Module : The Cost of Capital

Introduction:

Module Outcome:

Specific Learning Outcomes:

4.1
4.2 Evaluate the factors to consider in Multinational capital structure.
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ready to
ENGAGE!

Pre-Activity!

we enter to a more complex topic of Global Finance and Electronic Banking. 20 points.
 Let’s
What Is Cost of Capital?
EXPLORE! Cost of capital is the required return necessary to make a capital
budgeting project, such as building a new factory, worthwhile. When
analysts and investors discuss the cost of capital, they typically mean
the weighted average of a firm's cost of debt and cost of equity
blended together. The cost of capital metric is used by companies
internally to judge whether a capital project is worth the expenditure
of resources, and by investors who use it to determine whether an
investment is worth the risk compared to the return. The cost of capi-
tal depends on the mode of financing used. It refers to the cost of eq-
uity if the business is financed solely through equity, or to the cost of
debt if it is financed solely through debt.

Many companies use a combination of debt and equity to finance their

businesses and, for such companies, the overall cost of capital is
derived from the weighted average cost of all capital sources, widely
known as the weighted average cost of capital (WACC).

Understanding Cost of Capital

Why is cost of capital important?

• It helps investors assess their options

• It can also be used to evaluate the performance of certain projects as compared to the cost of capital
 Computing Cost of Capital

To calculate the weighted average cost of capital, you must first calculate the cost of debt and the
cost of equity. The cost of debt and cost of equity can be represented by these formulas:

1. Find the cost of debt

The cost of debt refers to companies' interest rates that they pay on any debt, such as mortgages
and bonds. The cost of debt should be calculated after the marginal tax rate. Interest expense represents the
interest paid on the business' current debt, and T represents the company's marginal tax rate.

Formula: cost of debt = total debt / interest expense × (1 - T)

2. Find the cost of equity

The cost of equity refers to the return a company requires to determine if the capital return require-
ments are met in an investment. A business' cost of equity also represents the amount the market de-
mands in exchange for owning the asset and therefore holding the risk of ownership. Rf refers to the risk-
free rate of return, and Rm refers to the market rate of return. β, or beta, allows for sensitivity to move-
ments in the market.

Cost of equity can only be approximated by the capital asset model below:

Formula: CAPM (cost of equity) = Rf + β(Rm - Rf)

3. Find the weighted average cost of capital

A business' cost of capital is based on the weighted average of the cost of debt and the cost of equi-
ty.

Formula: WACC = (E / V x Re) + ((D / V) x Rd) x 1 - Tc

In this formula:

• E refers to the market value of the firm's equity

• D refers to the market value of the firm's debt

• V is the sum of E and D

• Re refers to the cost of equity

• Rd refers to the cost of debt

• Tc refers to the income tax rate

If the after-tax debt is already considered, then you may leave off the latter part of the formula (1 -
Tc). For instance, consider a business with a capital structure that consists of 60% equity and 40% debt.
Their cost of equity is 10%, and the after-tax cost of debt is 8%.

The weighted average cost of capital would be:

(0.6 × 10%) + (0.4 × 8%) = 13.7%

 Let’s
Lesson 7:
EXPLAIN!
The Capital Budgeting

What is Capital Budgeting?

Understanding Capital Budgeting

Ideally, businesses would pursue any and all projects and opportunities that enhance shareholder
value and profit. However, because the amount of capital or money any business has available for new pro-
jects is limited, management uses capital budgeting techniques to determine which projects will yield the
best return over an applicable period.

Although there are numerous capital budgeting methods, below are a few that companies can use to
determine which projects to pursue.

Discounted Cash Flow Analysis

Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project, the mix
of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs.

Present Value

These cash flows, except for the initial outflow, are discounted back to the present date. The resulting
number from the DCF analysis is the net present value (NPV). The cash flows are discounted since present
value states that an amount of money today is worth more than the same amount in the future. With any
project decision, there is an opportunity cost, meaning the return that is foregone as a result of pursuing the
project. In other words, the cash inflows or revenue from the project needs to be enough to account for the
costs, both initial and ongoing, but also needs to exceed any opportunity costs.

