Average weight cost of capital
It is the cost of capital of the existing projects. Existing projects are funded using existing funds hence the cost of the capital is the average of cost of all sources of funds used. The simplest formula of weighted average cost of capital can be as follows; WACC=Kd (l-t) (amount of debt used) Ke (amount of equity used) Total capital Total capital Where Kd –cost of debt Ke-cost of equity t-tax rate The cost of debt is the after tax cost because the interest on debt is tax deductible hence it is adjusted for tax.
The weighted average cost of capital is affected by the level of debt capital (gearing) in the capital structure of the firm Gearing is the inclusion of debt in the capital structure of the firm. As the amount of debt used increases, the level of weighted average cost of capital decreases because the interest on the debt is tax allowable. This is not the case for dividends received on ordinary or preference shares. Dividends received from these sources are fully taxable.
Any capital gains (appreciation ) in these securities are also taxable The continued and increasing use of debt capital in the capital structure of the firm will result in greater savings up to a certain point where the savings no longer match the cost of the debt. Hence the debt capital should only be used up to a certain optimum point where there company receives maximum tax deduction benefits. The use debt affects the use of equity capital in the capital structure o the firm and also the it applies to the use of equity.
The cost of tax, that is, the rate of tax charged on the company’s profits affects the overall cost of capital of the firm because the liability to tax is mostly affected by the capital structure of the company. Companies that have high amounts of debt in heir capital structures are usually charged less taxes because of the tax benefits received from interest rate tax allowance This is also true in that the returns on equity which are in the form of dividends are not tax exempt. Dividends are taxable and hence the equity holders demand a higher rate of return.
By the equity holders demanding a higher rate of return on he securities it pushes up the overall cost of capital of the firm and in this way it shows that the higher the tax the higher the overall cost of capital Cost of debt is the after tax cost Kd= interest (1-t) Value of debentures It is adjusted with tax because the interest on debentures is tax allowable The required rate of return for any security is the minimum rate of return that the investors demand in order to invest in that security
The required rate of return for any given security is equal to risk free rate added with the risk premium. The risk premium is demanded by investors in order to mitigate the risk assumed when one invests in the security. Capital assets pricing model (CAPM) It is a method of calculating the expected return of securities by relating the risk involved in investing in these securities and their expected returns. This model is based on the fact that investors demand an extra return called risk premium over and above the risk free rate of return
Investors require a higher rate of return because these securities are risky and hence to mitigate these risks they have to have high returns, which are more that the risk free rate. A simple capital asset pricing model formula is as follows; ERS=Rf +beta (Rm-Rm) Where; ERs-expected return of security Rf- risk free rate Beta-measure of systematic risk (risk that cannot be diversified) Rm – return of the market Theory and evidence behind CAPM CAPM was developed by William Sharpe (1964) and John Lintner (1965) and it is still widely used to estimate the expected return and the cost of capital of the firm.
William . F. Sharpe in the development of capital asset pricing model studied Harry Markowitz portfolio selection which dealt with efficient frontier of optimal portfolio investments work which he had done in 1952 and updated in 1959. In the Markowitz portfolio selection theory, he was unable of coming up with practical ways which showed how different portfolios held by investors work together or correlate. In his studies Sharpe was able to relate the portfolios to a single risk known as systematic risk.
This lead to the derivation of capital asset pricing model which deals with the security returns and the risks that come with the investment in the security. Capital assets pricing model recognizes that every security investment in the market has two risks that come with it The first risk is called the systematic risk. This risk is called beta. It cannot be diversified away by holding a portfolio of securities. Every investor in the market faces this type of risk The second risk is called unsystematic risk.
This is the risk that affects specifically a company or an industry. It can be diversified away by holding many securities from different sectors of the economy. The expected security returns thus can be dependent on the security beta (risk which cannot be diversified) since the unsystematic risk can be mitigated hence it is not a factor when determining what portfolio to hold in the market. Capital asset pricing model helps to determine the portfolio risk and return of the securities held by investors