and academically sound Cost of Capital. There are arguments for and against each method of calculating the Cost of Capital. This chapter has discussed some of the principal methods and explained the elements that make up the cost of equity and the Cost of Capital, and it is hoped that you can now decide which method is relevant to your own organization. In a large multinational organization an understanding of the true Cost of Capital may be considered to be important, whilst in a small company it might not be considered to be particularly material to most decisions....
eBook - ePubCorporate Finance
A Practical Approach
- Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
- 2012(Publication Date)
- Wiley(Publisher)
...Arriving at a Cost of Capital estimate requires a host of assumptions and estimates. Another challenge is that the Cost of Capital that is appropriately applied to a specific investment depends on the characteristics of that investment: The riskier the investment’s cash flows, the greater its Cost of Capital. In reality, a company must estimate project-specific costs of capital. What is often done, however, is to estimate the Cost of Capital for the company as a whole and then adjust this overall corporate Cost of Capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project. This chapter is organized as follows: In the next section, we introduce the Cost of Capital and its basic computation. Section 3 presents a selection of methods for estimating the costs of the various sources of capital, and Section 4 discusses issues an analyst faces in using the Cost of Capital. Section 5 summarizes the chapter. 2. Cost of Capital The Cost of Capital is the rate of return that the suppliers of capital—bondholders and owners—require as compensation for their contribution of capital. Another way of looking at the Cost of Capital is that it is the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk. A company typically has several alternatives for raising capital, including issuing equity, debt, and instruments that share characteristics of debt and equity. Each source selected becomes a component of the company’s funding and has a cost (required rate of return) that may be called a component Cost of Capital. Because we are using the Cost of Capital in the evaluation of investment opportunities, we are dealing with a marginal cost—what it would cost to raise additional funds for the potential investment project...
eBook - ePub- Kalpesh Ashar, Vibrant Publishers(Authors)
- 2022(Publication Date)
- Vibrant Publishers(Publisher)
...Chapter 3 Cost of Capital I n this chapter, we will look at various ways to finance an organization, and their respective costs. This information is useful in making key organizational decisions. The key learning objectives of this chapter are: ● Understand the cost of debt and equity ● Know the concept of WACC and how to calculate it Companies need to raise capital to conduct business. They use capital to invest in assets that help them generate sales. There are three basic ways using which companies borrow capital – debt, preferred stock, and common stock. Retained earnings is another source of capital, generally the largest for profitable companies. In the sections below, we describe the cost of raising money through each of these means and how a company calculates its total Cost of Capital. This information is used to make capital budgeting decisions for deciding which projects to undertake. 3.1 Cost of Debt (k d) Debt funding is a loan taken from another party, which requires a certain rate of interest to be paid at fixed intervals. For example, consider a company taking a $1 million loan from a bank at 10% with interest to be paid yearly. It would have to pay $100,000 interest before-tax cost of debt. However, companies are allowed to deduct the interest paid in their income statement. Hence, the after-tax cost of debt will be lower due to reduced tax burdens because of the interest payment. If, in the above example, the company has an effective tax rate of 40%, then the cost of debt would be: Cost of debt = 10% – Tax saving due to interest expense = 10% – (40% of 10%) = 6% The before-tax cost of debt is referred to as k d and the tax rate as T to give the cost of debt as: Cost of debt = k d (1 – T) It needs to be noted that the above cost of debt is assuming that the company is making profits. If it is running losses, then its effective tax rate would be zero, thereby making T = 0...
eBook - ePubThe Capital Budgeting Decision
Economic Analysis of Investment Projects
- Harold Bierman, Jr., Seymour Smidt(Authors)
- 2012(Publication Date)
- Routledge(Publisher)
...One estimate of the cost of the common stock equity is The weighted average Cost of Capital for the company as a whole is estimated in Table 9.1. Table 9.1 Estimate of the Cost of Capital (WACC) The WACC of a firm can be interpreted as being the cost of both current capital and an additional dollar of new capital if the existing capital structure is maintained. This is inexact, but it simplifies the analysis. For capital budgeting the WACC should be computed by using the normal capital structure for the project or cash flow component. The WACC of Example 9.1 is computed using the expected return required for the present debt and the present common stock. If we were considering the raising of new capital to finance additional investments, it would be more accurate to speak in terms of the return that would be required if a mixture of additional debt and common stock were to be issued. For decisions we want a weighted average of marginal costs for debt and stock. In situations where the issuance of the debt and common stock will not change the firm’s capital structure, the marginal costs may equal the average costs. If the capital structure were to change, but the weighted average Cost of Capital does not change, the marginal Cost of Capital is again equal to the average cost. Shareholders are exposed to the risk of financial distress costs as soon as debt in some form (e.g., accounts payable or a bank loan) is acquired. With debt, it is possible that equity holders will lose their investment interest in a company that may in the future become a profitable operation. With a well-managed profitable company in a safe industry, the introduction of a small amount of non-equity capital presumably will increase the risks of financial distress costs only a small amount. In practice, these costs from debt issuance are nearly always present, because a company will always have at least some accounts payable outstanding...
