Question

Explain how to estimate the cost of capital for a particular project, including the cost of debt and/or the cost of equity. What makes debt or equity a better choice for a given project--or is a blend always preferable? Explain your reasoning using an example

Answer 1

Cost of capital is estimated by apportioning the cost of equity as well as cost of debt and then assigning the respective weights according to their proportion in overall capital of capital.

The weights of both form of capital is then multiplied with their respective costs and then combined to arrive at cost of capital of a firm.

Cost of capital of firm =( Cost of equity + Cost of debts)

It is always to be remembered that interest payments which are paid to the debtholders or creditors are tax deductible in nature or secured with interest rate shield.

The estimation of both the cost is dependent upon the rate of payments associated with that form of capital. It also discounts the risk exposures of different form of capital.

Selection of whether choose for debt financing or equity financing is dependent upon different factors such as -

1.The risk exposures involved - If the project is highly risky, It is always better to opt for a lesser amount of debt financing as they involves with fixed rate of payment and a high level of credit risks.

2.The Level of control needed is very high and the company doesnot need any kind of interference from creditors , then it will go for equity financing and lesser amount of debt financing.

3.If the company wants a huge amount of financing , It will always be beneficial to opt for a blend of both the form of capital.

4.The company will always try to maintain the current business structure and it will try to follow the same structure like an equity oriented company which is debt free will opt for equity financing.

However it is always common and safer to have a blend of both the form of capital.