Question

What is the appropriate cost of capital to use for valuing the total capital structure of a business with a complex capital structure?

Answer 1

A required return is the amount of profit which is expressed as a percentage of the investment that will be earned over a given period of time. This required rate of return will be equal to the cost of capital after some period of time, as the required rate from the investor will get converted into cost to the borrower. Therefore, cost of capital for a given investor will always be equal to its required return. However, things can become more complicated and complex when organizations fund new projects via a wide variety of stakeholders and sources. This is when the concept of weighted average cost of capital (WACC) takes place, as there can be more than one investor with different rates of return. So, the WACC will be the calculation which includes the percentage of the overall borrowed capital, contributed by each form of investment, whether debt or equity, and the respective required rates.

The equation of WACC will look like the following:

WACC= [D/(D+E)*Kd] + [E/(D+E)*Ke]

D= Value of Debt

E= Value of equity

Kd= Cost of debt

Ke= Cost of equity

For an investment to be worthwhile and efficient, the return on capital should be greater than the cost of capital. A company with complex structure includes securities which is a blend of both debt and equity, so both the cost of debt and the cost of equity must be calculated in order to determine a company’s cost of capital. The cost of each security gets multiplied by the percentage of total capital taken up by the particular security, with the help of WACC and then the results from each security included in the total capital of the company is summed up.