StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

Explain a company's cost of capital and how it is calculated - Essay Example

Cite this document
Summary
The factors of production include labor, land, entrepreneurs and of course the capital. Capital is a necessary factor as it aids production be it in terms of real capital like tools, machineries and equipment or financial capital like the money. Companies can raise capitals by issuing stocks or bonds or making investments…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER91.4% of users find it useful
Explain a companys cost of capital and how it is calculated
Read Text Preview

Extract of sample "Explain a company's cost of capital and how it is calculated"

The factors of production include labor, land, entrepreneurs and of the capital. Capital is a necessary factor as it aids production be it in terms of real capital like tools, machineries and equipment or financial capital like the money. Companies can raise capitals by issuing stocks or bonds or making investments. Raising capitals is also considered as a form of investment because when you invest on something, you have to release a capital or you have to capitalize on your investment. But just like the other factors, capital has a cost.

This cost is equal to the marginal investor’s required return on the security in question (Brigham, Houston, & Clark, 2004). This means that since the investor provided the capital, there is a rate of return that would be demanded by them to compensate them for the time value of their money and the risk that they have to incur in investing. For this risk, cost of capital is sometimes called as hurdle rate. And for a project to be considered approved, it must earn more than its hurdle rate. The cost of capital determines how a company can raise money through issuing bonds, borrowing or both (Invetopedia.com, 2011).

Determining the cost of capital is important in capital budgeting, determination of a company’s Economic Value Added (EVA), deciding when to lease or purchase of assets and regulation of electric, gas and telephone companies. The cost of capital is specific to each particular type of capital that the company uses (Moneyterms.co.uk, 2011). It could be the cost of equity or the cost of debt or the combination of both. The cost of equity is the rate of return on equity required by a company implicitly estimated using valuation ratios.

The differences in the cost of equity is an important component of differences in the ratings at which different companies and sectors trade. The cost of capital of a security is for the valution of the securities. It is compared with the appropriate discount rate to apply to future cash flows that the security will pay. The Capital Asset Pricing Model(CAPM) and arbitrage pricing theory are considered as models of valuation. The cost of listed debt securities can be computed in a same manner to equities.

It is commonly done by comparing the yield spreads with other similar securities. Everytime the company raises additional capital, additional cost also is incurred. This is the marginal cost of capital. It varies according to the type of additional capital used (Investorwords.com, 2011). The capital raised by using unsecured debt will require a higher cost or interest rate than a debt with collateral like a secured bond. The higher rate is used to offset the risk. But there is an option for a company to calculate its cost of capital in a way that each category of capital is proportionately weighted.

It is by using the Weighted Average Cost of Capital or WACC. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm (Investopedia.com, 2011). Market rates and the company’s perceived market risk can affect its cost of capital.

Market rates are used to determine the proper discount rate to be used in calculating the present value of the cash flows. If interest rates in the economy rise, the cost of debt capital increases as the company have to pay bondholders a higher interest rate. This will also increase the cost of equity capital. The level of market risk also determines the level of returns that investors will require. They will automatically demand a higher return on riskier investments. So, a company raising a capital for a risky project will have a higher cost of capital than a company with safer projects.

Bibliography Brigham, E. F., Houston, J. F., & Clark, D. A. (2004). Fundamentals Of Financial Management. Florida: Thomson South-Western. Investopedia.com. (2011). Weighted Average Cost of Capital . Retrieved March 19, 2011, from Investopedia.com: http://www.investopedia.com/terms/w/wacc.asp Investorwords.com. (2011). Marginal Cost Of Capital. Retrieved March 19, 2011, from Investorwords.com: http://www.investorwords.com/6573/marginal_cost_of_capital.html#ixzz1GvQCYl8X Investopedia.com. (2011).

