Saturday Brain Storming Thought (139) 13/11/2021
COMPILED BY ER. AVINASH KULKARNI
CAPITAL COST
Capital costs are fixed, one-time expenses incurred on the purchase of land, buildings, construction, and equipment used in the production of goods or in the rendering of the services
Capital cost is the total cost needed to bring a project to a commercially operable status
Key Takeaways of Capital Cost
1) cost of capital represents the return a company needs t9 to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building
2) cost of capital encompasses the cost of both equity and debt, weighted according to the company’s preferred or existing capital structure (WACC)
3) A company’s investment decisions for new projects should always generate that exceeds the firm’s cost of the capital used to finance the project
4) otherwise, the project will not generate a return for investors
Calculation of cost of capital
Cost of capital refers to the return a company expects on a specific investment to make it worth the expenditure of resources
1) Cost of debt
Cost of debt refers to interest rates paid on any debt, such as mortgages and bonds
Interest expense is the interest paid on current debt
Cost of debt = (total debt/interest expense) X (1 – marginal tax rate)
2) Cost of Equity
Cost of equity refers to the return a company requires to determine if capital requirements are met in an investment
It also represents the amount the market demands in exchange for owing tge asset and therefore holding the risk of ownership
Cost of equity = TF + β (Rm – Rf)
Rf = Risk-free rate of return
Rm = market rate of return
β (Beta) = risk estimate
3) Weighted average cost of capital (WACC)
Cost of capital based on the weighted average of the cost of debt and the cost of equity
WACC = (E/V X Re) + (D/V X Rd) X (1 – Tc)
E = the market value of the firm’s equity
D = the market value of the firm’s debt
V = the sum of E & D
Re = the cost of equity
Rd = the cost of debt
Tc = the income tax rate
Higher WACC meaning
Higher WACC means companies paying more to service their debt or the capital they are raising
As a result, the company’s valuation may decrease
Overall return to investors may be lower
Significance of cost of capital
1) maximization of the firm’s value
2) capital budgeting decisions
3) working capital management
4) decisions regarding leasing
5) dividend decisions
6) determination of capital structures
7) evaluation of financial performance
The cost of capital depends upon
1) demand and supply of capital
2) expected rate of inflation
3) various risks involved
4) Debt-equity ratio of firm
Cost of capital includes
1) cost of debenture
2) cost of loan capital
3) cost of equity share capital
4) cost of preference share capital
5) cost of retained earnings
Types of cost of capital
1) explicit cost of capital
2) implicit cost of capital
3) specific cost of capital
4) WACC
5) marginal cost of capital
Fundamental factors affecting the cost of capital
1) market opportunity
2) capital providers preferences
3) risk
4) inflation
5) Federal Reserve policy
6) Federal budget deficit or surplus
7) trade activity
8) foreign trade surpluses or deficits
9) country risk
10) exchange rate risk
Individual company factors affecting the cost of capital
1) capital structure policy
2) dividend policy
Components of cost of capital
1) returns at zero risk level
ie project involves no financial or business risk
2) Business risk premium
More risk – higher returns expectation – the cost of capital increase
3) Financial risk premium
Financial risk relates to the pattern of capital structure of the firm
Higher debt content – more risk
The company cost of capital
It is the rate of return expected by the existing capital providers
The project cost of capital
It is the rate of return expected by providers for a new project tge company proposes to undertake
Cost of preference
1) given the fixed nature of preferences dividend and principal
2) repayment commitment and the absence of tax deductibility
3) the cost of preference is simply equal to its yield
Classification of cost of capital
1) Historical cost
Historical cost represents the cost which has already Beed incurred for financing a project
2) Future cost
Future Cost is calculated on the basis of past data
Future cost refers to the expected cost of funds to be raised for financing a project
Link with the cost of capital
Cost of capital is the minimum rate of return
ie business must earn before generating value
Good cost of capital
Between 10-12%
Cost of capital in NPV
The cost of capital refers to the required return needed on a project or investment to make it worthwhile
Factors affecting capital structure decisions
1) leverage or trading on equity, effect on earnings per share
2) growth and stability of sales
3) cost of capital
4) cash flow capacity of the firm
5) control
6) flexibility
7) size of the firm
8) marketability and timings of shares
9) flotation costs
10) credit standings of the firm
Compiled by:-
Er. Avinash Kulkarni
Chartered Engineer
Govt Regd Valuer
IBBI Regd Valuer
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