What is the cost of capital? Learn and identify methods quickly and simply

If you are an economic savvy person or are intending to do business, the cost of capital is one of the important economic indicators to help you more smoothly in business and business management. Let’s find out right through the article below.

What is the cost of capital?

What is the cost of capital?

The cost of capital is the percentage cost of the various sources of capital needed to finance capital expenditures .

All sources of capital have a cost, which can be direct as in the case of debt capital or an opportunity cost in the case of retained earnings.

The cost of raising new capital is the marginal cost of capital.

The cost of common stock is directly tied to the required rate of return required by common stockholders before they take stock in a company. When capitalized, this expected rate of return should be higher than the prevailing market price. Typically, the cost of common stock is reported as dividend per share/market price per share + dividend growth rate.

The cost of preferred stock equals a fixed dividend rate . Dividends paid on both common and preferred shares are generally paid out of after-tax earnings and are therefore expenses on an after-tax basis.

The cost of retained earnings is an opportunity cost that some argue should equal the rate of return that shareholders could earn if it were distributed to them. Others argue that without this reserve, the company would have to raise new equity. So, according to them, the cost of capital should be equal to the cost of common stock.

Interest is a allowable expense , so the after-tax interest payable may be appropriate in this case. Firms can choose a capital structure that minimizes the overall cost of capital when making the selection. The cost of capital is used as the discount rate in calculating the net present value of new projects and comparing it to the project’s internal rate of return.

Meaning of cost of capital

Meaning of cost of capital

The cost of capital is representative of the firm’s barrier that a business needs to overcome in order to create surplus value . It is often used for the company to review the feasibility of the project before embarking on the project.

In economics and accounting, the cost of capital is widely used as a way to describe the opportunity cost of investing in a business.

From an investor’s perspective, the cost of capital is the expected return for those who are providing capital to a business.

The cost of capital is widely used as a business metric , it is used as a discount rate to calculate the value of an investor’s cash flow.

The cost of capital does not depend on how and where capital is raised , it depends on the use of funds, not the source of capital.

Method of determining the cost of capital

The cost of capital is a representation of the profit a company must generate

The cost of capital is a representation of the profit the company must generate to carry out the project . It includes equity and debt . When the profit generated exceeds the cost of capital, then the project is feasible. The way to determine the cost of capital is as follows:

Debt cost

When a business raises capital by borrowing, the business needs to pay interest on its loan, which is called the cost of debt . It is calculated by taking the rate on a risk-free bond with a maturity that matches the maturity structure of the corporate debt and adding a default premium.

Cost of equity

The cost of equity is determined by valuing the capital asset as follows:

Cost of equity = risk-free rate of return + expected risk premium

Or

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

Weighted average cost of capital

The weighted average cost of capital (WACC) is a metric used to measure a company’s cost of capital. Represents the minimum profit the company must generate on its existing asset base to satisfy its creditors.

When calculating WACC, it is necessary to estimate the fair market value of equity if not listed by other firms. To calculate the weighted average cost of capital, you need to calculate your personal financial resources first: cost of debt, cost of preferred capital, and cost of equity.

Factors that affect the cost of capital

Factors that affect the cost of capital

The cost of capital of a business will be affected by factors such as:

Formula for calculating cost of capital

Formula for calculating cost of capital

You can calculate the cost of capital for a business by taking the weighted average of the costs paid for each good. The weight here is the weight of the value of each security divided by the total value of the securities that the company has issued.

WACC = (E/V)*Re + (D/V)*Rd *(1-Tc)

In there:

Re: cost of equity
Rd: cost of debt
E: market value of total equity
D: market value of total debt
V: total long-term capital of the enterprise
Tc: corporate income tax

So we have just learned all about the cost of capital, a very important concept in the field of economics. Hopefully, through the article Tnhelearning.edu.vn shared, you will gain more useful knowledge for yourself.

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