Accountancy Department

College of Business and Accountancy

Notre Dame University, Cotabato City 9600

Cost of Capital

Submitted to:

Ms. Momena K. Lampatan, CPA

In Partial Fulfilment of the requirement for Acctg 223N Course

HASNIAH A. AKMAD
2022
College of Business and Accountancy Special Term, SY 2021-
2022

Introduction

The Cost of Capital is the most important and controversial area in Financial
Management. Capital Budgeting decisions have a major impact on the firm, and Cost of Capital
is used as a criterion to evaluate the capital Budgeting decisions i.e., whether to accept or reject a
project. Knowledge about cost of capital, and how it is influenced by financial leverage, is useful
in making capital structure decisions. The cost of capital is the most important concept in
financial decision making. The chief objective of measuring the cost of capital is its use as a
decision criterion in capital budgeting. For an investment to be worthwhile, the expected return
on capital must be greater than the cost of capital. The cost of capital is the rate of return that
capital could be expected to earn in an alternative investment of equivalent risk. If a project is of
similar risk to a company’s average business activities it is reasonable to use the company’s
average cost of capital as a basis for the evaluation. A company’s securities typically include
both debt and equity; one must therefore calculate both the cost of debt and the cost of equity to
determine a company’s cost of capital. However, a rate of return larger than the cost of capital is
usually required. The WACC is the minimum return that a company must earn on an existing
asset base to satisfy its creditors, owners, and other providers of capital, or they will invest
elsewhere. Companies raise money from a number of sources: common equity, preferred equity,
straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities,
executive stock options, governmental subsidies, and so on. Different securities, which represent
different sources of finance, are expected to generate different returns. The WACC is calculated
taking into account the relative weights of each component of the capital structure. The more
complex the company’s capital structure, the more laborious it is to calculate the WACC

According to Ezra Solomon, ‘the cost of capital is the minimum required rate of earnings
or the cut-off rate of capital expenditure’

The cost of capital influences the financing policy decision, i.e. the proportion of debt
and equity in the capital structure. Optimal capital structure of a firm can maximize the
shareholders’ wealth because an optimal capital structure logically follows the objective of
minimization of overall cost of capital of the firm. Thus while designing the appropriate capital
structure of a firm cost of capital is used as the yardstick to determine its optimality.

The definition given by Keown et al. refers to the cost of capital as ‘the minimum rate of
return necessary to attract an investor to purchase or hold a security’. Analysing the above
definitions we find that cost of capital is the rate of return the investor must forego for the next
best investment. In a general sense, cost of capital is the weighted average cost of fund used in a
firm on a long-term basis.

Another key point in this literature review is that, the cost of capital is also used to
evaluate the acceptability of a project. If the internal rate of return of a project is more than its
cost of capital, the project is considered profitable. The composition of assets, i.e. fixed and
current, is also determined by the cost of capital. The composition of assets, which earns return

1
College of Business and Accountancy Special Term, SY 2021-
2022

higher than cost of capital, is accepted. Various methods used in investment decisions require the
cost of capital as the cut-off rate.

I. Literature Review

The Calculation Methods of Capital Cost

According to E.R. Yescombe, Edward Farquharson, WACC is thus not really an

appropriate measure for a project company. The usual measure of the cost of capital for
PPP projects is the project IRR. This is calculated as the IRR on the original investment,
derived from the projected net operating cash flow (before financing costs) over the
project.

As one of the core concepts of corporate financial management, on the one hand,
cost of capital is the cost of corporate financing and is related to firm’s financing
behavior. According to the “financing priority” theory, when a firm needs financing, the
first consideration is internal financing while equity financing is secondary. In addition,
the cost of debt capital and equity capital also determines the financing structure of firms.
On the other hand, the cost of capital is the necessary rate of return for investors, which is
related to the investment decision of firms. Taking the cost of capital as the discount rate,
if the net present value of a project is lower than 0, then the project is not worth investing,
because the investment income cannot offset the cost of financing; If the net present
value is greater than or equal to zero, then the investment is profitable and the project is
worth investing in. As a bridge connecting both investment and financing and investors
and managers, cost of capital plays an important role in corporate finance. There are three
main methods to measure the cost of capital in relevant literatures: average cost of capital,
weighted average cost of capital and internal rate of return.

