Business
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.
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9 Key excerpts on "Cost of Capital"
eBook - ePubIslamic 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.
eBook - ePubCorporate Finance
A Practical Approach
- Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
- 2012(Publication Date)
- Wiley(Publisher)
Cost of Capital estimation is a challenging task. As we have already implied, the Cost of Capital is not observable but, rather, must be estimated. 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 CapitalThe 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
eBook - ePubFinancial Management
An Introduction
- Jim McMenamin(Author)
- 2002(Publication Date)
- Routledge(Publisher)
Clearly to stay in business and maintain its value a firm must earn a rate of return which at least matches, but preferably exceeds, its Cost of Capital. If the rate of return earned equals the Cost of Capital, then, in theory (assuming the firm's risk characteristics remain unchanged) the value of the firm will be maintained.Conversely, if the rate of return earned is greater than the Cost of Capital then in theory (again assuming the firm's risk characteristics remain unchanged) the value of the firm will be increased. A firm which earns a rate of return which is less than its Cost of Capital will erode its market value and find it difficult to attract investors.Thus we can define the Cost of Capital as the minimum rate of return a firm is required to earn on its investments in order to satisfy investors and to maintain its market value, in other words it is the investor's required rate of return.The key question is: how is this rate of return determined? The essential purpose of this chapter is to answer this question.How the Cost of Capital is determined
We can begin by briefly reviewing the sources of financing for the firm's long-term investment decisions. The firm's capital structure may be viewed as a pool of resources from which its investment projects are financed. Sometimes projects may be financed specifically from debt, such as long-term loans or debentures, or alternatively they may be financed by equity, perhaps in the form of a rights issue. On other occasions the exact source will be indeterminate as projects will be financed from the firm's overall pool of capital resources.
eBook - ePubThe Controller's Function
The Work of the Managerial Accountant
- Steven M. Bragg(Author)
- 2011(Publication Date)
- Wiley(Publisher)
- Preparing the appropriate reports on the status and changes in shareholders’ equity as required by agencies of the U.S. government, management, credit agreements, and other contracts
- Making the necessary analyses to assist in planning the most appropriate source (e.g., debt or equity) of new funds, and the timing and amount required of each
- Maintaining in proper and economical form the capital stock records of the individual shareholders. In a larger firm, a separate department or outside stock transfer agent might perform these functions
- Making the required analysis periodically on such matters as:
Cost of Capital- Dividend policy
- Dividend reinvestment plans
- Stock splits/dividends
- Stock repurchases
- Capital structure
- Trend and outlook for earnings per share
- Cost of Capital for the company and industry
- Tax legislation as it affects shareholders
- Price action of the market price of the stock, and influences on it
Before determining the amount of a company's Cost of Capital, it is necessary to determine its components. This section describes in detail how to arrive at the Cost of Capital for these components, as well as the weighted average calculation that brings together all the elements of the Cost of Capital.The first component of the Cost of Capital is debt . Debt is a company's commitment to return to a lender both the interest and principal on an initial or series of payments to the company by the lender. It can be short-term debt, which is typically paid back in full within one year, or long-term debt, which can be repaid over many years, with continual principal repayments, large repayments at set intervals, or a large payment when the entire debt is due, which is called a balloon payment. All these forms of repayment can be combined in an infinite number of ways to arrive at a repayment plan that is uniquely structured to fit the needs of the individual corporation.The second component of the Cost of Capital is preferred stock
eBook - ePub- Alastair Graham(Author)
- 2004(Publication Date)
- Routledge(Publisher)
3Funding Options
The choice between equity, debt and hybrid financial instruments is influenced by a variety of factors:In the previous chapter, it was suggested that management should make an estimate of the total external funding requirements over the business planning period, and categorize them into long-term, shorter-term and contingency funds. The next stage in the planning process is to decide, in broad terms, how much of the new funds should be raised in the form of equity, how much as debt, and whether hybrid financial instruments should be used for part of the funding.- the cost of each funding option (particularly the cost of equity and the cost of debt capital)
- stock market rating
- operational profits and cash flows
- leverage (financial leverage)
- the purpose for which the funds are required (nature and duration of the funded activities)
- availability
- recent funding measures
- control of the company
- individual preferences.
Cost of Capital
The Cost of Capital is the average return, over the long term, that investors expect to receive from their investment. It is therefore the average yield that companies should expect to pay. There is the cost of equity stocks, and a cost for each issue of debt capital and each bank loan. Each financial instrument has a different cost to the issuer, and the Cost of Capital can vary over time, as investor expectations change.To a company, the overall cost of its funds (debt, equity and hybrid instruments together) is the return its investors expect to receive in the long term, expressed as a percentage annual rate of return. This average cost of funds is commonly referred to as the company’s weighted average Cost of Capital. A company’s aim should be, if possible, to minimize its average cost of funds, and raise capital at the cheapest rate possible.
eBook - ePubInvestment Valuation
Tools and Techniques for Determining the Value of any Asset, University Edition
- Aswath Damodaran(Author)
- 2012(Publication Date)
- Wiley(Publisher)
Although equity is undoubtedly an important and indispensable ingredient of the financing mix for every business, it is but one ingredient. Most businesses finance some or much of their operations using debt or some security that is a combination of equity and debt. The costs of these sources of financing are generally very different from the cost of equity, and the cost of financing for a firm should reflect their costs as well, in proportion to their use in the financing mix. Intuitively, the Cost of Capital is the weighted average of the costs of the different components of financing—including debt, equity, and hybrid securities—used by a firm to fund its financial requirements. This section examines the process of estimating the cost of financing other than equity, and the weights for computing the Cost of Capital.Calculating the Cost of Debt The cost of debt measures the current cost to the firm of borrowing funds to finance projects. In general terms, it is determined by the following variables:- The riskless rate. As the riskless rate increases, the cost of debt for firms will also increase.
