Karla News

Cost of Capital

Cost of Capital

 

Memorandum

TO: Managers and Finance Personnel

FROM: VP of Finance

DATE: September 12, 2011

SUBJECT: Cost of Capital

Introduction

Today we will be explaining a company’s cost of capital and how the cost of capital for a company is calculated. The marginal cost of capital will also be explained, as well as how the marginal cost of capital differs from the WACC (Weighted Average Cost of Capital). Finally, we will be discussing how the market rates of Superior Living’s perceived market risk can impact the cost of capital for the company.

Cost of Capital

A company’s cost of capital is defined as the initial cost of all money spent on a project. In other words, for Superior Living the cost of capital for the new production plant will be the required rate of return necessary to make the capital budgeting project worthwhile. In order for the project investment to be worthwhile for the company the capital return expected should be greater than the capital cost. With that being said, the cost of capital relevant to the capital budgeting project will include the cost of debt and the cost of equity for the company in initiating the project (Cost of Capital, n.d.).

Calculating Cost of Capital

Calculating the cost of debt for the project can be relatively easy to calculate, while calculating the cost of equity can be more challenging. The cost of debt capital for the project would be equal to the actual alleged interest charge in regards to the company’s debt. Adjustments would then be made for the income tax deductible regarding the operating cost incurred by the company. After the income tax fee is deducted from the debt capital this would capitulate on the long term debt growth and a marginal tax rate could be applied to come up with the capital debt calculation (Cost of Capital, n.d.). The cost of debt would be determined like this: cost of debt = Interest Rate on debt – 1 tax rate. In regards to calculating the cost of equity, the shareholders of equity will require a minimum rate of return which would be equivalent to the earnings from a stake free investment in addition to a profit for enduring the additional risk. With that being said, the cost of equity would be determined like this: cost of equity = risk free return rate + expected premium for risk. And finally, once the cost of debt and equity have been determined and blended then the WACC can be calculated, and a discounted rate for the projects projected cash flows can be applied (Evans, n.d.).

See also  Determining Your Federal Income Tax Filing Status

Marginal Cost of Capital and how it differs from WACC

The marginal cost of capital is basically the cost a company would have to incur if additional funds were needed to be raised to finance a project. It differs from the WACC in that it is the costs associated with the last dollar of capital raised for financing an investment. The marginal cost of capital would depend on the present cost of personal resources of capital a company has. With that being said, the marginal cost of capital will be displayed as a percentage and then it will be compared to the expected return rate required to be earned for the proposed project (“Marginal Cost of,” n.d.)

How market rates and market risk of a company impact cost of capital

The market rates can impact our cost of capital by increasing the interest rates of our liabilities owed. For instance, if Superior Living is perceived to our lenders as a high risk market our interest rates will be increased, and perhaps we will be declined any future loans due to the fact that we are alleged to be taking on much more debt than we can possibly payback. This is when we would be required to investigate the company’s cost of debt and/or equity in which the WACC would need to be estimated in regards to how much change would need to be applied. The cost of capital would then need to be calculated up to and after the change points (CTU Online, 2011).

Conclusion

The cost of capital is the rate of return that the company must achieve on the project in order for the project to be worth investing in. With that being said, the cost of one project may not be the same as another, and therefore a specific type of financing may need to be implied for a particular company when considering funding for a project. Furthermore, by looking at the marginal cost of capital the company can recognize which investments to accept and reject, and success can be achieved in our future endeavors (“Marginal Cost of,” n.d.).

See also  Comparison Between Real Option Valuation & Discounted Cash Flow Valuation

 

References

Cost of Capital. (n.d.). Retrieved from http://www.investopedia.com/terms/c/costofcapital.asp#axzz1XkRvKkll

CTU Online. (2011). Applied Managerial Finance. Phase 3 course materials [text]. Retrieved from https://campus.ctuonline.edu/pages/MainFrame.aspx?ContentFrame=/Home/Pages/Default.aspx

Evans, M. (n.d.). Online financial courses – The management of capital. Retrieved from http://en.coursgratuits.net/3/calculating-cost-of-capital.php

Marginal cost of capital business definition. Retrieved from http://business.yourdictionary.com/marginal-cost-of-capital