Cost of Equity Capital
Cost of equity capital refers to the return that a company is expected to generate for its shareholders. It represents the compensation demanded by investors for bearing the risk of owning a company's stock. This cost is used in financial valuation models to determine the required rate of return for equity investors.
8 Key excerpts on "Cost of Equity Capital"
eBook - ePubCorporate Finance
A Practical Approach
- Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
- 2012(Publication Date)
- Wiley(Publisher)
...Arriving at a cost of capital estimate requires a host of assumptions and estimates. Another challenge is that the cost of capital that is appropriately applied to a specific investment depends on the characteristics of that investment: The riskier the investment’s cash flows, the greater its cost of capital. In reality, a company must estimate project-specific costs of capital. What is often done, however, is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project. This chapter is organized as follows: In the next section, we introduce the cost of capital and its basic computation. Section 3 presents a selection of methods for estimating the costs of the various sources of capital, and Section 4 discusses issues an analyst faces in using the cost of capital. Section 5 summarizes the chapter. 2. COST OF CAPITAL The cost of capital is the rate of return that the suppliers of capital—bondholders and owners—require as compensation for their contribution of capital. Another way of looking at the cost of capital is that it is the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk. A company typically has several alternatives for raising capital, including issuing equity, debt, and instruments that share characteristics of debt and equity. Each source selected becomes a component of the company’s funding and has a cost (required rate of return) that may be called a component cost of capital. Because we are using the cost of capital in the evaluation of investment opportunities, we are dealing with a marginal cost—what it would cost to raise additional funds for the potential investment project...
eBook - ePub- Terence C.M. Tse(Author)
- 2017(Publication Date)
- Routledge(Publisher)
...Such additional rewards depend on how sensitive the company’s return is vis-à-vis the market return (β). The resulting CAPM is therefore the return that the investor needs to obtain in order to justify the extra risk of putting her money into ABC. From ABC’s perspective, this same required return represents the company’s cost of raising the capital from this shareholder – in short, the cost of equity. WACC An investment should only go ahead if the value it can create is higher than the amount of money put in. Put differently, an investment is only attractive when the return that it can provide exceeds the cost of the capital injected. Since a company can source capital from both lenders and shareholders, the cost of capital must reflect the mix of the debt and equity that it has taken on – hence the term WACC. As can be seen in the formula in Figure 9.1, WACC takes into account the respective percentages of debt and equity used by the company, as well as the cost of debt and the cost of equity. Whereas equity does not have tax benefits, a tax shield is applied to the debt portion of capital composition given that the interest is paid before taxes. The resulting WACC can then be used to discount FCF. 3) Working Capital The third concern of corporate finance, in addition to capital budgeting and capital structure, is (net) working capital. This refers to the cash that has to be tied up in order to get the business activities and day-to-day operations going. To run operations, a company often has to pay money “out of its own pocket”; for instance, it may have sold a good but it must wait to be paid (so cash is being tied up). The opposite can also happen: a company may receive its purchases up front but pay for them later. In this case, it holds onto its cash for a bit longer, which means that more cash is available for other business activities. Since using cash has a cost, managers should actively seek to lower the amount of cash needed for a business operation...
eBook - ePub- Kalpesh Ashar, Vibrant Publishers(Authors)
- 2022(Publication Date)
- Vibrant Publishers(Publisher)
...Chapter 3 Cost of Capital I n this chapter, we will look at various ways to finance an organization, and their respective costs. This information is useful in making key organizational decisions. The key learning objectives of this chapter are: ● Understand the cost of debt and equity ● Know the concept of WACC and how to calculate it Companies need to raise capital to conduct business. They use capital to invest in assets that help them generate sales. There are three basic ways using which companies borrow capital – debt, preferred stock, and common stock. Retained earnings is another source of capital, generally the largest for profitable companies. In the sections below, we describe the cost of raising money through each of these means and how a company calculates its total cost of capital. This information is used to make capital budgeting decisions for deciding which projects to undertake. 3.1 Cost of Debt (k d) Debt funding is a loan taken from another party, which requires a certain rate of interest to be paid at fixed intervals. For example, consider a company taking a $1 million loan from a bank at 10% with interest to be paid yearly. It would have to pay $100,000 interest before-tax cost of debt. However, companies are allowed to deduct the interest paid in their income statement. Hence, the after-tax cost of debt will be lower due to reduced tax burdens because of the interest payment. If, in the above example, the company has an effective tax rate of 40%, then the cost of debt would be: Cost of debt = 10% – Tax saving due to interest expense = 10% – (40% of 10%) = 6% The before-tax cost of debt is referred to as k d and the tax rate as T to give the cost of debt as: Cost of debt = k d (1 – T) It needs to be noted that the above cost of debt is assuming that the company is making profits. If it is running losses, then its effective tax rate would be zero, thereby making T = 0...