With present value, the future cash flows are discounted by the risk-free rate such as the rate on
a U.S. Treasury bond, which is guaranteed by the U.S. government. The future cash flows are discounted by
the risk-free rate (or discount rate) because the project needs to at least earn that amount; otherwise, it
wouldn't be worth pursuing.
 Cost of Capital

Also, a company might borrow money to finance a project and as a result, must at least
earn enough revenue to cover the cost of financing it or the cost of capital. Publicly-traded compa- nies
might use a combination of debt–such as bonds or a bank credit facility–and equity–or stock shares. The
cost of capital is usually a weighted average of both equity and debt. The goal is to calculate the
hurdle rate or the minimum amount that the project needs to earn from its cash inflows to cover the costs.
A rate of return above the hurdle rate creates value for the company while a project that has a re- turn
that's less than the hurdle rate would not be chosen. Project managers can use the DCF model to helpchoose
which project is more profitable or worth pursuing. Projects with the highest NPV should rank over others
unless one or more are mutually exclusive. However, project managers must also consider any risks of
pursuing the project.

Payback Analysis

Payback analysis is the simplest form of capital budgeting analysis, but it's also the least accurate.
It's still widely used because it's quick and can give managers a "back of the envelope" understanding of
the real value of a proposed project. Payback analysis calculates how long it will take to recoup the costs
of an investment. The payback period is identified by dividing the initial investment in the project by the
average yearly cash inflow that the project will generate. For example, if it costs $400,000 for the initial
cash outlay, and the project generates $100,000 per year in revenue, it'll take four years to recoup the in-
vestment.

Payback analysis is usually used when companies have only a limited amount of funds (or
liquidity) to invest in a project and therefore, need to know how quickly they can get back their in-
vestment. The project with the shortest payback period would likely be chosen. However, there are some
limitations to the payback method since it doesn't account for the opportunity cost or the rate of return
that could be earned had they not chosen to pursue the project.

Also, payback analysis doesn't typically include any cash flows near the end of the project's life. For
example, if a project being considered involved buying equipment, the cash flows or revenue generat- ed
from the factory's equipment would be considered but not the equipment's salvage value at the end of the
project. The salvage value is the value of the equipment at the end of its useful life. As a result, pay- back
analysis is not considered a true measure of how profitable a project is but instead, provides a rough estimate
of how quickly an initial investment can be recouped.

Throughput Analysis

Throughput analysis is the most complicated form of capital budgeting analysis, but also the most
accurate in helping managers decide which projects to pursue. Under this method, the entire company is
considered as a single profit-generating system. Throughput is measured as an amount of material pass-
ing through that system.

The analysis assumes that nearly all costs are operating expenses, that a company needs to maxim-
ize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to
maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the sys-
tem that requires the longest time in operations. This means that managers should always place a higher
priority on capital budgeting projects that will increase throughput.
 Let’s
ELABORATE!

• Cost of capital typically encompasses the cost of both equity and debt, weighted according to the company's
preferred or existing capital structure, known as the weighted average cost of capital (WACC).
• A company's investment decisions for new projects should always generate a return that exceeds the firm's
cost of the capital used to finance the project; otherwise, the project will not generate a return for investors.
•

•
 Let’s
Lesson 8:
EXPLAIN!
The Capital Structure

What is Capital Structure?

The capital structure is the particular combination of debt and equity used by a company to finance its over-
all operations and growth. Debt comes in the form of bond issues or loans, while equity may come in the form
of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital
structure.

Understanding Capital Structure

Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance
sheet, are purchased with this debt and equity. Capital structure can be a mixture of a company's long-
term debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term
debt versus long-term debt is considered when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/ E)
ratio, which provides insight into how risky a company's borrowing practices are. Usually, a companythat is
heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors.
This risk, however, may be the primary source of the firm's growth.

