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Cost of Capital

Can you provide calculations showing “Cost of Capital” our and explain exactly what this means? Why is it important for us to know what this figure is? The cost of capital is defined as the rate of return that a company would receive if it invested the money anywhere with comparable risk. The company can raise money through a borrowing, stock issue or a mix of the both 7. General Formula For Cost of Capital: The required rates of return are market-determined. They are established in the capital markets by the actions of competing investors.

The influence of market is direct in the case of new issue of ordinary and preference shares and debt. The market price of securities is a function of the return expected by investors. Thus, the opportunity cost of capital is given by the following formula: Where, I0 is the capital supplied by investors in period 0 8, Ct is returns expected by investors 9 and k is the required rate of return or cost of capital. Weighted average Cost of Capital vs. Specific costs of Capital A firm obtains capital from various sources.

As explained earlier, because of the risk differences and the contractual agreements between the firm and investors. The cost of capital of each source of capital is known as component, or specific cost of capital. The combined cost of all sources of capital is called overall, or average cost of capital. The component costs are combined according to the weight of each component capital to obtain the average cost of capital. Thus, the overall cost is also called the weighted average cost of capital 10. Cost of Debt: A company raises debt in various ways.

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It may borrow funds from financial institutions or public either in a form of public deposits or debentures for a specified period of time at a certain rate of interest. A debenture or bond may be issued at par or at a discount or premium as compared to its face value. The construal rate of interest or the coupon rate forms the basis for calculating the cost of debt. Debt issued at Par: The before tax cost of debt is the rate of return required by lenders. It is easy to compute before-tax cost of debt issued and to be redeemed at par; it is simply equal to the contractual 11 of interest.

Where k is the before-tax cost of debt, i is the coupon rate of interest, b is the issue price of the bond (debt) and in Equation (2) it is assumed to be equal to the face value (F), and INT is the amount of interest. The amount of interest payable to the lender is always equal to: Interest= face value of debt x Interest rate We could arrive at same results as above by using Equation (1): BHP Billiton cash outflow are US$ 15 interest per year for 7 years and US$ 100 at the end of seventh year in exchange for US$ 100 now.

Thus; By trial and error, we find that the discount rate (k) which solves the equation, is 15 percent: Clearly, the before-tax cost of bond is the rate, which the investment should yield to meet the outflows to bondholders. Debt Issued at Discount or Premium: Equation (1) and (2) will give identical results only when debt is issued at per and redeemed and can be written as follows top the before-tax cost of debt 12: Where B is the repayment of debt on maturity and other variables as defined earlier.

Equation (3) can be used to find out the cost of debt whether debt is issued at par or discount or premium, i. e. , B0=F or B0>F or B0<F. Let us consider an example. Cost of bond Sold at discount: Assuming that in BHP Billiton the preceding example of 7 year 15 percent bonds, each bond is sold below par for US$ 94. Equation (3), Kd is calculated as If the discount or premium is adjusted for computing taxes, the following method 13 can also be used to calculate the before-tax cost of debt:

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