Free Summary of Cost of Capital Essay Sample
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The capital cost is the total cost of all the individual assets of a company. The cost of capital is very useful in financial management of a company since it is a key tool in measuring economic profit, making investment decisions and measuring business performance. The cost-of-capital theory has some reasonable confusion regarding its application. The estimated capital spending of U.S. corporations is more than $500 billions and difference in capital cost can result to a substantial change in the country’s expenditure. It is therefore very important to estimate the cost of capital for individual firms.
Different companies use different methods to estimate their capital cost according to a research done. The research was done to identify the uncertainties in the application of the cost-of-capital theory and set out a discussion and research on how to improve it. It also helped companies to compare themselves with other related companies as well as determining how companies estimate their capital cost. In addition, it also reveled how best capital cost can be estimated and how it used in by companies in decision making.
Many other researches have been done to determine how companies estimate their capital cost. For instance, in 1993, Bierman did a survey and found that 74% use some form of discounting in their capital budgeting and 93% of the companies use a weighed-average capital cost. Other methods used in the estimation of capital cost include; capital-asset pricing model (CAPM), internal rate of return and pay back period, time-adjustment capital budgeting techniques among others.
The weighted-average cost of capital (WACC) is a standard means of determining a company’s cost of capital. It is applied on the individual sources of capital used by the company.
WACC = (Wdebt(1 – t)Kdebt + (Wpreferred Kpreferred) + (Wequity Kequity)
K = Component cost of capital
W = weight of each component as percentage of total capital
t = marginal corporate tax rate
For this formula, only three sources of capital have been used but it can be expanded to accommodate other sources. In estimating a company’s WACC, many observations can be made using the finance theory. It estimates the current financial market condition of the firm and also the weight in the equation is the market weight but not historical weight. In addition, the cost of dept should be after corporate tax. The main challenge in using this method is in the estimation of equity capital.
Since the use WACC cannot accurately estimate cost of equity, most companies use Capital Asset Pricing Model (CAPM) to estimate cost of equity. Other companies use multi-factor asset-pricing models in calculating cost of equity. The CAPM states that, the required return (K) on any asset can be expressed as;
K = Rf + β(Rm –Rf)
Rf = interest rate available on a risk-free bond.
Rm= return required to attract investors to hold to the broad market portfolio of risk assets.
β = the relative risk of the particular asset.
When using CAPM, the cost of equity (Kequity) for a company is depended on three components which include; the Risk-Free Rate of Return (Rf), the stock’s equity beta (β) and the market risk premium (Rm –Rf). The stock’s equity beta is used to measure the risk of the company’s stock in relation to other risky assets. The market risk premium is used to attract company investors to hold risky assets other than risk free bonds.