Debt is one of the two main ways a company can raise money in the capital markets. Companies
benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds
may be tax deductible. Debt also allows a company or business to retain ownership, unlike equity. Addi-
tionally, in times of low interest rates, debt is abundant and easy to access.

Equity allows outside investors to take partial ownership in the company. Equity is more expensive
than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid
back. This is a benefit to the company in the case of declining earnings. On the other hand, equity repre-
sents a claim by the owner on the future earnings of the company.

Measures of Capital Structure

Companies that use more debt than equity to finance their assets and fund operating activities have
a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than
debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an
aggressive capital structure can also lead to higher growth rates, whereas a conservative capital struc- ture
can lead to lower growth rates. Analysts use the debt-to-equity (D/E) ratio to compare capital struc- ture. It is
calculated by dividing total liabilities by total equity. Savvy companies have learned to incorpo- rate both
debt and equity into their corporate strategies. At times, however, companies may rely too heav- ily on
external funding, and debt in particular. Investors can monitor a firm's capital structure by tracking the D/E
ratio and comparing it against the company's industry peers.
 Computing a Capital Structure

Let's consider two different examples of capital structure:

Company A, for our purposes, has $150,000 in assets and $50,000 in liabilities. This means Compa-
ny A's equity is $100,000.

The company's capital structure is therefore such that for every 50 cents of debt, the company
makes $1 of equity.

This, then, would be an example of a low-leverage, or even low-risk, equity capital-structured com-
pany.

Now, take its cross-town rival, Company B. Company B has $120,000 in assets, $100,000 in debt and
therefore $20,000 in equity.

Company B is "highly leveraged." For every $5 of debt, the company has $1 in equity. This means
not only the company needs to increase its returns to be able to finance its debt, eventually, but the com-
pany also will be viewed as a greater risk to future lenders.

A real-life example of a vendor financing capital structure was when Sam Walton's Wal-Mart (now
Walmart (WMT) - Get Report ) took off. Walton was able to often sell Tide and other Procter & Gamble
products before having to pay P&G (PG) - Get Report , effectively using P&G's money to grow.

How Do You Calculate Capital Structure?

Since capital structure is the amount of debt or equity or both employed by a firm to fund its opera-
tions and finance its assets, capital structure is typically expressed as a debt-to-equity ratio.

To calculate the debt-to-equity ratio, the formula is relatively straight forward.

The company's total liabilities are divided by its total shareholder's equity.

Using our previous examples, Company A has $150,000 in assets, and $50,000 in liabilities.

Company A's equity is determined by subtracting its liabilities from its overall assets, meaning it
has $100,000 in equity.

Dividing Company A's total liabilities of $50,000 by its total shareholders' equity of $100,000, it has
a Debt/Equity ratio of 0.5, meaning for every 50 cents of debt, the company has $1 of equity -- and is
therefore low-leveraged.

Company B on the other hand, has $120,000 in assets, but $100,000 in debt. That means its equity is
$20,000, but its liabilities are $100,000.

Debt/Equity Ratio = $100,000 divided by $20,000 = 5.

This means that for every $5 in debt, Company B hold $1 in equity.

That's why Company B is considered "highly leveraged."

References and Additional Readings:

https://www.investopedia.com/terms/c/costofcapital.asp

https://investinganswers.com/dictionary/c/cost-capital

https://www.indeed.com/career-advice/career-development/what-is-cost-of-
capital

https://www.investopedia.com/terms/c/capitalbudgeting.asp#:~:text=Ca
pital%
20budgeting%20is%20used%20by,return%20meets%20a%20set%20benchmark.

https://www.investopedia.com/terms/c/capitalstructure.asp

https://www.thestreet.com/investing/earnings/capital-structure-14971332

https://brainmass.com/business/discounted-cash-flows-model/case-
determining-the-cost-of- capital-37313