3/29/2018 Cost of capital - Wikipedia

Cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or, from an
investor's point of view "the required rate of return on a portfolio company's existing securities".[1] It is used to evaluate
new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus
setting a benchmark that a new project has to meet.

Contents
Basic concept
Cost of debt
Cost of equity
Expected return
Comments
Cost of retained earnings/cost of internal equity

Weighted average cost of capital

Capital structure
Modigliani–Miller theorem
See also
References
Further reading

Basic concept
For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital. Given a
number of competing investment opportunities, investors are expected to put their capital to work in order to maximize
the return. In other words, the cost of capital is the rate of return that capital could be expected to earn in the best
alternative investment of equivalent risk; this is the opportunity cost of capital. If a project is of similar risk to a company's
average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation.
However, for projects outside the core business of the company, the current cost of capital may not be the appropriate
yardstick to use, as the risks of the businesses are not the same.[2]

A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the
cost of equity to determine a company's cost of capital. Importantly, both cost of debt and equity must be forward looking,
and reflect the expectations of risk and return in the future. This means, for instance, that the past cost of debt is not a
good indicator of the actual forward looking cost of debt.

Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital (WACC), can
be calculated. This WACC can then be used as a discount rate for a project's projected free cash flows to firm.

Cost of debt
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When companies borrow funds from outside lenders, the interest paid on these funds is called the cost of debt. The cost of
debt is computed by taking the rate on a risk-free bond whose duration matches the term structure of the corporate debt,
then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things
being equal, the risk rises as the cost of debt rises). Since in most cases debt expense is a deductible expense, the cost of
debt is computed on an after-tax basis to make it comparable with the cost of equity (earnings are taxed as well). Thus, for
profitable firms, debt is discounted by the tax rate. The formula can be written as

where is the corporate tax rate and is the risk free rate.

Cost of equity
The cost of equity is inferred by comparing the investment to other investments (comparable) with similar risk profiles. It
is commonly computed using the capital asset pricing model formula:

Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)

where Beta = sensitivity to movements in the relevant market. Thus in symbols we have

where:

Es is the expected return for a security;

Rf is the expected risk-free return in that market (government bond yield);
βs is the sensitivity to market risk for the security;
Rm is the historical return of the stock market; and
(Rm – Rf) is the risk premium of market assets over risk free assets.

The risk free rate is the yield on long term bonds in the particular market, such as government bonds.

An alternative to the estimation of the required return by the capital asset pricing model as above, is the use of the Fama–
French three-factor model.

Expected return
The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model",
which is

Comments
The models state that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk
(β) times the market risk premium.

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The risk premium varies over time and place, but in some developed countries during the twentieth century it has
averaged around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The
capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005.[3] The dividends
have increased the total "real" return on average equity to the double, about 3.2%.

The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and
capital structure. This value cannot be known "ex ante" (beforehand), but can be estimated from ex post (past) returns and
past experience with similar firms.

Cost of retained earnings/cost of internal equity

Note that retained earnings are a component of equity, and, therefore, the cost of retained earnings (internal equity) is
equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a
component of the return on capital to equity holders, and influence the cost of capital through that mechanism.

Cost of internal equity = [(next year's dividend per share/(current market price per share -
flotation costs)] + growth rate of dividends)]

Weighted average cost of capital

The weighted cost of capital (WACC) is used in finance to measure a firm's cost of capital. WACC is not dictated by
management. Rather, it represents the minimum return that a company must earn on an existing asset base to satisfy its
creditors, owners, and other providers of capital, or they will invest elsewhere.[4]

The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same
as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost
of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value
of all equity, not the shareholders' equity on the balance sheet. To calculate the firm's weighted cost of capital, we must
first calculate the costs of the individual financing sources: Cost of Debt, Cost of Preference Capital, and Cost of Equity
Cap.

Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.[5]

Capital structure
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for
profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will
be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest
rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this
increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well.
Management must identify the "optimal mix" of financing – the capital structure where the cost of capital is minimized so
that the firm's value can be maximized.

The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin.

The structure of capital should be determined considering the weighted average cost of capital.

Modigliani–Miller theorem

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If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that,
under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.

See also
Preference share
Ordinary share

References
1. Brealey, Myers, Allen. "Principles of Corporate Finance", McGraw Hill, Chapter 10
2. Fernandes, Nuno. 2014, Finance for Executives: A Practical Guide for Managers, p. 17.
3. Fred's Intelligent Bear Site (http://home.earthlink.net/~intelligentbear/com-dj-infl.htm)
4. Fernandes, Nuno. 2014, Finance for Executives: A Practical Guide for Managers, p. 32.
5. Business Valuation Glossary - WACC Calculation using an Iterative Procedure (http://www.valuadder.com/glossary/w
eighted-average-cost-capital.html)

Further reading
Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American
Economic Review. American Economic Association. 48 (3): 261–297. JSTOR 1809766 (https://www.jstor.org/stable/1
809766).
Rosenbaum, Joshua; Joshua Pearl (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers &
Acquisitions. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-44220-4.
Yee, Kenton K. (2000). "Aggregation, Dividend Irrelevancy, and Earnings-Value Relations". Contemporary Accounting
Research. 22 (2): 453–480. doi:10.1506/GEH4-WNJR-G58F-UM0U (https://doi.org/10.1506%2FGEH4-WNJR-G58F-
UM0U). SSRN 667781 (https://ssrn.com/abstract=667781)  .

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