I believe it's the rate of return which has to be earned on an investment in order to increase the value of stakeholder鈥檚 investment. Is there something I am missing? Is there more to cost of capital? You are correct.
The precise definition for the cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt. It is also known as the "Hurdle Rate" or "Discount Rate".
The cost of capital is the rate of return that a firm's projects (a/k/a, capital investments) must return to add to shareholder value. That is why it is called the "Hurdle Rate," because a new project has to clear this rate before being approved.
Additionally, bankers would use this same rate to calculate the present value of a future cash flow; that is, they would use this rate to "discount" a future cash flow to its present value.
There is a lot behind the cost of capital. Enclosed below is some background on how to calculate the cost of capital, in case you are interested....
To figure out the cost of capital, you need to know the cost of debt and the cost of equity. If the cost of debt (after tax) was 8% and the cost of equity was 14%, and the firm had a debt-to-equity ratio of 2.0, then the cost of capital would be...
[(8% * 2) + (14% * 1) ] / (2 + 1) = 10% cost of capital
Figuring out the cost of debt is straightforward, and explicit. It is the interest rate on the loan or the bond, but changed to an "after-tax" rate.
The cost of equity is not straightforward. It is "imputed" by the expected return on investment for the company, which includes both the share price appreciation and dividend rate.
If you don't understand the difference between debt and equity, then the first thing you have to understand is that there are only three ways for a corporation to get money to finance their operations:
1.) Issuing stock (equity),
2.) Issuing debt (borrowing from a bank is equivalent for this purpose) (those two are external financing)
3.) Reinvesting prior earnings (internal financing)."
OK, with these fundamentals out of the way, let's attack the cost of capital in greater detail.
As said earlier, the cost of debt is easier to understand than the cost of equity, so let's go there first...
If a firm issues debt, or takes a loan, the firm is required to pay interest on the debt. This is exactly like the interest you pay on your credit cards or home mortgage. The "cost of debt" is the interest rate. Simple as that! The lender (or bondholder) expects to get paid the interest.
One catch with calculating the cost of debt is to make sure to convert the cost of debt (the interest rate) from pre-tax to post-tax to account for the income tax benefit from paying interest.
Interest payments to debt holders are a pre-tax expense. A firm can deduct them from its profits to lower the taxes it has to pay, which boosts its earnings. However, dividend payments to stock holders are a post-tax expense. They are deducted *after* taxes are paid. So, with debt as a pre-tax expense, and equity as a post-tax expense, you have an apples-to-oranges situation. You need to change the pre-tax interest rate quoted by the bank (or the coupon on the bond) to an after-tax interest rate so that you compare "apples-to-apples."
Leaving the cost of debt aside for a moment, let's attack the cost of equity...
Now, if someone invests in a firm as a shareholder (a/k/a, equity), the firm does *not* have to pay interest, because the shareholder is an owner of the firm. The investor "expects" the share price to go up, but there are no promises. While the debt holder's expectation of return is explicitly represented by the interest rate (as promised), the equity holders expectation is imputed by the share price (no promises).
This expected return on equity cannot be calculated in isolation. One needs to calibrate the expected return based upon the riskiness of the firm, and its industry. Investments in public utilities are not as risky as investments in bio-technology companies. Thus, the expectation for return on investment in a public utility is much lower than that for a bio-technology company. This expectation for return on investment is the "cost" of equity.
Since the payment of interest on debt gives the firm the benefit of a tax deduction, the cost of debt is "cheaper" than the cost of equity, which does not offer any tax deductions. (There is an interesting theory by Mogliani and Miller that shows this is not an intrinsic difference, but merely an accident of the tax deduction). Maybe this would help:
"The required return necessary to make a capital budgeting project - such as building a new factory - worthwhile. Cost of capital would include the cost of debt and the cost of equity.
also,the cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested its money someplace else with similar risk. " |
