Cost of Capital

Cost of Capital The cost of capital refers to the cost incurred by a company to acquire finance, i.e. both debt and equity. From an investor’s perspective, it is the required return on all the company’s assets (Sharpe 367).Advertising We will write a custom assessment sample on Cost of Capital specifically for you for only $16.05 $11/page Learn More The cost of capital is used to assess the acceptability of projects since it is the least return that shareholders expect to receive in order to provide capital to a company. Calculating the Cost of Capital A firm’s overall cost of capital comprises of the cost of debt and the cost of equity. The cost of debt is easier to calculate than the cost of equity, reason being that its calculation is based on interest payments to investors (Pearl 290). In contrast, equity investors do not receive fixed payments, making determination of the cost of equity more difficult. Determining the Cost of Debt To calculate the cost of debt, one has to first establish the interest rate being paid on a risk-free bond e.g. Treasury bill, with the same maturity as the company’s debt. A default premium is then added to this risk-free rate to determine the cost of debt (Yee 454). The cost of debt is determined as an after tax cost as most interest payments on corporate debt are tax deductible. The precise formula for calculating the cost of debt is as follows: Kd = (Rf + credit risk rate) (1-T) Where,Advertising Looking for assessment on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More Kd = Cost of debt Rf = Risk-free rate T= Corporate tax rate Calculating the Cost of Equity The cost of equity is determined using the following formula: Ke = Rf + ÃŽ ²s (Rm – Rf) Where, Ke = Cost of equityAdvertising We will write a custom assessment sample on Cost of Capital specifically for you for only $16.05 $11/page Learn M ore ÃŽ ²s = Company’s beta Rm = Return on market portfolio The company’s beta indicates the sensitivity of returns on the firm’s security to changes in returns on the market portfolio, which refers the portfolio of all securities available in the stock market (Modigliani 261). Moreover, return on the market portfolio refers to the average historical return on the whole set of securities existing in a stock market, over a given time-period. The overall Cost of Capital The total cost of capital is the weighted average of the cost of debt and the cost of equity. This can be expressed as follows: Ko = Wd Kd + We Ke Where, Ko = Total cost of capitalAdvertising Looking for assessment on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More Wd = proportion of debt in a firm’s capital structure We = Proportion of equity in a firm’s capital structure. The Effect of Market Interest Rates and Perceived Market Risk on the Cost of Capital When the market interest rates are high, the cost of capital will also be high since high interest rates point out to higher required rate of return by investors. The converse is true. Similarly, increase in perceived marked risk leads to higher cost of capital as investor raise the required rate of return to take care of the increase in the default risk of companies (Sharpe 370). The opposite situation is true as lower perceived market risk leads to lower cost of capital. Market risk refers to systematic or economy-wide risk that cannot be diversified, for instance, recession. Market risk is measured based on the historical returns on the market portfolio. Standard Deviation and Coefficient of Variation The standard deviation measures the dispersion between returns on a compa ny’s security and the returns on the market portfolio. It is used to indicate the level of risk on a security (Sharpe 326). The Coefficient of variation, on the other hand, indicates dispersion between a security and market portfolio returns in a standardized manner, i.e. instead of showing the average standard deviation, it is expressed as a ratio of standard deviation to the average returns on a stock. This measure is very useful when comparing the risks of various stocks (Sharpe 330). My Opinion on Abel Athletics’ Current Cost of Capital If what the CFO says regarding Treasury raising debt at 7 percent is true, the company’s cost of capital must be above this figure. Therefore, the 6 per cent cost of capital as claimed is erroneous. Modigliani, Franco. The Cost of Capital, Corporation Finance and the Theory of Investment. New Jersey: Prentice Hall, 1998. Print Pearl, Joseph. Investment Banking: Valuation, Leveraged Buyouts, and Mergers Acquisitions. Hoboken , NJ: John Wiley Sons, 2009. Print Sharpe, William. Investments. New Delhi: Pearson Education Publishers, 2010. Print Yee, Kenton. Aggregation, Dividend Irrelevancy, and Earnings-Value Relations. New York: Addison-Wesley, 2000. Print