Question

1) Explain with examples how the cost of capital is determined

Answer 1

Cost of capital is expected return on capital invested from new project. It shows the minimum rate of return required to earn in the business for smooth operating and without hurdle of loss. If expected return of investors is higher than cost of capital then it is beneficial for the business and it shows that cost of finance is lower and income can be generated in foreseeable future. There are main two means finance for any business, first equity & second debt. A company's overall cost of capital is a mixture of returns needed to compensate all creditors and stockholders. This is often called the weighted average cost of capital (WACC) and refers to the weighted average costs of the company's debt and equity.

The weighted average cost of capital is the weighted average of costs of various sources of finance.

WACC = Ke [E/V] + Kd (1 – T) [D/V] + Kp [PS/V]

Where,

Ke = cost of equity,

Kd = pre-tax cost of debt,

Kp = cost of preferred stock, and

T = tax rate.

E, D, and PS are the amounts of equity, debt, and preferred stock in the capital structure.

V = Market value of all securities (E + D + PS)

Cost of Debt

As an organization, one of the options for sourcing capital is to pursue debt. This can either be through taking out a loan or putting selling corporate bonds. These options tend to have lower interest rates, and long payback periods. Debt is paid back first in the case of bankruptcy, lowering it’s risk as an investment (and subsequently, lowering it’s return). The cost of this capital is calculated as:

Kd=(Rf+credit risk rate)(1−T)

Rf is the risk-free rate and T is the corporate rate. Tax is included in debt as debt is discounted as a deductible expense.

Cost of Equity

Equity, usually represented as shares of stock, is another option for borrowing (and investing) at the organizational level. Equity’s cost is calculated via the capital asset pricing model (CAPM), as follows:

Es=Rf+βs(Rm−Rf)

The variables above are:

• Es is the expected return for a security
• Rf is the expected risk-free rate
• βs is the sensitivity to market risk
• Rm is the historical return of the market
• (Rm – Rf) is the risk premium compared to the risk-free rate

Note that the weights used in WACC calculation are target, market value weights and not book value weights. Market value reflects the value of the firm better than the book value. Book value reflects the historical value of assets in place whereas market value reflects the value of both assets in place and present value of future growth opportunities. Moreover, securities are issued at market values and not book values.

Further, the proportions are the target proportions the company intends to maintain. The concept of target capital structure will be taken up later. The weighted average cost of capital is the hurdle rate to be applied to projects that have similar risk characteristics (and financing) as the firm. That is, investments should earn the hurdle rate to meet investors’ expectations. Otherwise investors will be worse off.

Suppose:
Debt to Total Capital			35.0%
Common stock to Total Capital			40.0%
Preferred Stock			25.0%
Interest on debt			7.0%
Cost of common stock			19.4%
Preferred stock dividend			8.0%
Corporate Tax Rate			38.0%
Weighted average cost of Capital = Debt * Interest * (1-t) + Preferred stock * dividend + Common stock * Cost of Common stock
Weighted average cost of Capital = (0.35*0.07*(1-0.38))+(0.40*0.194)+(0.25*0.08)
Weighted average cost of Capital = 11.3%