In
businessA business is a legally recognized organization designed to provide goods and/or services to consumers. Businesses are predominant in capitalist economies, most being privately owned and formed to earn profit that will increase the wealth of its owners and grow the business itself...
and
financeFinance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money and risk and how they are interrelated...
, the
cost of capitalIn economics, capital or capital goods or real capital are factors of production used to create goods or services that are not themselves significantly consumed in the production process. Capital goods may be acquired with money or financial capital...
is the cost of obtaining funds for, or, conversely, the required return necessary to meet its cost of financing a capital budgeting project. Said another way, it is "the minimum return that a company should make on its own investments, to earn the cash flow out of which investors can be paid their return." Cost of capital encompasses the two fundamental sources of financing: the
cost of debtDebt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned...
(including bonds and loans) and the
cost of equityEquity is the name given to the set of legal principles, in jurisdictions following the English common law tradition, which supplement strict rules of law where their application would operate harshly...
.
Summary
Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected
return on capitalReturn on capital Estimated by dividing the after-tax operating income by the book value of invested capital.-Formula:*This differs from ROIC. Return on invested capital is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its...
must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.
The
cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component (
risk premiumA risk premium is the minimum difference a person requires to be willing to take an uncertain bet, between the expected value of the bet and the certain value that he is indifferent to....
), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or
credit ratingsIn investment, the bond credit rating assesses the credit worthiness of a corporation's debt issues. It is analogous to credit ratings for individuals and countries. The credit rating is a financial indicator to potential investors of debt securities such as bonds...
, the interest rate is largely
exogenousExogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
.
The
cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore
inferred by comparing the investment to other investments (comparables) with similar risk profiles to determine the "market" cost of equity.
The cost of capital is often used as the
discount rateThe discount rate is an interest rate a central bank charges depository institutions that borrow reserves from it.The term discount rate has two meanings:...
, the rate at which projected
cash flowCash flow refers to the movement of cash into or out of a business, a project, or a financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used*to determine a project's rate of return or value...
s will be discounted to give a
present valuePresent value is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
or
net present valueNet present value or net present worth is defined as the total present value of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects...
.
Cost of debt
The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this is used for large corporations only.
The formula can be written as
(Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate.
Expected return
The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which is
That equation is also seen as, Expected Return =
dividend yieldThe dividend yield or the dividend-price ratio on a company stock is the company's annual dividend payments divided by its market cap, or the dividend per share divided by the price per share. It is often expressed as a percentage. Its reciprocal is the Price/Dividend ratio.-Preferred share...
+ growth rate of dividends.
Capital asset pricing model
The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The expected return on equity according to the
capital asset pricing modelIn finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
. The market risk is normally characterized by the
β parameterIn finance, the beta of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole....
. Thus, the investors would expect (or demand) to receive:
Where:
- Es
- The expected return for a security
- Rf
- The expected risk-free return in that market (government bond yield)
- βs
- The sensitivity to market risk
Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:* Equity risk, the risk that stock prices will change....
for the security
- RM
- The historical return of the stock market/ equity market
- (RM-Rf)
- The risk premium
A risk premium is the minimum difference a person requires to be willing to take an uncertain bet, between the expected value of the bet and the certain value that he is indifferent to....
of market assets over risk free assets.
In writing:
- The expected return (%) = risk-free return (%) + sensitivity to market risk * (historical return (%) - risk-free return (%))
- Put another way the expected rate of return (%) = the yield on the treasury note closest to the term of your project + the beta of your project or security * (the market risk premium)
- the market risk premium has historically been between 3-5%
Comments
The models states that investors will expect a return that is the risk-free return plus the security's sensitivity to
market riskMarket risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:* Equity risk, the risk that stock prices will change....
times the market risk premium.
The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.
The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real
capital gainA capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
return has been about the same as annual real GDP growth. The capital gains on the
Dow Jones Industrial AverageThe Dow Jones Industrial Average also referred to as the Industrial Average, the Dow Jones, the Dow 30, or simply as the Dow; is one of several stock market indices, created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...
have been 1.6% per year over the period 1910-2005.
http://home.earthlink.net/~intelligentbear/com-dj-infl.htm The dividends have increased the total "real" return on average equity to the double, about 3.2%.
The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and
capital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
. This value cannot be known "ex ante" (beforehand), but can be estimated from
ex post (past) returns and past experience with similar firms.
Cost of Retained Earnings / Cost of Internal Equity
Note that
retained earningsIn accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation makes a loss, then that loss is retained and called variously retained losses, accumulated losses or...
are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism
Weighted average cost of capital
The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.
The total capital for a firm is the value of its equity (for a firm without outstanding
warrantIn finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is usually higher than the stock price at time of issue....
s and
optionsIn finance, an option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset on or before the option's expiration time, at an agreed price, the strike price. In return for granting the option, the seller collects a...
, this is the same as the company's
market capitalizationMarket capitalization/capitalisation is a measurement of the size of a business enterprise equal to the share price times the number of shares outstanding of a public company...
) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the
debt to equity ratioThe debt-to-equity ratio is a financial ratio indicating the relative proportion of equity and debt used to finance a company's assets. This ratio is also known as Risk, Gearing or Leverage. It is equal to total debt divided by shareholders' equity...
is the market value of all equity, not the shareholders' equity on the balance sheet.To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources:
Cost of Debt
Cost of Preference Capital
Cost of Equity Capital
Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.
Capital structure
Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the
interest rateAn interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower...
that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the
capital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
where the cost of capital is minimized so that the firm's value can be maximized.
The
Thomson Financial league tablesThomson Financial's standard league tables are rankings of Investment Banks in terms of the dollar volume of deals they work on. New standard league table sessions in compliance with 2004 league table criteria for Debt, Equity, Syndicated loan, Project Finance and M&A are currently available...
show that global debt issuance exceeds equity issuance with a 90 to 10 margin.
Modigliani-Miller theorem
If there were no tax advantages for issuing debt, and equity could be freely issued,
Miller and ModiglianiThe Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how...
showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same. Their paper is foundational in modern corporate finance.
External links