Cost of Capital

November 23, 2010Capital Investmentby EconomyWatch

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Cost of capital is the minimal return that investors intend to earn on their investments. For shareholders,the cost of capital is the dividend and capital gains on the share value, while for bondholders it is the interest rate quoted on a bond.

While investing, it is essential to consider the opportunity cost of the invested capital, as it represents the return that isforegone by investors by choosing an alternative investment opportunity that has similar or comparable risk. So, this factor maybe considered while calculating the cost of capital.

Calculating Cost of Capital

There are two ways to calculate the cost of capital:

Weighted Average Cost of Capital (WACC)- This is the minimum return that a company must realize from an existing asset base inorder to fulfill the needs of its creditors, owners and investors. Weighted average cost of capital (WACC) for the invested capital contains equal proportions of equity and debt, which is calculated as:

WACC = (E/F) Re + (D/F) Rb (1-tc)

Where Total capital invested (F) = D + E

and,

Re = Expected rate of return on equity or cost of equity (%)

Rb = Expected rate of return on borrowings or cost of debt (%)

tC = Corporate tax rate (%)

D = Current value of the firm’s total debt and leases

E = Total market value of equity and equity equivalents

However, if a part of the capital comprises of a preferred stock or an asset with a different cost of invested equity, then the formula may be modified as follows:

WACC = Wd (1-T) Rd + We Re

Wd = Debt portion of value

T = Tax rate

Rd = Cost of debt (rate)

We = Equity portion of the total value of a firm

Re = Rate (Cost) of internal equity

Capital Asset Pricing Model (CAPM) – This model states that investors must be compensated for the risks associated with aninvestment and time value of money. So, the CAPM calculates the expected return from a security (Es) as follows:

Es = Rf + ßs (Rm-Rf)

Where:

Rf = Expected risk-free return from the security

ßs = Sensitivity of the security to market risk

Rm = Historical returns from financial markets

(Rm-Rf) = Risk premium of market assets over risk-free assets

Investors are advised to refrain from investing when the expected return falls short of the required return.

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