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Introduction of cost of capital

The concept of "cost of capital" is very important in financial management. It is weighted average cost of various sources of finance used by a firm may be in form of debentures, preference share capital, retained earning and equity share capital. A decision to invest in a particular project depend upon the cost of capital of the firm or the cut off rate which is minimum rate of return expected by the investors. When a firm is not able to achieve cut off rate, the market value of share will fall. In fact, cost of capital is minimum rate of return expected by its investors. Every firm have different types of goals or objectives such as profit maximization, cost minimization, wealth maximization and maximum market share. If a firm have main objective is wealth maximization then that firm earn a rate of return more than its cost of capital.
This chapter is devoted to the definition and application of the cost of capital concept to the valuation of cash flows from different points of view. We present an approach to estimate the cost of debt and general formulations for the cost of equity and the traditional weighted average cost of capital WACC, for the free cash flow, FCF and the non-traditional capital cash flow, CCF. We explain in detail the traditional textbook formula for the WACC with respect to the CCF and FCF. We demonstrate the solution of the circularity problem between the WACC and the value of the cash flow. At the end of the chapter we present some questions to encourage the reader to have further insights to the subject. Download Info An Introduction to the Cost of Capital Introduction To compare cash flows a firm has to define a cost of capital. This cost of capital will be used for discounting future cash flows to the present. We have to calculate the market value of the cash flow today and compare it with the amount invested. When we use the expression market value we understand it to refer to the present value of future cash flows discounted at the average cost of capital. It is a proxy for what the stock market estimate for the traded firms. Precisely, these techniques of discounted cash flow (DCF) based on cash flows and the cost of capital are utilized in

non traded firms that account for more than 99.5% of the firms in the world. This relationship between cash flows and cost of capital creates circularity: the cost of capital depends on value and value depends on cost of capital. The resources for the firm come from two sources: the owners of equity and the owners of financial debt. In this chapter we study each source of funds in terms of their cost and the combined cost known as Weighted Average Cost of Capital, WACC. Capital Markets Firms obtain financing resources or opportunities for investment of excess cash in the capital and money markets. A capital market is a place where investors and consumers of capital (generally companies or the government), raise long-term funds (longer than a year). Selling bonds and stocks are two ways to generate capital, thus bond markets and stock markets (such as the Dow Jones) are considered capital markets. The capital market is an effective and efficient mechanism for assigning and distributing the resources of capital in the process of transfering savings to investment (or the Circular Flow of Economic Activity). The borrowing and lending of short-term obligations such as Treasury bills, commercial papers and bankers' acceptances occur in the money market. Cost of Capital The cost the firm pays for the resources that it must obtain to make the investments is not so evident. Here it is necessary to consider not only what is paid in terms of interest on a financial debt, but also what the shareholders expect to earn. In any case, firms pay for the use of funds from third parties and that price is the cost of capital. Cost of Debt In this context we call debt the financial debt. Financial debt is a liability that has a contractual interest rate and has to be paid in some period of time. It is not just any liability, but the one expected to generate interest charges. Although in practice there is not a real distinction, we introduce a subtle but

theoretically relevant difference: the market cost of debt and the contractual cost of debt. Market cost of debt is the discount rate the market uses to determine the value of a bond. This is the Internal Rate of Return, IRR, obtained when the future cash flows for the bond are compared with the price today. Contractual cost of debt is the rate of interest that is effectively used to calculate the interest charges. This distinction is of utmost importance because the former, market cost of debt, is used to estimate the
An Introduction to the Cost of Capital: Ignacio Vlez-Pareja Joseph Tham

4 value of debt and the later is used to calculate the tax savings as discussed in VlezPareja and Tham (2010). There are other approaches to defining the market cost of debt: 1) To ask the lenders. 2) To estimate the grading of the firm issued by independent rating agencies such as Moodys, Fitch Investor Services or Standard and Poors and using the Merrill Lynch Bond Index usually reported in The Wall Street Journal. However, current practitioners and firms use the contractual cost of debt as a proxy to the market cost of debt. We assume in this chapter that the market cost of debt is identical to the contractual cost of debt. We also assume that the market value of debt is the book value of debt. As mentioned above, one usual approach for estimating the cost of debt is to calculate the IRR of the future Cash Flow to Debt, CFD. We have to remind that IRR is an average that hides components inside the cost of debt, such as inflation. The cost of debt could change from period to period not only due to the inflation rate but also due to the composition of the debt portfolio of the firm.

