Defining cost of capital Assumptions Explicit and implicit cost Measurement of specific costs Various Models Book value and market value weights
Cost of capital is the minimum required rate of earning or the cut off rate for capital expenditure. It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return. Any investment which does not cover the firm’s cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth.)
Firms business and financial risks are unaffected by the acceptance and financing of projects. Firms financial structure is assumed to remain fixed.
The explicit cost of capital is associated with the raising of funds.. In other words, it is nothing but internal rate of return . In capital budgeting decision, investor will see which investment provides high internal rate of return but which company gets the money at high internal rate of return; it means that company is accepting money at high explicit cost of capital.
Implicit cost of capital is opportunity cost, if money is used one of best alternatives for effective use of resources. For example: I have Rs. 100,000, I can deposit it in bank and earn Rs.3500 as bank interest but I did not invested it in saving bank account and invested in the shares of XYZ company. So, my implicit cost of investment in shares will equal to the bank interest. This is not in money form because, it is not necessary that XYZ company give me my cost investment in shares. But, after thinking, I take the opportunity for getting best reward from investment, so I have taken this decision.
Interest expense is tax deductible. Therefore, when a company pays interest, the actual cost is less than the expense. After tax k d Before tax k d 1 t
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
If a firm uses both debt and equity financing, the cost of capital must include the cost of each, weighted to proportion of each (debt and equity) in the firm’s capital structure. Therefore, a firm’s overall cost of capital must reflect the required return on the firm’s assets as a whole Wd= percentage of debt to total capital Wp= percentage of preference share to total capital WACC wd kd wpkp w cs k cs
The weights that we use to calculate the WACC will obviously affect the result. Therefore, the obvious question is: “where do the weights come from?” There are two possibilities: Book-value weights Market-value weights
One potential source of these weights is the firm’s balance sheet, since it lists the total amount of long- term debt, preferred equity, and common equity. We can calculate the weights by simply determining the proportion that each source of capital is of the total capital.
The problem with book-value weights is that the book values are historical, not current, values The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate Calculation of market-value weights is very similar to the calculation of the book-value weights The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital