Explain a company's cost of capital and how it is calculated - Essay Example

The factors of production include labor, land, entrepreneurs and of the capital. Capital is a necessary factor as it aids production be it in terms of real capital like tools, machineries and equipment or financial capital like the money. Companies can raise capitals by issuing stocks or bonds or making investments. Raising capitals is also considered as a form of investment because when you invest on something, you have to release a capital or you have to capitalize on your investment. But just like the other factors, capital has a cost.

This cost is equal to the marginal investor’s required return on the security in question (Brigham, Houston, & Clark, 2004). This means that since the investor provided the capital, there is a rate of return that would be demanded by them to compensate them for the time value of their money and the risk that they have to incur in investing. For this risk, cost of capital is sometimes called as hurdle rate. And for a project to be considered approved, it must earn more than its hurdle rate. The cost of capital determines how a company can raise money through issuing bonds, borrowing or both (Invetopedia.com, 2011).

Determining the cost of capital is important in capital budgeting, determination of a company’s Economic Value Added (EVA), deciding when to lease or purchase of assets and regulation of electric, gas and telephone companies. The cost of capital is specific to each particular type of capital that the company uses (Moneyterms.co.uk, 2011). It could be the cost of equity or the cost of debt or the combination of both. The cost of equity is the rate of return on equity required by a company implicitly estimated using valuation ratios.

The differences in the cost of equity is an important component of differences in the ratings at which different companies and sectors trade. The cost of capital of a security is for the valution of the securities. It is compared with the appropriate discount rate to apply to future cash flows that the security will pay. The Capital Asset Pricing Model(CAPM) and arbitrage pricing theory are considered as models of valuation. The cost of listed debt securities can be computed in a same manner to equities.

It is commonly done by comparing the yield spreads with other similar securities. Everytime the company raises additional capital, additional cost also is incurred. This is the marginal cost of capital. It varies according to the type of additional capital used (Investorwords.com, 2011). The capital raised by using unsecured debt will require a higher cost or interest rate than a debt with collateral like a secured bond. The higher rate is used to offset the risk. But there is an option for a company to calculate its cost of capital in a way that each category of capital is proportionately weighted.

It is by using the Weighted Average Cost of Capital or WACC. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm (Investopedia.com, 2011). Market rates and the company’s perceived market risk can affect its cost of capital.

Market rates are used to determine the proper discount rate to be used in calculating the present value of the cash flows. If interest rates in the economy rise, the cost of debt capital increases as the company have to pay bondholders a higher interest rate. This will also increase the cost of equity capital. The level of market risk also determines the level of returns that investors will require. They will automatically demand a higher return on riskier investments. So, a company raising a capital for a risky project will have a higher cost of capital than a company with safer projects.

Bibliography Brigham, E. F., Houston, J. F., & Clark, D. A. (2004). Fundamentals Of Financial Management. Florida: Thomson South-Western. Investopedia.com. (2011). Weighted Average Cost of Capital . Retrieved March 19, 2011, from Investopedia.com: http://www.investopedia.com/terms/w/wacc.asp Investorwords.com. (2011). Marginal Cost Of Capital. Retrieved March 19, 2011, from Investorwords.com: http://www.investorwords.com/6573/marginal_cost_of_capital.html#ixzz1GvQCYl8X Investopedia.com. (2011).

Cost of Capital. Retrieved March 19, 2011, from Investopedia.com: http://www.investopedia.com/terms/c/costofcapital.asp Moneyterms.co.uk. (2011). Cost of Capital. Retrieved March 19, 2011, from Moneyterms.co.uk: http://moneyterms.co.uk/cost-of-capital/