corporate finance cost of capital foundational topics Flashcards
why it is important to value cost of capital for a company
A company grows by making investments that are expected to increase revenues and profits. It acquires the capital or funds necessary to make such investments by borrowing (i.e., using debt financing) or by using funds from the owners (i.e., equity financing). By applying this capital to investments with long-term benefits, the company is producing value today. How much value? The answer depends not only on the investments’ expected future cash flows but also on the cost of the funds. Borrowing is not costless, nor is using owners’ funds.
The cost of this capital is an important ingredient in both investment decision making by the company’s management and the valuation of the company by investors. If a company invests in projects that produce a return in excess of the cost of capital, the company has created value; in contrast, if the company invests in projects whose returns are less than the cost of capital, the company has destroyed value. Therefore, the estimation of the cost of capital is a central issue in corporate financial management and for an analyst seeking to evaluate a company’s investment program and its competitive position.
Cost of capital estimation is a challenging task. As we have already implied, the cost of capital is not observable but, rather, must be estimated. Arriving at a cost of capital estimate requires a multitude of assumptions and estimates. Another challenge is that the cost of capital that is appropriately applied to a specific investment depends on the characteristics of that investment: The riskier the investment’s cash flows, the greater its cost of capital. In reality, a company must estimate project-specific costs of capital. What is often done, however, is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project.
cost of capital
The rate of return that suppliers of capital require as compensation for their contribution of capital.
it is the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk. In other words, to raise new capital, the issuer must price the security to offer a level of expected return that is competitive with the expected returns being offered by similarly risky securities
The cost of capital of a company is the required rate of return that investors demand for the average-risk investment of a company. A company with higher-than-average-risk investments must pay investors a higher rate of return, competitive with other securities of similar risk, which corresponds to a higher cost of capital
Similarly, a company with lower-than-average-risk investments will have lower rates of return demanded by investors, resulting in a lower associated cost of capital. The most common way to estimate this required rate of return is to calculate the marginal cost of each of the various sources of capital and then calculate a weighted average of these costs. You will notice that the debt and equity costs of capital and the tax rate are all understood to be “marginal” rates: the cost or tax rate for additional capital.
component cost of capital
The rate of return required by suppliers of capital for an individual source of a company’s funding, such as debt or equity.
WACC
A weighted average of the after-tax required rates of return on a company’s common stock, preferred stock, and long-term debt, where the weights are the fraction of each source of financing in the company’s target capital structure.
The WACC is also referred to as the marginal cost of capital (MCC) because it is the cost that a company incurs for additional capital. Further, this is the current cost: what it would cost the company today.
WACC formula
WACC = wd.rd(1 − t) + wp.rp + we.re wd = the target proportion of debt in the capital structure when the company raises new funds
rd = the before-tax marginal cost of debt
t = the company’s marginal tax rate
wp = the target proportion of preferred stock in the capital structure when the company raises new funds
rp = the marginal cost of preferred stock
we = the target proportion of common stock in the capital structure when the company raises new funds
re = the marginal cost of common stock