eBook - ePubReturn on Investment Manual
Tools and Applications for Managing Financial Results
- Robert Rachlin(Author)
- 2019(Publication Date)
- Routledge(Publisher)
...In many companies, it is the prime source of capital. The question often arises as to how much debt should a company have in relation to equity. The answer is not a simple one and is not always reduced to a mathematical formula. Rather, there are many decisions to make in determining the level of debt within a company. Since debt may provide proportionately more funds as a percentage of equity, these decisions are extremely important and must be evaluated from company to company. Evaluating the cost of average capital Since the cost of debt is tax deductible, it is generally cheaper to acquire debt than equity funds. Let us look at a simple example of how debt can reduce the average weighted Cost of Capital. Assume a company has a capital structure with a weighted average cost of 13.16%, as shown in Table 19-3. Let us assume that this company borrows $80,000 at 20% interest to finance a capital project. Even though more debt is acquired at a higher rate (20%), the weighted average cost for the company is now 12.63%, assuming no change in the total equity, as illustrated in Table 19-4. You can see that financing a capital project with additional debt reduced the weighted average cost of the company’s total capital from 13.16% to 12.63%. Under this situation, it would be advisable to add more debt to finance not only capital investments but other areas of the company, such as working capital. Determining the impact of additional debt on return rates. The adding of more debt can produce more earnings even when that additional debt has a higher cost. Let us use data presented in Table 19-3 and Table 19-4 as an example by assuming that the after-tax return on capital on the original capital is 15%. The debt of $80,000, which was used to finance a capital project, generated a return rate of 20%. Using both of these return rates, you will see that the overall earnings increased $16,000, or a total of $61,000 ($45,000 + $ 16,000)...
eBook - ePub- Vibrant Publishers, Kalpesh Ashar(Authors)
- 2019(Publication Date)
- Vibrant Publishers(Publisher)
...Cost of Capital Companies need to raise capital to conduct business. They use capital to invest in assets that help them generate sales. There are three basic ways using which companies borrow capital – debt, preferred stock, and common stock. Retained earnings is another source of capital, generally the largest for profitable companies. In the sections below we describe the cost of raising money through each of these means and how a company calculates its total Cost of Capital. This information is used to make capital budgeting decisions for deciding which projects to undertake. Cost of Debt (k a) Debt funding is a loan taken from another party that has a certain rate of interest to be paid at fixed intervals. For example, consider a company taking a $1 million loan from a bank at 10% with interest to be paid yearly. It would have to pay $100,000 interest before-tax cost of debt. However, companies are allowed to deduct the interest paid in their income statement. Hence, the after-tax cost of debt will be lower due to reduced tax burden because of the interest payment. If in the above example, the company has an effective tax rate of 40%, then the cost of debt would be as below: Cost of debt = 10% – Tax saving due to interest expense = 10% – (40% of 10%) = 6% The before-tax cost of debt is referred to as k d and the tax rate as T to give the cost of debt as: Cost of debt = k d (1 – T) It needs to be noted that the above cost of debt is assuming that the company is having profit. If it is running losses, then its effective tax rate would be zero, thereby making T = 0...
eBook - ePub- Alan J. Baker(Author)
- 2018(Publication Date)
- Routledge(Publisher)
...This resolves the question of the values of b* and (1 - b*) in equation (xvi) ; b* is equal to B/V, the prevailing ratio of debt to the market value of the firm; and (1 — b*) is equal to S/V, the ‘market value weight’ of equity. Our Cost of Capital concept evidently deserves to be described as the ‘market value weighted average Cost of Capital’ (MVWACC). As was demonstrated at the opening of this sub-section, our financing proportionality rule ensures that c (now recognised as the firm’s Cost of Capital) will remain constant when a new investment is undertaken. However, representing the Cost of Capital as a weighted average can be somewhat misleading as far as the financing of intramarginal investments is concerned. Given management’s intention of maintaining a constant MVWACC, the general requirement that debt must increase in the same proportion as Q obviously implies a greater amount of new debt in the case of a project with a higher value of r. Generalising the financing rule stated in (xvii) for any investment j yields b j = r ¯ j B Q ¯ (xxii) For a marginally acceptable investment (r j = r *), bj will be equal to B/V; but when r j > r * it is essential that b j > B/V by an equal proportion if the firm’s MVWACC is to be held at its original level. The advantages of ensuring that this occurs are most obvious when numerous projects are being considered; if the firm’s Cost of Capital were to change with each project selected, the problems of choice would be needlessly complicated. Besides, investments undertaken in the past are effectively revalued if the firm’s Cost of Capital changes; and firms will be anxious to avoid a situation in which the reasoning behind current accept-or-reject decisions may be undermined by avoidable changes in the Cost of Capital in the future...
