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Encyclopedia > Cost of capital

The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). Firms finance their operations by three mechanisms: issuing stock (equity), issuing debt (borrowing from a bank is equivalent for this purpose) (those two are external financing), and reinvesting prior earnings (internal financing). Capital has a number of related meanings in economics, finance and accounting. ... In finance, the cost of equity is the minimum rate of return a firm must offer shareholders to compensate for waiting for their returns, and for bearing some risk. ... The cost of debt is the cost of borrowing money (usually denoted by Kd). ... Domestic credit to private sector in 2005 Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. ... This article does not cite any references or sources. ... This article does not cite any references or sources. ... “Banker” redirects here. ... In accounting, retained earnings refers to the portion of net income from a period which is retained by the corporation, rather than distributed to its owners. ...

Contents

Summary

Capital (money) used to fund a business should earn returns for the capital owner who risked their saved money. For an investment to be worthwhile the estimated return on capital must be greater than the cost of capital. Otherwise stated, the risk-adjusted return on capital (incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital. Return on capital, also known as Return On Invested Capital (ROIC) is defined as NOPLAT / Invested Capital usually expressed as a percentage. ...


The cost of debt is relatively simple to calculate, as it is composed of the interest paid (interest rate), including the cost of risk (the risk of default on the debt). In practice, the interest paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous. Exogenous (or exogeneous) (from the Greek words exo and gen, meaning outside and production) refers to an action or object coming from outside a system. ...


Cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments with similar risk profiles to determine the "market" cost of equity.


The cost of capital is often used as the discount rate, the rate at which projected cash flow will be discounted to give a present value or net present value. Discount rate as used in finance and economics is distinct from the discount rate described below; please refer to discounting and discounts. ... The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value of money, and other factors such as investment risk. ... It has been suggested that this article or section be merged with Discounted cash flow. ...


Cost of debt

The cost of debt is computed by taking the rate on a non-defaulting 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 the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. This is used for large corporations only. The cost of debt is the cost of borrowing money (usually denoted by Kd). ... A tax deduction or a tax-deductible expense, is an item which is subtracted from gross income in order to arrive at the taxable income. ... In finance, discounting is the process of finding the current value of an amount of cash at some future date, and along with compounding cash form the basis of time value of money calculations. ...


Cost of equity

Expected return

The expected return can be calculated as the "dividend capitalization model" which is (dividend per share / price per share) + growth rate of dividends. Which is the dividend yield + growth rate of dividends*dividend.. The dividend yield on a company stock is the companys annual dividend payments divided by its market cap, or the dividend per share divided by the price per share. ...


Capital asset pricing model

The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The expected return on equity according to the capital asset pricing model. The market risk is normally characterized by the β parameter. Thus, the investors would expect (or demand) to receive: An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data. ... An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data. ... The Beta coefficient, in terms of finance and investing, is a measure of a stock (or portfolio)’s volatility in relation to the rest of the market. ...


E_s = R_f + beta_s(R_m - R_f).,


Where:

Es
The expected return for a security
Rf
The expected risk-free return in that market (government bond yield)
βs
The sensitivity to market risk for the security
RM
The historical return of the equity market
(RM-Rf)
The risk premium of market assets over risk free assets.

In writing: The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no risk. ... Market risk is the risk that the value of an investment will decrease due to moves in market factors. ... A stock market is a market for the trading of publicly held company stock and associated financial instruments (including stock options, convertibles and stock index futures). ... A risk premium is the minimum difference between the expected value of an uncertain bet that a person is willing to take and the certain value that he is indifferent to. ...

  • The expected return (%) = risk-free return (%) + sensitivity to market risk * (historical return (%) - risk-free return (%))
  • Put another way the expected rate of return (%) = the yield on the treasury note closest to the term of your project + the beta of your project or security * (the market risk premium)
  • the market risk premium has historically been between 3-5%

Comments

The models states that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk times the market risk premium. The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no risk. ... Market risk is the risk that the value of an investment will decrease due to moves in market factors. ...


The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. Government debt (public debt, national debt) is money owed by government, at any level (central government, federal government, national government, municipal government, local government, regional government). ...


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 Industrials have been 1.6% per year over the period 1910-2005 ([1]). The dividends have increased the total "real" return on average equity to the double, about 3.2%. A developed country is a country that has achieved (currently or historically) a high degree of industrialization, and which enjoys the higher standards of living which wealth and technology make possible. ... (19th century - 20th century - 21st century - more centuries) Decades: 1900s 1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s The 20th century lasted from 1901 to 2000 in the Gregorian calendar (often from (1900 to 1999 in common usage). ... In finance, a capital gain is profit that results from the appreciation of a capital asset over its purchase price. ... In finance, a capital gain is profit that is realized from the sale of an asset that was previously purchased at a lower price. ... The Dow Jones Industrial Average (DJIA) is one of several stock market indices created by Wall Street Journal editor and Dow Jones & Company founder Charles Dow. ...


