Financial Management Principals
Every company needs to raise funds or capital for financing its projects. The cost of capital represents the maximum return that a company must earn on its investments so that the market value of company’s stock or equity does not decrease. In other words, a firm must earn a return on the investments that are financed by the shareholders, at a rate which is equal or more than the rate of return required by equity holders of the firm. Otherwise, if a certain project fails to earn an expected rate of return, there will be a fall in the market value of company’s shares and will also result in reduction of shareholder’s wealth.
Therefore, we can say that a firm’s cost of capital is the required rate of return required by a firm from a certain investment so that it can increase the market value of the firm(Scribd. com , n. d. ). A firm’s cost of capital represents the minimum rate of return required of the investment in order to maintain if not increase the market value of its equity. The cost of capital comprises of two components; cost of equity and cost of debt. However, it may include only
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Cost of equity – The cost of equity capital for a firm is the rate of return required on an investment by the shareholders of the firm. This required return comprises of both dividend payments and capital gains in terms of increase in share price. These returns are not historical returns but rather the expected future returns by the ordinary shareholders. The cost of equity varies from company to company depending upon the financial and business risk of the companies. The cost of equity is calculated by the following formula: Ke (Cost of equity) = Dividend per share (for next year)/Current market value of shares +
Dividends growth rate (Brigham & Houston, 2009). The cost of equity reflects the opportunity cost of shareholders of a firm for their investment in the firm’s equity. The above formula calculates the cost of equity based on the firm’s current rate of return. A higher cost of equity means a higher risk for the investment and therefore the required return demanded by shareholders will be higher as well. 2. Cost of debt – The cost of debt is an effective rate that the company pays as interest payments on its debt. The cost of debt is a part of capital structure that forms the cost of capital of a firm along with the cost of equity.
As interest expense is a tax deductible expense so the after-tax cost of debt is usually taken. The cost of debt can be calculated by the following formula: kd (Cost of debt) = Interest expense ? (1 – tax rate)/ Total debt amount Once we know the cost of equity and cost of debt of a firm, we can find out the real cost of capital of a firm through its weighted average cost of capital (wacc) formula. In this formula, each category of firm’s cost of capital is to be proportionately weighted. A higher WACC reflects a higher business and financial risk of a firm and therefore a higher return for investment.
WACC is calculated by the following formula: WACC: E/V ? ke + D/V ? kd (1- tax rate) Where: E = market value of firm’s equity V = Total value of a firm (Equity + Debt) Ke= Cost of equity D = market value of firm’s debt E/V= percentage of debt financing in a total capital financing of a firm D/V= percentage of debt financing in a total capital financing of a firm (Brigham & Houston, 2009). 2. How do market rates and the company’s perceived market risk influence its cost of capital, and how does the company’s debt to equity mix impact this cost of capital?
When a firm raises finances, the return it pays to the investors reflects the cost of getting the required capital, whether it is in the form of interest payments or dividends to shareholders. The return on investment required by investors is derived from the market’s assessment of adequate return to compensate for the certain risk level and the risk perceived by the company. The required return increases according the increase in risk(Gitman,2000). The company’s debt to equity mix is a main determinant of company’s total cost of capital.
The higher the company is geared, the higher will be its cost of capital because the higher gearing or debt level will increase the financial risk of the company. Therefore, investors will demand the higher returns on their investment with the higher risk profile of a firm thus increasing the overall cost of capital of a firm (Investopedia,n. d. ). 3. What is market risk, and how is it measured? Market risk is the risk that the value of an investment will decrease because of the change in value of the market risk factors. These market risk factors include share prices, foreign exchange rates, interest rate risk and etc.
Market risk is usually measured by an approach called Value at Risk. This approach takes various assumptions for measuring risk. One of the assumptions it uses is that the certain portfolio of an investment stays the same over a certain period of mode. Such an assumption however, can be useful for short time horizons but for the longer time horizons, it is not considered too useful (Brigham & Houston, 2009). 4. Don mentioned using standard deviation and the coefficient of variation to measure risk. What does that mean? The standard deviation is sometimes used by analysts and investors to measure the portfolio of investment or a stock.
The main reason being that the standard deviation is a useful measure of volatility, the more an investment’s returns vary from the average returns, the more risky it will be considered. The coefficient of variation represents the ratio of standard deviation to mean and it is a useful tool to compare a degree of variation from one data series to another. For investors, it helps them to determine the amount of volatility or risk they are assuming in comparison to the expected return from an investment. The lower ratio means the investment is favorable for investors in terms of a better risk-return tradeoff.
Reference: Brigham, E. F. &Houston, J. F. (2009). Fundamentals of Financial Management (with Thomson ONE – Business School Edition) Gitman, L. J. ( 2000). Principles of managerial finance. McGraw-Hill Investopedia. (n. d. ). Weighted Average Cost of Capital. Retrieved July 23, 2010, from http://www. investopedia. com/terms/w/wacc. asp Scribd. com. (n. d. ). Cost of Capital. Retrieved July 23,2010, from http://www. scribd. com/doc/9675052/Cost-of-Capital Thismatter (n. d. ) Single Asset Risk Retrieved July 23,2010, from http://thismatter. com/money/investments/single-asset-risk. htm