- The default risk (and associated default spread) of the company. As the default risk of a firm increases, the cost of borrowing money will also increase. Chapter 7 looked at how the default spread has varied across time and can vary across maturity.
- The tax advantage associated with debt. Since interest is tax deductible, the after-tax cost of debt is a function of the tax rate. The tax benefit that accrues from paying interest makes the after-tax cost of debt lower than the pretax cost. Furthermore, this benefit increases as the tax rate increases.
The simplest scenario for estimating the cost of debt occurs when a firm has long-term bonds outstanding that are widely traded. The market price of the bond in conjunction with its coupon and maturity can serve to compute a yield that is used as the cost of debt. For instance, this approach works for a firm that has dozens of outstanding bonds that are liquid and trade frequently.Some firms have bonds outstanding that do not trade on a regular basis. Since these firms are usually rated, we can estimate their costs of debt by using their ratings and associated default spreads. Thus, a firm with an A rating can be expected to have a cost of debt approximately 1.00 percent higher than the Treasury bond rate, since this is the spread typically paid by AA-rated firms.
eBook - ePubCorporate 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 Capital8.1 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
eBook - ePubLitigation Services Handbook
The Role of the Financial Expert
- Roman L. Weil, Daniel G. Lentz, Elizabeth A. Evans(Authors)
- 2017(Publication Date)
- Wiley(Publisher)
The appropriate Cost of Capital for evaluating an investment (e.g., a company) is the required rate of return on the assets that make up the company. Only if the company finances its operations entirely with equity does this required return on assets equal the equity Cost of Capital. A weighted average Cost of Capital (WACC) reflects the returns required by the providers of different types of financing. The rate of return required on the assets themselves does not change. The return required by alternative sources of financing varies, however, according to the risk associated with each form of financing. The WACC formula will properly incorporate financing into the Cost of Capital calculation only if the mix of equity and debt reflects the company’s expected financing during the future investment time horizon.In addition, firms can deduct from taxable income the interest they pay on debt, but they cannot deduct dividends from taxable income. The tax benefit associated with debt financing reduces the cost of borrowing. The Cost of Capital used to discount after-tax cash flows should reflect this tax benefit when firms use debt in their capital structure. The WACC formula adjusted for tax effects follows, where t equals the firm’s marginal tax rate.39 The following formula reflects the basic WACC:where- RE =equity Cost of Capital,
- RD =debt Cost of Capital,
- E/V=ratio of equity financing to total financing,
- D/V=ratio of debt financing to total financing, and
- t=corporate tax rate.
This formula seems to imply that a firm can lower its Cost of Capital by increasing its leverage. This incorrect implication does not fully consider that leverage increases the cost of equity, which offsets the effect of the lower rate on debt. Increased leverage also increases the cost of debt.We can expand this formula to include additional components of a company’s financing, such as preferred shares. Exhibit 10-7
- (Author)
- 2019(Publication Date)
- Wiley(Publisher)
The reading is organized as follows: In Section 2 we introduce the capital structure decision and discuss the assumptions and theories that lead to alternative capital structures. In Section 3 we present important practical issues for the analyst, such as the role of debt ratings in the capital structure decision and international differences in capital structure policies. The final section summarizes the reading.2 . The Capital Structure Decision
A company’s capital structure is the mix of debt and equity the company uses to finance its business. The goal of a company’s capital structure decision is to determine the financial leverage or capital structure that maximizes the value of the company by minimizing the weighted average Cost of Capital. The weighted average Cost of Capital (WACC) is given by the weighted average of the marginal costs of financing for each type of financing used. For a company with both debt and equity in its capital structure for which interest expense is tax deductible at a rate t, the WACC, which we will denote rwacc isEquation (1)where rd is the before-tax marginal cost of debt, re is the marginal cost of equity, and t is the marginal tax rate.1 Variables D and E denote the market value of the shareholders’ outstanding debt and equity, respectively, and the value of the company is given by V = D + E. You will notice that the debt and equity costs of capital and the tax rate are all understood to be “marginal” rates. The overall Cost of Capital is therefore a marginal cost also: what it costs the company to raise additional capital using the specified mixture of debt and equity. Further, this is the current cost: what it would cost the company today. What it cost in the past is not relevant. Therefore, the cost of equity, the cost of debt, and the tax rate that we use throughout the remainder of this reading are marginal: the cost or tax rate for additional capital.In the following section, we first consider the theoretical relationship between leverage and a company’s value. We then examine the practical relationship between leverage and company value in equal depth.2.1
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