Question

Describe the components included in weighted average cost of capital. How do you determine a "good" cost of capital? Identify the factors that may affect a company’s cost of capital.

Answer 1

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

WACC and its Components

where:

• Re = Cost of equity
• Rd = Cost of debt
• E = Market value of the firm’s equity
• D = Market value of the firm’s debt
• V = E + D = Total market value of the firm’s financing
• E/V = Percentage of financing that is equity
• D/V = Percentage of financing that is debt
• Tc = Corporate tax rate​

Since shareholders will expect to receive a certain return on their investments in a company, the equity holders' required rate of return is a cost from the company's perspective, because if the company fails to deliver this expected return, shareholders will simply sell off their shares, which leads to a decrease in share price and in the company’s value. The cost of equity, then, is essentially the amount that a company must spend in order to maintain a share price that will satisfy its investors.

Calculating the cost of debt (Rd), on the other hand, is a relatively straightforward process. To determine the cost of debt, you use the market rate that a company is currently paying on its debt. If the company is paying a rate other than the market rate, you can estimate an appropriate market rate and substitute it in your calculations instead.

There is no exact defination of a "good" cost of capital. The market rate is the expected return on the stock market right now. There is typically lots of debate about this number but generally it falls between 10-12%. The risk-free rate is the return you’d get on a risk-free investment, such as a treasury bill (somewhere between 1-3%). Thus a "good" cost of capital is something which can give risk adjusted returnds over the risk free rate. Higher the risk factor, higher will be the expectation with the "good" cost of capital.

The factors that may affect a company’s cost of capital

When company wants to get any new fund from outside resource, it checks its cost of capital. Company can get the new money through shares and debt. For getting debt, we have to pay cost of debt in the form of interest payment. For getting equity or preference share capital, we have to pay dividend to shareholders.

So, for making optimal model of cost of capital in which cost of capital will be minimum, we have to study the factors affecting cost of capital. Following are the main factors which affects cost of capital.

1. Current Economic Conditions
If banks are growing, they can easily give loan at low rate of interest because they need to increase the sale for stability of their products. At that time, company's cost of debt will decrease which is the part of company's cost of capital. Not just bank but whole economic conditions should be ok for this. If there is big recession in the market, no financial institute will decrease the rate of interest because they also have to pay the return to their customers. It means, every loan providing company has also cost of capital. If there will be stability in the market, cost of debt will decrease and cost of equity capital will increase.

2. Current Capital Structure
When we have studied optimal capital structure, we have to study the cost of capital because for optimal capital structure, we need to calculate weighted average cost of capital. But if company did not consider cost of capital as factor, we can include the study of current capital structure as the factor for cost of capital. Current debt equity ratio will effect the cost of capital. If debt is more than share capital, we have to pay more cost of debt. If share capital is more than debt, we have to pay cost of equity or pref. share capital.

3. Current Dividend Policy
Every company has to make dividend policy. What amount of total earning, company is interested to pay as dividend. For this, we have to study Price-Earning Ratio (Dividend/EPS). If Price earning ratio will increase, cost of retained earning will decrease because we will less money which have retained and use for promoting of business as source of fund.

4. Getting of New Fund
Company's new fund's requirement will also affect the cost of capital. If company needs $ 20 million dollars immediately for business promotion, company will have to pay high rate of interest because with this, risk of financial institution will increase. Every loan provider works with patience, he needs to analyze the company before providing big loan. If he will give big loan immediately, it is sure, he will get more return from company and company has to pay more cost of this. Except this, every time, when company will go to market for getting fund, company company will get the money at new market rate. So, company has also to follow new rate of cost of capital. It may increase or decrease company's current cost of capital rate.

4. Financial and Investment Decisions
When we get new share capital or debt, we have to tell to fund providers about the usage of their fund. If there is more risk in the investment, both shareholders and creditors will get high reward for this. So, our financial and investment decisions will effect the cost of capital.

5. Current Income Tax Rates
We know, we charge the interest before tax charges. When we earn money, we deduct our interest charges, then we deduct tax charges. So, if tax rate will high, it will effect the cost of share capital because with high tax charges, our net earn will decrease and it will decrease earning per share. So, we will give less dividend to our shareholders.

6. Breakpoint of Marginal Cost of Capital
Marginal cost of capital is the cost raising one more unit of capital. Its breakpoint will affect the cost of capital. Before studying, how marginal cost of capital affects current cost of capital, we have to understand the breakpoint of marginal cost of capital

Break Point = Amount of Capital at which Sources Cost of Capital Changes/Proportion of New Capital Raised from the Source