Instituto de Empresa

THE COST OF CAPITAL F02/228-I-M

TERMS AND EQUATIONS
Weighted Average Cost of Capital (WACC): This is the return investors (shareholders
and bankers) expect. The WACC takes into account the proportionate weight of the
equity and debt.
The way to calculate it is as follows:
WACC

( )
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=
E D
E
C
E D
D
t C
E D
1
C
D
= Cost of Debt
C
E
= Cost of Equity
D = Fraction or total amount of Debt
E = Fraction or total amount of Equity
t = Tax rate
Risk free rate: This is the return that investors can get by investing in the market in
investment funds or shares where there is a total guarantee of earning the interest
generated and of getting back the invested capital within the expected time intervals.
This is normally applied to the profitability of bonds and treasury bills.
Profitability Vs. Risk: The relationship existing between these two concepts is that the
greater the risk, the greater the return that shareholders can expect to receive since the
uncertainty of getting back the initial investment and its interest increases. In the same
way, if the risk is lower, then the expected return goes down.
Beta Coefficient (|): This is a factor that multiplies the Risk Premium or Market Risk
Rate. This quantifies the volatility of a specific share as compared to the profitability of a
diversified portfolio in which this share is included. This variable is obtained statistically
and normally available to whomever is interested in obtaining it.
In the financial world we distinguish between two different beta coefficients:
- The Leveraged Beta or Equity Beta: This gives both the operative and
financial risk.
- Unleveraged Beta or Asset Beta: This gives only the operating risk; which
means to say, the risk inherent to working with the company's assets in the
corresponding sector.
One way, of many, to relate these two risk factors is as follows.
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=
E
D
E
A
1
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*
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+ =
E
D
A E
1 | |
*
(
*
) There are authors who multiply the Debt to
Equity ratio (D/E) by the factor (1-t) in
these equations.
|
E
= Leveraged or Equity Beta Coefficient
|
A
= Unleveraged or Asset Beta Coefficient.
D = Fraction or total amount of Debt
E = Fraction or total amount of Equity
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Instituto de Empresa
THE COST OF CAPITAL F02/228-I-M

Operating Risk Vs. Financial Risk: Operating risk is that which is connected to the
activity that the company carries out and its assets, it is also known as business risk.
While Financial risk refers to the companys level of debt.
Risk Premium or Market Risk Rate: This is the rate of risk for investing in a diversified
portfolio of shares in the stock market. It is accepted that the market risk rate may be
around 6% in the case of the Spanish stock market. This figure is obtained by analysing
the historic data of this stock exchange.
Cost of Equity: This is the return expected by shareholders. It is calculated with the
following equation:
P E FR E
R R C u E
C
E
= Cost of Equity
R
FR
= Risk Free Rate
R
P
= Risk Premium or Market Risk Rate
E
E
= Leveraged Beta Coefficient or Equity Beta
Cost of Debt: This is the return expected by bankers or capital-lending agents. In order
to calculate the effective cost of debt you must multiply the cost of debt by factor (1-t), t
equals the tax rate, since there is a tax shield for the interests which must be taken into
account.
Growth Rate (g): This is the factor that is used in some cases when the dividends or
cash flow keep on growing at a constant rate. It represents a percentage or fraction of
the increase.
Net Present Value (NPV): This is one of the most accepted ways of evaluating the
viability of investments. It compares the initial investment of the project you wish to
make with the present value of the cash flow that is expected to be generated in the
project. It is obtained mathematically from the difference between these two values so
that you can decide if the investment being analysed is profitable or not.
IBEX 35: This is the stock market index composed of the thirty-five most liquid
companies on the Spanish Stock Exchange.
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