Cost of capital

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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 is "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
• Example
• Cost of debt
• Cost of equity
• Expected return
• Comments
• Weighted average cost of capital
• Factors that can affect cost of capital
• Capital structure
• Current dividend policy
• Financial and investment decisions
• Current income tax rates
• Interest rates
• Accounting information
• Breakpoint of marginal cost of capital
• 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 or cost of capital is a firm's cost of raising funds. 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 the firm.

Example

Suppose a company considers taking on a project or investment of some kind, for example installing a new piece of machinery in one of their factories. Installing this new machinery will cost money; paying the technicians to install the machinery, transporting the machinery, buying the parts and so on. This new machinery is also expected to generate new profit (otherwise, assuming the company is interested in profit, the company would not consider the project in the first place). So the company will finance the project with two broad categories of finance: issuing debt, by taking out a loan or other debt instrument such as a bond; and issuing equity, usually by issuing new shares.

The new debt-holders and shareholders who have decided to invest in the company to fund this new machinery will expect a return on their investment: debt-holders require interest payments and shareholders require dividends (or capital gain from selling the shares after their value increases). The idea is that some of the profit generated by this new project will be used to repay the debt and satisfy the new shareholders.

Suppose that one of the sources of finance for this new project was a bond (issued at par value) of $200,000 with an interest rate of 5%. This means that the company would issue the bond to some willing investor, who would give the $200,000 to the company which it could then use, for a specified period of time (the term of the bond) to finance its project. The company would also make regular payments to the investor of 5% of the original amount they invested ($10,000), at a yearly or monthly rate depending on the specifics of the bond (these are called coupon payments). At the end of the lifetime of the bond (when the bond matures), the company would return the $200,000 they borrowed.

Suppose the bond had a lifetime of ten years and coupon payments were made yearly. This means that the investor would receive $10,000 every year for ten years, and then finally their $200,000 back at the end of the ten years. From the investor's point of view, their investment of $200,000 would be regained at the end of the ten years (entailing zero gain or loss), but they would have also gained from the coupon payments; the $10,000 per year for ten years would amount to a net gain of $100,000 to the investor. This is the amount that compensates the investor for taking the risk of investing in the company (since, if it happens that the project fails completely and the company goes bankrupt, there is a chance that the investor does not get their money back).

This net gain of $100,000 was paid by the company to the investor as a reward for investing their money in the company. In essence, this is how much the company paid to borrow $200,000. It was the cost of raising $200,000 of new capital. So to raise $200,000 the company had to pay $100,000 out of their profits; thus we say that the cost of debt in this case was 50%.

Theoretically, if the company were to raise further capital by issuing more of the same bonds, the new investors would also expect a 50% return on their investment (although in practice the required return varies depending on the size of the investment, the lifetime of the loan, the risk of the project and so on).

The cost of equity follows the same principle: the investors expect a certain return from their investment, and the company must pay this amount in order for the investors to be willing to invest in the company. (Although the cost of equity is calculated differently since dividends, unlike interest payments, are not necessarily a fixed payment or a legal requirement.)

Cost of debt

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

${\displaystyle K_{D}=(R_{f}+{\text{credit risk rate}})(1-T)}$,

where ${\displaystyle T}$ is the corporate tax rate and ${\displaystyle R_{f}}$ 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

${\displaystyle E_{s}=R_{f}+\beta _{s}(R_{m}-R_{f})}$

where:

E_s is the expected return for a security;

R_f is the expected risk-free return in that market (government bond yield);

β_s is the sensitivity to market risk for the security;

R_m is the historical return of the stock market; and

(R_m – R_f) 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.

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 ^{[ citation needed ]} if the company is not listed. The Adjusted Present Value method (APV) is much easier to use in this case as it separates the value of the project from the value of its financing program.

Factors that can affect cost of capital

Below are a list of factors that might affect the cost of capital. ^{[5] [6]}

Current dividend policy

Modigliani–Miller theorem

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

See also

• Ordinary share
• Preference share

Related Research Articles

Cash flow, in general, refers to payments made into or out of a business, project, or financial product. It can also refer more specifically to a real or virtual movement of money.

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management. The WACC 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.

The Modigliani–Miller theorem is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the enterprise value of a firm is unaffected by how that firm is financed. This is not to be confused with the value of the equity of the firm. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing shares or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

In finance, a convertible bond, convertible note, or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.

In finance, valuation is the process of determining the value of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.

Adjusted present value (APV) is a valuation method introduced in 1974 by Stewart Myers. The idea is to value the project as if it were all equity financed ("unleveraged"), and to then add the present value of the tax shield of debt – and other side effects.

Preferred stock is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.

Stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value. A target price is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings.

In financial accounting, free cash flow (FCF) or free cash flow to firm (FCFF) is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets. It is that portion of cash flow that can be extracted from a company and distributed to creditors and securities holders without causing issues in its operations. As such, it is an indicator of a company's financial flexibility and is of interest to holders of the company's equity, debt, preferred stock and convertible securities, as well as potential lenders and investors.

In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt, and preferred stock, and is detailed in the company's balance sheet. The larger the debt component is in relation to the other sources of capital, the greater financial leverage the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible.

Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.

In finance, the cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.

Valuation using discounted cash flows is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach".

The following outline is provided as an overview of and topical guide to finance:

In the theory of capital structure, internal financing or self-financing is using its profits or assets of a company or organization as a source of capital to fund a new project or investment. Internal sources of finance contrast with external sources of finance. The main difference between the two is that internal financing refers to the business generating funds from activities and assets that already exist in the company whereas external financing requires the involvement of a third party. Internal financing is generally thought to be less expensive for the firm than external financing because the firm does not have to incur transaction costs to obtain it, nor does it have to pay the taxes associated with paying dividends. Many economists debate whether the availability of internal financing is an important determinant of firm investment or not. A related controversy is whether the fact that internal financing is empirically correlated with investment implies firms are credit constrained and therefore depend on internal financing for investment. Studies show that the availability of funds within a company is a major driver for investment decisions. However, the success and growth of a company is almost entirely dependant on the financial management and the use of internal financing does not explicitly mean success or growth for the firm. The financial manager can use a range of sources including but not limited to retained earnings, the sale of assets, and the reduction and control of working capital to drive expansion and better utilise funds. The availability of internal finance does not have a massive effect on firm growth.

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are publicly listed, the market price of the shares is used in certain financial ratios.

In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.

Dividend policy, in financial management and corporate finance, is concerned with the policies regarding dividends; more specifically paying a cash dividend in the present, as opposed to, presumably, paying an increased dividend at a later stage. The considerations, in outline, are as follows. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit and influenced by the company's long-term earning power: when cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program. Practical issues and competing theories are discussed below. For an overview, see Corporate finance § Dividend policy.

Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.

References

Further reading

• Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review . 48 (3): 261–297. JSTOR   1809766.
• Rosenbaum, Joshua; Joshua Pearl (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John Wiley & Sons. ISBN   978-0-470-44220-3.
• 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. S2CID   154429249. SSRN   667781.