Cost of Capital

The cost of capital is generally speaking the rate of return that companies must achieve on the investments made in projects that have the same risk profile as the company in order to ensure that the market value of the company remains static. Utilizing this concept, the value of a company is viewed as the present value of the company's expected future earnings. Therefore one can deduce that the cost of capital for a company is the rate at which the company's future earnings are discounted by the marketplace. This implies that it is dependent on the non-diversifiable risk profile of the company.

It is normal for any commercial company to want to remain profitable and to increase the shareholders value of the company. With this in mind it stands to reason that any application of funds should give a return of at least the cost of capital, and ideally better than the cost of capital used in the project. For this reason it is very important to know the cost of capital applicable to any company

A basic assumption of the traditional cost of capital analysis model is that a company's business- and financial risk are generally speaking unaffected by the company starting and financing new projects.

The Basic Concept

Even though the cost of capital for a company is measured at a specific point in time, it reflects the cost of the funds applied in the company over a long period of time. This measurement is normally done based on the best available information and not necessarily on exact and precise information.

A company could raise new funds from the following sources a variety of sources. This includes the capital markets, through the issue of a share issues, for example. Another source of fund is loan stock. Loan stock is long-term debt capital raised by a company for which they pay a predetermined interest rate. A further source of capital is retained earnings. Utilizing retained earnings will affect the profit available for distribution as dividends to shareholders and therefore also have a specific cost. Borrowing from financial institutions remains an important source of finance to companies. Companies often also make use of leasing or hire purchasing capital equipment as a source of funds. Leasing is a special type of rental. There are fundamentally two types of lease contracts namely operating leases and finance leases.

In some countries the government will provide finance to companies as a component of its policy to help in the development of specific industries or geographical areas. These grants often come with a small price tag for the receiving entity. The application of venture capital in projects varies over time, depending on the general economic conditions and the risk appetite of the investors. Venture capital is funds an investor provides to a company and may be lost in totality if the project fails. The cost of this type of capital can vary significantly. Some companies that have a large debtor's book utilize factoring to secure funds. The factor finance company will normally pay a certain percentage of the value of the debtors at the time of sale, and will take responsibility for receiving payment from the debtor. There are a number of other less popular sources of funds available that are not mentioned here.

Most projects are funded utilizing various sources of funds. The cost of the capital for these projects should then be calculated utilizing the weighted average cost of capital. The weighted average cost of capital is frequently used as a benchmark, often also called a "hurdle rate" for establishing the financial feasibility of a project.

When calculating the weighted average cost of capital one should start by calculating the cost of every individual source of capital and then calculate their weighted average. The weight of each kind of capital will be determined by the proportion that each contributes to the entire capital structure. The optimal capital structure will determine the weights given to each source of capital.

Factors Affecting Financing Cost of Projects

As stated above, the cost of capital is determined with the assumption that both the business and financial risk of a company remains constant and that the risk appetite of investors remain unchanged, the residual factor that affect the cost of capital is the long term supply and demand for investment capital. This long term nominal of capital is sometimes called the risk free cost of a specific type of fund. It therefore stands to reason that the nominal cost of capital for a company is the sum of the risk free rate, the business risk premium and the financial risk premium.

In addition to these factors the so called risk free rate is also affected by the inflationary expectations. If one now include the risk premium to this rate the nominal rate of interest or the particular security will be determined.

Conclusion

The practical determination of the cost of capital for a company is not as simple as described above as this is purely done to explain the concepts. The only explicit conclusion that should be drawn is that the cost of a specific type of financing for a particular company is in one way or another functionally related to the risk free cost of that specific type of financing used by the company and is further adjusted by the company's business and financial risk.

© Carl Marx