The Cost of Capital

Cost of capital is the price that the company has to pay to obtain capital for funding of investment projects such as large purchases or expansions. Costs associated with the acquisition of capital will include after- tax interest expenses associated with debt or required rate of return required by shareholders for use of their investment dollars (CTU Online, 2008). The cost of capital should represent the minimum amount of return on investments that is required to earn sufficient cash flows from which those who have contributed capital can receive their expected returns.

For capital acquired from shareholders, cost of capital represents expected dividends, as well as assumed capital gains on their share values. For the loan holder, such as the bank, the cost of capital is the rate of interest on the loan providing the capital for a specific project. Accuracy in the cost of capital calculation is necessary in meeting the requirements of the investor, otherwise investors can be expected to place their capital dollars with an opportunity that provides greater promise (Malawi College of Accounting, n.d.).

The weighted average cost of capital is the percentile expression of the overall return the company must earn on its investments to maintain the value of their stock. This cost is used to gauge whether or not an investment opportunity is worth undertaking, as acceptable propositions will exceed the actual cost of capital and build shareholder value (Ross, Westerfield, & Jordan, 2008 and Value Based Management, 2008). The WACC seeks to estimate the firm's overall cost of capital by finding the weighted average of the costs relative to the individual financial sources of its unique capital structure. The WACC is the mean value of each source of capital in the firm's capital structure, found by multiplying the cost of capital of each source by its respective percentage of the total capital structure as presented on the balance sheet (Gallagher, Andrew, 2003).

Whether the capital for a project is drawn from the owners' retained earnings, or from the sale of additional stock, the use of that equity has an associated cost. However, the costs associated with tapping into the earnings of present stockholders vs. acquiring capital from new stockholders is different as drawing from retained earnings carries only the cost of the rate of return required by the stockholder, whereas use of new stock dollars requires an additional cost referred to as flotation costs. Flotation costs are the costs incurred as a result of the issuance of new securities and will include the fees and commissions paid to the investment banker(s) and attorneys (CTU Online, 2008 and Gallagher, et al.). This information is essential for planning, calculating, and appropriate choice as they each relate to using the correct cost of capital to ensure continual value.

As the company seeks to acquire additional capital, the cost of capital will change at the margin, and can be correctly accounted for by figuring the marginal cost of capital, or MCC. The MCC is the weighted average cost of the next dollar of capital to be acquired and can only be realized or figured once management has assessed and identified the point at which the firm's cost of capital will change the WACC, estimated the value of the change, and calculated the cost of capital up to and after the identified point of change. The change in the WACC with the addition of capital occurs due to the change in one or more of the components of capital that comprise the entire capital structure (Gallagher, et al.).

Cost of capital will be influenced further by current and fluctuating market rates. The market rate is the prevailing rate of interest for any given time; consequently costs of capital incurred through interest rates paid to lenders or expected by other investors will fluctuate with the rising and falling market rates of different periods (Web Finance, Inc., 2008). Cost of capital will require adjustment to ensure that additional costs associated with the market interest rate are met by the WACC that investment decisions are based upon.

Fluctuations in market risk are similarly going to demand adjustment to the WACC as the level of risk associated with investment is directly linked to the value of the expected return. Investment activities with greater risk require greater returns for the investor, and external market factors will cause decreases or increases in stock value (Gallagher, et al.). Regardless of the fluctuations in the market, investors will expect a minimum return value, and the company will have to meet that value to retain or acquire further investment. The additional costs that may be incurred with producing or providing that minimum return, regardless of market fluctuation, must be included in the firm's WACC to ensure all obligations are met and that capital remains available.

Sources Cited:

CTU Online (2008). Phase 3 course materials. Colorado Technical University Online. Colorado

Springs, CO. MGM625-0803B-02: Applied Finance for Decision Making.

Gallagher, T.J. and Andrew, J.D., Jr. (2003). Financial management: principles and practice, 3e.

Prentice Hall. Upper Saddle River, NJ.

Malawi College of Accounting (n.d.). Session 8: cost of capital. Kewl: Knowledge Environment

for Web Based Learning. Washington State University. Spokane, WA. Retrieved on

September 17, 2008 from Web site:

http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page41.htm

Ross, S.A., Westerfield, R.W. and Jordan, B.D. (2008). Fundamentals of corporate finance, 8e.

McGraw-Hill Irwin. Boston, MA.

Value Based Management (2008). WACC-weighted average cost of capital. Value Based

Management.net. Bilthoven, The Netherlands. Retrieved on September 18, 2008 from Web

Site: http://www.valuebasedmanagement.net/methods_wacc.html

Web Finance, Inc. (2008). Market rate: definition. Retrieved on September 18, 2008 from Web

site: http://www.investorwords.com/5654/market_rate.html