To be remembered
TO: administrators and financial personnel
FROM: VP of Finance
DATE: December 12, 2011
SUBJECT: Cost of Capital
Preface
The company’s cost of capital will be explained today and how the cost of capital is calculated for the company. The marginal cost of capital will also be explained, and how the marginal cost of capital differs from the WACC (Weighted Average Cost of Capital). Finally, we will discuss how the market rates are perceived as a higher risk of the market, the cost of capital for the company may be affected.
Cost of Capital
A company’s cost of capital is defined as the initial cost of all capital invested in the business. In other words, the higher the cost of capital to produce the new plant will be, the required rate of return necessary to make the capital budgeting project worthwhile. In order for the investment strategy to be worthwhile the company must expected return on capital greater than the cost of capital. With that being said, the cost of capital refers to the capital budgeting plan, the cost of debt and the cost of equity for a company to start a business (Cost of Capital, n.d.).
Calculating the Cost of Capital
Calculating the cost of debt for a property can be easily calculated, while calculating the cost of equity can be more difficult. The cost of debt capital for the project would be equal to the interest charged on the company’s debt. Adjustments will then be made for the Federal income tax deductible on the financial activity that has been done by the company. After the market tax tax is deducted from the capital debt this would be long term debt growth and surrender. a marginal tax rate could be applied to increase the debt capital ratio (Cost of Capital, n.d.). The cost of debt can be determined in this way: cost of debt = Interest Rate on debt – 1 tax rate. With regard to calculating the cost of equity, equity shareholders require a minimum return that is equal to the profit from the collateral-free investment plus the profit to bear the additional risk. That being said, the cost of equity can be defined as follows: cost of equity = risk free rate of return + premium for expected risk. And finally, the determined and mixed cost of debt and equity can then be calculated as the WACC, and the projected discount rate projects cash flows can be applied (Evans, n.d.).
Marginal cost of capital and how it differs from WACC
The marginal cost of capital is basically the cost the company would have to incur if additional funds were needed to carry out the project’s expenses. It differs from the WACC in that it determines the costs associated with the last dollar of capital invested in the investment. The marginal cost of capital depends on the company’s current personal capital resources. With this said, the marginal cost of capital will be presented as a percentage and then compared with the expected rate of return required to be earned for the project (“Marginal Cost”, n.d.
How markets and market risk affect a company’s cost of capital
Market prices can undermine our cost of capital by increasing the market interest rate of debt obligations. For example, if Higher Living is perceived by our lenders as a high risk market, our interest-rates will be increased. and we may have to decline some future loans because of the fact that we are taking on much more debt than we can repay. This would require looking at the company’s cost of debt and/or equity where the WACC would need to be estimated in order to apply the change. Capital costs would need to be calculated both at and after the change points (CTU Online, 2011).
Conclusion
The cost of capital is the rate of return that the company must achieve on the project in order to invest in the property to be worth it. That being said, the cost of one project cannot be the same as another, and therefore specific. the type of financing that a particular company needs to be involved in when considering the financing of the project. In addition, by looking at the marginal cost of capital a company can identify which investments to accept and reject, and success in future projects can be achieved (“Marginal Cost” n.d.).
References
Capital cost. (n.d.). Retrieved from http://www.investopedia.com/terms/c/costofcapital.asp#axzz1XkRvKkll
CTU Online. (2011). On the administration of public affairs. Phase 3 Course materials [text]. Retrieved from https://campus.ctuonline.edu/pages/MainFrame.aspx?ContentFrame=/Home/Pages/Default.aspx?
Evans, M. (n.d.). Online financial courses – Capital management. Retrieved from http://en.coursgratuits.net/3/calculating-cost-of-capital.php
Marginal cost of capital business definition. Retrieved from http://business.yourdictionary.com/marginal-cost-of-capital
