3 Cost of Capital

STRATEGIC FINANCIAL MANAGEMENT
COST OF CAPITAL
Topic # 3
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". 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.
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. 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.
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 cash
flows.
Important variables influencing a corporations cost of capital include the
following:
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Cost of Capital
1. General Economic Condition This factor determines the risk free

or riskless rate of return.
2. Marketability of Companys Securities As the marketability of a
security increases, investors required rate of return decrease,
lowering the corporations cost of capital
3. Operating and financial decisions made by management If
management accepts investment with high levels of risk increases.
Investor then require a higher rate of return, which causes a higher
cost of capital to the company.
4. Amount of financing being requested Requests for a larger
amounts of capital increase the firms cost of capital.
Weighted Average Cost of Capital
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 firms 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.
Companies raise money from a number of sources: common stock, preferred
stock, straight debt, convertible debt, exchangeable debt, warrants, options,
pension liabilities, executive stock options, governmental subsidies, and so on.
Different securities, which represent different sources of finance, are expected
to generate different returns. The WACC is calculated taking into account the
relative weights of each component of the capital structure. The more complex
the company's capital structure, the more laborious it is to calculate the
WACC.
Companies can use WACC to see if the investment projects available to them
are worthwhile to undertake.
Calculation
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Cost of Capital
In general, the WACC can be calculated with the following formula: [3]
where is the number of sources of capital (securities, types of liabilities); is

the required rate of return for security ; and
is the market value of all
outstanding securities .
In the case where the company is financed with only equity and debt, the
average cost of capital is computed as follows:
where D is the total debt, E is the total shareholders equity, Ke is the cost of
equity, and Kd is the cost of debt. The market values of debt and equity should
be used when computing the weights in the WACC formula.
Marginal Cost of Capital
In economics, marginal cost is the change in the total cost that arises when
the quantity produced is incremented by one unit, that is, it is the cost of
producing one more unit of a good. In general terms, marginal cost at each
level of production includes any additional costs required to produce the next
unit. For example, if producing additional vehicles requires building a new
factory, the marginal cost of the extra vehicles includes the cost of the new
factory. In practice, this analysis is segregated into short and long-run cases,
so that, over the longest run, all costs become marginal. At each level of
production and time period being considered, marginal costs include all costs
that vary with the level of production, whereas other costs that do not vary
with production are considered fixed.
The graph is plotted with Price, Cost and Revenue on the Y-axis and Quantity
on the X-axis.
If the good being produced is infinitely divisible, the size of a marginal cost will
change with volume; so a non-linear and non-proportional cost function
includes the following:
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Cost of Capital
variable terms dependent on volume,
constant terms independent on volume and occurring with the respective

lot size,
jump fix cost increase or decrease dependent on steps of volume

increase.
In practice the above definition of marginal cost as the change in total cost as a
result of an increase in output of one unit is inconsistent with the differential
definition of marginal cost for virtually all non-linear functions. This is as the
definition finds the tangent to the total cost curve at the point q which
assumes that costs increase at the same rate as they were at q. A new
definition may be useful for marginal unit cost (MUC) using the current
definition of the change in total cost as a result of an increase of one unit of
output defined as: TC(q+1)-TC(q) and re-defining marginal cost to be the change
in total as a result of an infinitesimally small increase in q which is consistent
with its use in economic literature and can be calculated differentially.
If the cost function is differentiable joining, the marginal cost is the cost of the
next unit produced referring to the basic volume.
If the cost function is not differentiable, the marginal cost can be expressed as
follows.
A number of other factors can affect marginal cost and its applicability to real
world problems. Some of these may be considered market failures. These may
include information asymmetries, the presence of negative or positive
externalities, transaction cost, price discrimination and others.
Investment Opportunity Schedule (IOS)
An investment opportunity schedule (IOS) is a chart or graph that relates the
internal rate of return on individual projects to cumulative capital spending. To
set up an investment opportunity schedule, the analyst first computes each
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Cost of Capital
projects internal rate of return (or modified internal rate of return). If mutually
exclusive projects are part of the analysis, only the highest ranked projects go
on to the next step.
After computing the individual modified internal rules of return (MIRR), the
projects are ranked from highest to lowest by MIRR, keeping a tally of
cumulative project spending
Investment opportunities schedule (IOS): A ranking of investment possibilities
from best (highest returns) to worst (lowest returns). The graph that plots
project IRRs in descending order against required total dollar investment.
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Cost of Capital

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STRATEGIC FINANCIAL MANAGEMENT

1. General Economic Condition This factor determines the risk free

where is the number of sources of capital (securities, types of liabilities); is

variable terms dependent on volume,

constant terms independent on volume and occurring with the respective

jump fix cost increase or decrease dependent on steps of volume

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