eBook - ePubMastering Corporate Finance Essentials
The Critical Quantitative Methods and Tools in Finance
- Stuart A. McCrary(Author)
- 2010(Publication Date)
- Wiley(Publisher)
...Instead, the returns should depend on short-term interest rates, the difference between short- and long-term rates, currency markets, inflation, and real economic growth. To use the APT or to add other risk factors, it is necessary to measure the sensitivity of stock returns to each of the identified factors. The result is a more complicated but potentially more accurate way to determine the required return on a stock. COST OF DEBT Some companies issue debt frequently. These companies can easily determine the cost of borrowed money. That cost should include underwriting fees and other charges. The cost of debt borrowing should also include the tax savings from the deduction of interest expense from taxable corporate income. In Chapter 1, Equations 1.28 and 1.29 used the after-tax cost of debt financing to determine present and future value. Companies that do not issue debt regularly may be able to determine their cost of debt from the pricing of their outstanding debt issues. For example, if a company had previously issued debt with a 5 percent coupon that now trades at a discount, the company’s current cost of debt would be above 5 percent. Equation 4.13 in the following chapter values such a bond when the required return had risen from 5 percent to 6 percent. The same pricing tools could be used to determine the appropriate interest rate for a company at any point in time. Some companies have not issued debt. If it is possible to identify one or more companies that are similar and that have issued debt, it may be possible to determine an appropriate cost of debt from these comparable companies. WEIGHTED AVERAGE COST OF CAPITAL Companies may finance their operations with a blend of debt and equity. A company considering a capital investment may choose to finance that particular project with cash on hand, new debt financing, or retained earnings (equity) or through a new stock offering...
eBook - ePub- Jerald E. Pinto(Author)
- 2020(Publication Date)
- Wiley(Publisher)
...The estimated regression equation is then used with the risk ratings for less developed markets to predict the required return for those markets. This model has been recommended by Morningstar (Ibbotson). 5. The Weighted Average Cost of Capital The overall required rate of return of a company’s suppliers of capital is usually referred to as the company’s cost of capital. The cost of capital is most commonly estimated using the company’s after-tax weighted average cost of capital, or weighted average cost of capital (WACC) for short: a weighted average of required rates of return for the component sources of capital. The cost of capital is relevant to equity valuation when an analyst takes an indirect, total firm value approach using a present value model. Using the cost of capital to discount expected future cash flows available to debt and equity, the total value of these claims is estimated. The balance of this value after subtracting the market value of debt is the estimate of the value of equity. In many jurisdictions, corporations may deduct net interest expense from income in calculating taxes owed, but they cannot deduct payments to shareholders, such as dividends. The following discussion reflects that base case. If the suppliers of capital are creditors and common stockholders, the expression for WACC is (14) where MVD and MVCE are the current market values of debt and (common) equity, not their book or accounting values. Dividing MVD or MVCE by the total market value of the firm, which is MVD + MVCE, gives the proportions of the company’s total capital from debt or equity, respectively. These weights will sum to 1.0. The expression for WACC multiplies the weights of debt and equity in the company’s financing by, respectively, the after-tax required rates of return for the company’s debt and equity under current market conditions. “After-tax,” it is important to note, refers to just corporate taxes in this discussion...
