You are currently viewing “CAPITAL COST “-ALL YOU NEED TO KNOW-COMPILED BY ER. AVINASH KULKARNI

“CAPITAL COST “-ALL YOU NEED TO KNOW-COMPILED BY ER. AVINASH KULKARNI

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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