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Introduction to Cost of Capital


January 10th, 2011 Bryce DeGroot Capital is the lifeblood of business. To define the term broadly, capital is the resources available to a company. The return on investment required by investors is known as cost of capital. This cost is the annual cost of accessing capital. To say it in a different way, cost of capital is the rate of return that motivates investors to extend capital to a company. The scarcity of capital means that owners of capital require a return as compensation for the risk of the investment. In addition to risk, opportunity cost also influences cost of capital. Opportunity cost is the cost of passing up the next best alternative when making an investment. For example, if capital is used for one purpose, the opportunity cost is the value of the next best purpose the capital could have been used for. In any business, cost of capital applies to both shareholders (equity capital) and lenders (debt capital). Todays Private Capital Markets You may be wondering about current capital costs for private companies. To answer this question, we will look to the most comprehensive study of capital for private companies. In the chart following, you will see a sampling of data that we sourced from the Pepperdine Private Capital Markets Survey. The figures represent the annual cost of accessing a given type of capital. The full PCM Survey explores capital markets in exhaustive detail, and the chart below is only intended to provide a high-level framework for understanding costs of capital in today's market. The categories on the chart represent higher risk moving from left to right, which explains the higher cost of capital or required return.

The left half of the chart that represents the cost of debt capital, while the right half of the chart represents equity capital categories. Commercial bank financing, both cash flow and asset based, represents the lowest cost source of capital. This form of capital is low cost because commercial lenders are risk averse and the commercial lender holds a relatively strong position to compel a company to make debt payments.

Mezzanine debt is higher on the capital cost line and is characterized as higher risk debt that is not backed by collateral. Mezzanine debt is typically used when a company cannot access capital from traditional commercial lenders, and it may be convertible to shares of stock if the company defaults. Private Equity represents investment firms that invest in late-stage or mature private companies while Venture Capital firms invest in early stage companies. Angel investors invest seed capital in start up companies. Venture capital and angel investors require very high rates of return to reflect the elevated risk of early stage ventures. Bringing Cost of Capital Home to Main Street Many private business owners do not know their cost of capital. If you take a loan from you bank, then you will know the interest rate. But the cost of debt capital also includes the total cost of borrowing the money. The same principle exists for equity investments. It may not be as apparent as the interest charged on borrowing money; it is what the investor will require as return on investment. Even companies with a sole shareholder should consider equity cost of capital and how it compares with the market. A given company can be compared with return on equity experienced by other companies in the same industry. Every company should be familiar with the concepts of cost of capital to use in business investment decisions, as well as in considering acquisitions or divestitures. An investment should only be entered if its anticipated rate of return exceeds the companys cost of capital. In a future newsletter we will explore some practical ways to approach business decisions with cost of capital in mind. Cost of Capital In this course 1 Introduction 2 Estimating Future Cash Flow 3 Discounting and Discount Rates 4 Cost of Capital 5 Two Types of Capital, Two Costs 6 The Perpetuity Value

7 The Bottom Line

The rate we use to discount a company's future cash flows back to the present is known as the company's required return, or cost of capital. A company's cost of capital is exactly as its name implies. When a company raises capital from its lenders and owners, both types of investors require a return on their investment. Lenders expect to be paid interest on their loans, while owners expect a return, too. A stable, predictable company will have a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital. That means, all else equal, that the riskier company's future cash flows are worth less in present value terms, which is why stocks of stable companies often look more expensive on the surface. The cost of capital used in a DCF model can have a significant impact on the fair value, so it's important to pay attention to this estimated figure. The rate you would use to discount cash flows if using the "cash flow to the firm" method is actually a company's weighted average cost of capital, or WACC. A company's WACC accounts for both the firm's cost of equity and its cost of debt, weighted according to the proportions of equity and debt in the company's capital structure. Here's the basic formula for WACC: (Weight of Debt)(Cost of Debt) + (Weight of Equity)(Cost of Equity) For example, if the market value of a company's equity is $600 million and it has $400 million of debt on its balance sheet, then 60% of its capital is equity and 40% is debt. If the company's cost of equity is 10% and its cost of debt is 7%, then its WACC is: (60% x 10%) + (40% x 7%) = 8.8% Note: If using the "cash flow to the firm" DCF method, the WACC would be your discount rate. However, this method does not discount free cash flow. Rather, it discounts operating earnings before interest but after taxes. Arriving at this figure involves complicated adjustments for interest and taxes. To keep it simple, we will just use the "free cash flow to equity" method in our example in the next lesson.