eBook - ePub- Alan J. Baker(Author)
- 2018(Publication Date)
- Routledge(Publisher)
...For firm x the cost of equity, k x * — the required level of expected return on equity investment — would be estimated as follows: k ¯ x * = r ¯ f + β x (R ¯ M − r ¯ f) (xx) in which r f and R M now represent, respectively, management’s estimates of the average future values of the risk-free interest rate and the rate of return on the market portfolio, and β x is the estimated beta coefficient for firm x. In two ways this represents a move towards the traditional approach to the cost of equity. First, the value of k x * is accepted as the cost of equity for firm x rather than for any single project, subject to the qualification that projects undertaken by the firm do not significantly affect its systematic risk, β x. Second, the cost of capital is seen as influenced by the average anticipated performance of the market over a lengthy period of time, in much the same way as the traditional cost of equity can be interpreted as the rate of return equity investors can expect to earn over the long term (Merrett and Sykes, 1963, pp. 72-4, and 1963a). The attempt to link the return on each project to the performance of the market portfolio in the ultra-short period (or succession of short periods) gives way to a much-diluted compromise version of a CAPM criterion. A more ambitious gap-bridging exercise is to try to narrow the differences between traditional and portfolio valuation models. We have referred earlier to such factors as transactions costs and bankruptcy costs as possible reasons for a firm’s equity being valued not only on the basis of its systematic or undiversiflable risk; and these qualifications to the pure CAPM represent something of a move towards the traditional position. The two views can be brought even closer together by a determined effort to ‘get behind’ the expected end-period value of a risky security in the portfolio valuation model, i.e. P 1 in equation (ii). It can be shown (Baker, 1978, pp...
eBook - ePub- Brümmer LM, Hall JH, Du Toit E(Authors)
- 2017(Publication Date)
- Van Schaik Publishers(Publisher)
...183 11 Valuation and the required rate of return Learning outcomes After studying this chapter, you should understand the principles of valuation be able to master the basic valuation formula be able to calculate the cost of capital be able to calculate the cost of owners’ equity be able to calculate the cost of preference share capital be able to calculate the cost of long-term debt capital understand the weighted average cost of capital know how to apply the weighted average cost of capital in developing an organisation’s capital structure. Introduction In Chapter 10, the terms “cost of capital” and “required rate of return” were used frequently. These two terms are often used interchangeably. In one sense, they mean virtually the same thing, yet they can mean different things, depending on the context in which they are being used. In this chapter, we shall briefly discuss these concepts because the cost of capital, especially the weighted average cost of capital (WACC), plays a role in determining the discount rate in the net present value (NPV) method. Provided enough information can be obtained from the financial statements of a prospective debtor or investment project (e.g. the purchase of shares in an organisation), the task of calculating the WACC should be relatively easy. Besides providing a suitable discount rate, the WACC can also indicate whether an organisation is operating profitably or not. This can be done by comparing the organisation’s current rate of return on investment (ROI) with its WACC. For an organisation to be profitable, its ROI must always be greater than its WACC. 184 Apart from the information already mentioned, the WACC also provides the means for developing an organisation’s capital structure. Refer to the quarter marked Q.1 in LJE Ltd’s Statement of Financial Position in Chapter 4. The capital structure is not a haphazard conglomeration of capital items, but a very carefully planned structure...
eBook - ePub- Vibrant Publishers, Kalpesh Ashar(Authors)
- 2019(Publication Date)
- Vibrant Publishers(Publisher)
...Cost of Capital Companies need to raise capital to conduct business. They use capital to invest in assets that help them generate sales. There are three basic ways using which companies borrow capital – debt, preferred stock, and common stock. Retained earnings is another source of capital, generally the largest for profitable companies. In the sections below we describe the cost of raising money through each of these means and how a company calculates its total cost of capital. This information is used to make capital budgeting decisions for deciding which projects to undertake. Cost of Debt (k a) Debt funding is a loan taken from another party that has a certain rate of interest to be paid at fixed intervals. For example, consider a company taking a $1 million loan from a bank at 10% with interest to be paid yearly. It would have to pay $100,000 interest before-tax cost of debt. However, companies are allowed to deduct the interest paid in their income statement. Hence, the after-tax cost of debt will be lower due to reduced tax burden because of the interest payment. If in the above example, the company has an effective tax rate of 40%, then the cost of debt would be as below: Cost of debt = 10% – Tax saving due to interest expense = 10% – (40% of 10%) = 6% The before-tax cost of debt is referred to as k d and the tax rate as T to give the cost of debt as: Cost of debt = k d (1 – T) It needs to be noted that the above cost of debt is assuming that the company is having profit. If it is running losses, then its effective tax rate would be zero, thereby making T = 0...
