COST OF CAPITAL
Cost of Capital Introduction Many firms are faced with the needs to assess different types of financial performances daily. ... A firm’s cost of capital serves as the linkage between its financing and investment decisions. The cost of capital is a decision criterion that is to be used by the management of the firm. ... An enterprise must be able to use the cost of capital to be able to determine whether a specific project will provide an economic benefit to the firm’s owners. The structure of our paper over the cost of capital is as follows. First, we will discuss the key concepts of the cost of capital such as the investment criterion, the net present value of an investment, and the risks involved with the cost of capital. Second, we will determine the individual sources of capital that include the cost of long term debt, the cost of preferred stock, and the cost of common equity. Third, we will analyze and exemplify the cost of capital using the risk free rate, the market risk premium, and the company beta. Finally, we will go over the cost of equity for an investment and then calculate the weighted average cost of capital. ... There are three tools to estimate a firm’s cost of equity capital, which are the risk free rate, the market risk premium, and the company beta. ... Investment Criterion Investment projects requiring capital expenditures tend to fall into three categories: new products, cost reduction, and replacement of existing assets. ... This is the project’s cost of capital. ... 405 Cost of Capital Cost of capital is the risk-adjusted discount rate to use in computing a project’s NPV. There are three important points to keep in mind when figuring out a project’s cost of capital: · The risk of a particular project may be different from the risk of the firm’s existing assets. · The cost of capital should reflect only the market-related risk of the project (its beta), · The risk that is relevant in computing a project’s cost of capital is the risk of the project’s cash flows and not the risk of the financing instruments (e. ... Consider a firm whose average cost of capital for its existing assets is 16% per year. ... However, in general, using the firm’s average cost of capital to evaluate specific new projects will not be correct. The second Point to keep in mind is that the risk that is relevant in computing a project’s cost of capital is the risk of the project’s cash flows and not the risk of the financing instruments used to fund the project. The third point to make about the project’s cost of capital is that it should reflect only the systematic or market-related risk of the project, not the project’s unsystematic risk. ... This rate of return considers the investor’s opportunity cost of making an investment; that is, when the investment is made, the investor must forgo the return available on the next best investment. This forgone return then is the opportunity cost of undertaking the investment and consequently, is the investor’s required rate of return. But the investor’s required rate of return is not the same as the cost of capital. ... The second thing that causes the firm’s cost of capital to differ from investor’s required rate of return is any transaction costs incurred when a firm raises funds by issuing a particular type of security, sometimes called flotation costs. The Costs of Individual Sources of Capital The major avenues of long-term financing available to the firm include debt, preferred stock, convertible securities, retained earnings, and new common stock. Methods for approximating the cost of each of these sources of capital will be explained and demonstrated. ... The Cost of Long Term Debt A firm incurs long-term debt by selling bonds to investors who desire to purchase fixed-income securities and retain the position of a creditor rather than an equity investor in the organization. ... The par value method If the net proceeds to the firm from selling one new bond are equal to the maturity value (or par value) of the bond, then the par value method is appropriate for approximating the cost of the debt issue. Therefore we can use the following formula: Kd = i(1-T) Where kd = cost of debt on an after tax basis i = interest rate or coupon rate T = firm’s marginal income tax rate For example, the Blackburn Corporation is going to sell a new issue of twenty-year bonds. ... What is the cost of this debt issue to the firm’s? According to the formula shown above, the cost of the debt issue to the Blackburn Corporation is: Kd = 8. ... 0 percent Therefore, the cost of this twenty-year is 4 percent. However, if the $1000 investment is to earn its cost of capital, it must generate $80 in before-tax income. ... Thus, an 8 percent before tax cost of debt is equivalent to a 4 percent after tax cost of debt when the firm’s marginal tax rate is 50 percent. Under these conditions the investment returning 4 percent after taxes will meet the 4 percent cost of the bond issue that financed it.