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. Capital structure refers to the way a corporation finances itself through some combination of equity, debt or hybrid securities. ... Ex ante is a Latin term meaning beforehand. Ex ante evaluations deal with forecasting and forecasted returns on invested money. ... Ex ante is a Latin term meaning beforehand. Ex ante evaluations deal with forecasting and forecasted returns on invested money. ...


Note that retained earnings are a component of equity, and therefore the cost of retained earnings is equal to the cost of equity. 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. In accounting, retained earnings refers to the portion of net income from a period which is retained by the corporation, rather than distributed to its owners. ...


Weighted average cost of capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. The weighted average cost of capital (WACC) is used in finance to measure a firms cost of capital. ...


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. For other uses of the term Warrant, see Warrant (disambiguation) A warrant is a security that entitles the holder to buy or sell a certain additional quantity of an underlying security. ... In finance options are types of derivative contracts, including call options and put options, where the future payoffs to the buyer and seller of the contract are determined by the price of another security, such as a common stock. ... Market capitalization, or market cap, is a measurement of corporate or economic size equal to the stock price times the number of shares outstanding of a public company. ... The debt to equity ratio (D/E) is a financial ratio indicating the relative proportion of equity and debt used to finance a companys assets. ... In business and accounting, the shareholders equity refers to the amount of assets that are owned by a companys shareholders. ...


Formula

The cost of capital is then given as:


Kc= (1-δ)Ke+δKd


Where:

Kc
The weighted cost of capital for the firm
δ
The debt to capital ratio, D / (D + E)
Ke
The cost of equity
Kd
The after tax cost of debt
D
The market value of the firm's debt, including bank loans and leases
E
The market value of all equity (including warrants, options, and the equity portion of convertible securities)

In writing: The introduction to this article provides insufficient context for those unfamiliar with the subject matter. ... Please wikify (format) this article as suggested in the Guide to layout and the Manual of Style. ... In finance, the cost of equity is the minimum rate of return a firm must offer shareholders to compensate for waiting for their returns, and for bearing some risk. ... The cost of debt is the cost of borrowing money (usually denoted by Kd). ... This article or section should include material from [[{{{1}}}]]. Tenancy agreement A lease is a contract conveying from one person (the lessor) to another person (the lessee) the right to use and control some article of property for a specified period of time (the term), without conveying ownership, in exchange... A convertible security is a security (finance) that can be converted into another security, for example a bond that under certain terms can be converted into equity. ...

WACC = (1 - debt to capital ratio) * cost of equity + debt to capital ratio * cost of debt

Capital structure

Main article: 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 firms value can be maximized. Capital structure refers to the way a corporation finances itself through some combination of equity, debt or hybrid securities. ... Credit risk is the risk of loss due to a counterparty defaulting on a contract, or more generally the risk of loss due to some credit event. Traditionally this applied to bonds where debt holders were concerned that the counterparty to whom theyve made a loan might default on... An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. ... Capital structure refers to the way a corporation finances itself through some combination of equity, debt or hybrid securities. ...


The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin. Thomson Financials standard league tables are rankings of Investment Banks in terms of the dollar volume of deals they work on. ...


Modigliani-Miller theorem

Main article: Modigliani-Miller theorem

If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that the value of a leveraged firm and the value of a unleverage firm should be the same. (Their paper is foundational in modern corporate finance.) The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. ... The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. ...


References

  • F. Modigliani and M. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review (June 1958).

See also

An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data. ... The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. ... The weighted average cost of capital (WACC) is used in finance to measure a firms cost of capital. ... It has been suggested that this article or section be merged with Discounted cash flow. ...

External links

Definition

Articles

  • Dividend Irrelevancy and Price-Earning Ratios
  • TeachMeFinance.com - Cost of Capital
  • [R.D. Cohen papers and spreadsheets on M&M, WACC curve & optimal capital structure]

  Results from FactBites:
 
Cost of capital - Wikipedia, the free encyclopedia (1191 words)
The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision).
Similarly to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown.
The cost of equity is calculated as the "expected" return on equity during a past or future period (usually a year or annualized) based on interest rate levels and historical average equity market return.
[Islam-Online- Economy] (1073 words)
A profit maximizing firm will continue investing until the marginal productivity of capital becomes equal to the opportunity cost of capital; therefore, "cost of capital" in the Islamic system can be represented by the rate of return on alternate opportunities for investment of comparable risk.
The model implies that a firm's cost of capital (r) is a function of a firm's q ratio and the firm's market value (V), stream of expected future earnings (Y), ratio of retained earnings, and new stock financing.
For example, we are interested in finding the cost of capital for a firm with future expected earnings for next year (Y) of $1,000,000 and equity value of $10,000,000 (since there is no debt financing, value of the firm is equal to equity value).
  More results at FactBites »

 
 

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