cost_of_capital

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This article may require cleanup to meet Wikipedia's quality standards. Please improve this article if you

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The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds

(both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's

existing securities".

[1]

It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing

capital to the company, thus setting a benchmark that a new project has to meet.

Contents

[hide]

 1 Summary

 2 Cost of debt

 3 Cost of equity

o 3.1 Expected return

o 3.2 Comments

 3.2.1 Cost of retained earnings/cost of internal equity

 4 Weighted average cost of capital

 5 Capital structure

 6 Modigliani-Miller theorem

 7 References

 8 Further reading

[edit]Summary

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the

rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a

company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A

company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity

to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required.

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 can be modelled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of

default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is

largelyexogenous (not linked to the company's activities).

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 (comparable) with similar risk profiles to

determine the "market" cost of equity. It is commonly equated using the CAPM formula (below), although articles such as Stulz 1995 
question the validity of using a local CAPM versus an international CAPM- also considering whether markets are fully integrated or 
segmented (if fully integrated, there would be no need for a local CAPM). 
Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be 
calculated. This WACC can then be used as a discount rate for a project's projected cash flows. 
[edit]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, all other things being equal, 
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. 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. 
The yield to maturity can be used as cost of capital. 
[edit]Cost of equity 
Cost of equity = Risk free rate of return + Premium expected for risk 
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) Where Beta= sensitivity to 
movements in the relevant market:   
Where: 
E
s
 
The expected return for a security 
R
f
 
The expected risk-free return in that market (government bond yield) 
β
s
 
The sensitivity to market risk for the security 
R
M
 
The historical return of the stock market/ equity market 
(R
M
-R
f
) 
The risk premium of market assets over risk free assets. 
The risk free rate is taken from the lowest yielding bonds in the particular market, such 
as government bonds. 
 
[edit]Expected return 

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This article may require cleanup to meet Wikipedia's quality standards. Please improve this article if you can. The talk page may contain suggestions. (August 2008) The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. Contents [hide] 1 Summary 2 Cost of debt 3 Cost of equity 3.1 Expected return 3.2 Comments 3.2.1 Cost of retained earnings/cost of internal equity 4 Weighted average cost of capital 5 Capital structure 6 Modigliani-Miller theorem 7 References 8 Further reading [edit]Summary For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of s ...
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