Question

Explain how the cost of capital (rate) is calculated and how it is used in capital budgeting decisions.

Answer 1

Calculation of cost of capital

•   Cost of capital is required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm's cost of debt and cost of equity blended together.
•   A firm cost of capital is typically calculated using weighted average cost of capital formula that considers the cost of both debt and equity capital.
•   Cost of debt is merely the interest rate paid by company on its debt. However, since interest expense is tax- deductible, the debt is calculated on an after tax basis as follows:
Cost of Debt = Interest expense/ Total debt * (- Companies marginal tax rate
•   Cost of equity is more calculated since rate of return demanded by equity investors is not as clearly defined as it is by lenders. The cost of equity is approximated by Capital asset pricing model as follows:
CAPM( cost of equity) = Risk free rate of return+ Beta ( market rate of return – risk free rate of return)
•   The firm's overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; it is cost equity is 10% and the after tax cost of debt is 7%.
Therefore, its WACC would be:
( .7×10%)+ ( .3×7%)
9.1%

Cost of Capital used in Capital budgeting decision:

•   Proper estimate of cost of capital important for a firm in taking capital budgeting decision. Cost of capital is the discount rate used in evaluating the desirability of the investment project. Estimation of cost of capital necessary in taking leasing decision.
•   In internal rate of return method, the project will accepted if it has a rate of return greater than cost of capital.Net present value of the expected future cash flow from the project, the cost of capital is used as the rate of discounting. Cost of capital acts as standard for allocating the firm's investible fund in most optimum manner.
•   For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital. There should be judicious mix of debt and equity in the capital structure of a firm so that the business does not to bear undue Financial risk.
•   Cost of capital may be used to calculate the cost of carrying investment in Receivables and to evaluate alternative policy regarding Receivables.
•   Cost of capital is significant factor in taking dividend decision. The dividend policy of the firm should be formulated according to nature of the firm whether is growth firm, normal firm, or declining firm.