Cost of Capital. Retrieved March 19, 2011, from Investopedia.com: http://www.investopedia.com/terms/c/costofcapital.asp Moneyterms.co.uk. (2011). Cost of Capital. Retrieved March 19, 2011, from Moneyterms.co.uk: http://moneyterms.co.uk/cost-of-capital/

Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(“Explain a company's cost of capital and how it is calculated Essay”, n.d.)
Retrieved from https://studentshare.org/other/1412283-explain-a-company-s-cost-of-capital-and-how-it-is
(Explain a company'S Cost of Capital and How It Is Calculated Essay)
https://studentshare.org/other/1412283-explain-a-company-s-cost-of-capital-and-how-it-is.
“Explain a company'S Cost of Capital and How It Is Calculated Essay”, n.d. https://studentshare.org/other/1412283-explain-a-company-s-cost-of-capital-and-how-it-is.
  • Cited: 0 times

CHECK THESE SAMPLES OF Explain a company's cost of capital and how it is calculated

The Increase in the Value of a Specific Product

The comparison is mostly done in the form of ration and then it is calculated that what the current economic value of the company is.... Value added is used to calculate the progress in the overall company's performance and how it can be used to increase the gross profit of organization more with the passage of time1.... The second component refers to all the capital generated in the form of cash or other items, this capital is the result of all work force and all the investments that are exhausted in the work machinery for generate the capital for the profit of the company....
6 Pages (1500 words) Essay

To What Extent Are a Company's Annual Report and Accounts

To effectively do the business analysis value added system is used which is calculated by the market situation and path upon which the organization is working.... The value added calculation which is done to analyze a company's overall performance level is somewhat similar to the calculations done to determine the national accounts with respect to the whole economy.... The basic tool to do this job is value added framework of accounting which does not only helps in determining the performance level of the company under consideration but it also provides the accountants and financial professionals with a benchmark in the form of a calculated Value added for one company operating in the industry which is then used to analyze the performance of the overall industry....
5 Pages (1250 words) Essay

Capital Structure of CVS

Optimal capital structure refers to the balanced trade-off that minimizes the cost of capital while maximizing the stock price.... This means the after-tax returns of the company should exceed the cost of capital invested.... % Invested Capital = market capitalization = 262,500,000 (common stock * share price) EVA for CVS is: 7,875,000 EVA is dependent on return on invested capital as well as the cost of capital.... Higher ROIC and a lower cost of capital can increase EVA significantly....
2 Pages (500 words) Assignment

Numeric Example of Breakeven Point Analysis

The given project will attempt to discuss breakeven analysis in depth to understand how it is conducted, what are the factors that should be used while determining the breakeven point.... Breakeven analysis is one such vital tool that assists in understanding when the business will start generating profit, how much extra working capital should be arranged and how much money should be allocated for marketing and other vital activities.... Breakeven analysis is also necessary for new entrants to determine the total capital requirement for starting a business....
6 Pages (1500 words) Coursework

Capital Budgeting for a New Machine

Sunk cost is a sum of money which has already been spent and it is not recoverable.... Opportunity cost is a profit that is forgone by not investing in a particular opportunity.... The profit forgone from not choosing the other project is your opportunity cost (Shim & Siegel, 2008)....
7 Pages (1750 words) Coursework

What is The Cash Flows

It explains the management about the time during which investment will be recovered and how quick it could be utilized for another project.... It is also not possible to analyze the useful life of the asset and does not consider how much cash flow will be generated after payback period is achieved.... It is also mentioned that it ignores sunk cost and committed cost when applied (Atrill & McLaney, 2013)....
15 Pages (3750 words) Essay

Investment Appraisal and Management Control

Investment appraisal is an integral part of capital budgeting, and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training.... rdquo; (Business Dictionary, 2008) Investment Appraisal is basically concerned with the justification of capital expenditure.... nbsp;… Investment appraisal is assessing these income streams against the cost of investing....
14 Pages (3500 words) Report

Managing Financial Resources and Divisions

n the case of overtrading, companies run short of working capital and enter into a negative financial cycle.... This may affect a company's relations with suppliers.... nbsp;… Your responsibilities will mean you will need to oversee the management of the increased working capital needed to respond to the order and to contribute to the appraisals of new projects required to achieve the necessary expansion....
16 Pages (4000 words) Assignment
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us