The WACC is the broadest measure of the firm’s cost of funds and represents the
return that a firm must earn to induce investors to buy its common stock, preferred stock,
and bonds. The WACC23 is calculated using a weighted average of the firm’s cost of
equity (ke), cost of preferred stock (kpr), and pretax cost of debt (i) (Donald
M. DePamphilis Ph.D, 2022)

Cost of capital estimation

In modern corporate finance theory, the cost of capital has a significant impact on
the investment and financing activities of firms. Cost of capital is the weighted average
cost of capital where weights are based on the market value of equity and debt. The
market value of equity is the market capitalization and the market value of debt is

2
College of Business and Accountancy Special Term, SY 2021-
2022

estimated by multiplying the ratio of price of a long-term bond to face value of bond with
book value of debt. Interest bearing liabilities are taken as book value of debt
(Rajesh Kumar,2017).

Capital structure, capital cost, and capital productivity

The WACC summarizes the cost of interest-bearing liabilities and equity permanently
employed in the business. Investors’ return expectations for providing equity are driven by
alternative capital projects/stock market returns with comparable risk profiles. The average
price of debt/interest rate results from various risk and market-based agreements with
creditors (Hans-Arthur Vogel,2019).

II. Conclusion and Recommendations

This article reviews the literatures about calculation methods and influencing factors
of capital cost, which gives us a comprehensive view. To be more specific, the article
compares all the calculation methods and elaborates the relationships and differences among
them, what’s more, it reviews their popularity in China. Calculation methods are abundant
and using different methods to calculate the cost of capital can test the robustness of methods.
Besides, the article also concludes the factors which influence cost of capital significantly,
such as operation and governance of the company, information disclosure, external macro
environment and so on. Previous literatures only analyze the influence of a single factor and
pay little attention to the joint effect. In next, in one way, we can calculate cost of capital in
different ways to make sure the validity of calculation, in other way we should actively
explore other influencing factors and pay more attention to the joint effect of influencing
factors rather than influence of a single one, which is useful for evaluating and reducing cost
of capital and responding positively to calls put forward by supply-side structural reform.

This study shows that the most common approach in calculating the cost of capital is
to use the Weighted Average Cost of Capital (WACC). Under this method, all sources of
financing are included in the calculation, and each source is given a weight relative to its
proportion in the company's capital structure.

III. References:

Pittman, J.A. and Fortin, S. (2004) Auditor Choice and the Cost of Debt Capital for Newly
Public Firms. The Journal of Accounting & Economics, 37, 113-136.

Garcíameca, E. (2011) Ownership Structure and the Cost of Debt. European Accounting
Review, 20, 389-416.

3
College of Business and Accountancy Special Term, SY 2021-
2022

Wang, P. and Lan, J. (2016) Will Mixed Ownership Affect Capital Cost? The Economic and
Management Studies, 129-136.

Zou, Y., et al. (2017) Rational Estimation and International Comparison of Capital Cost of
Chinese Listed Companies. The World Economic Journal, 1-25.

Li, G. and Liu, L. (2009) Cost of Debt and Private Credit Discrimination. The Financial
Research, 137-150.

Chen, H. and Zhou, Z. (2014) Internal Control Quality and Corporate Debt Financing Cost.
Nankai Management Review, 17, 103-111.

Ye, D. and Li, X. (2017) CEO Financial Experience and Cost of Debt Capital. The Sanjing
Review, 135-152.

Gebhardt, W.R., Lee, C. and Swaminathan, B. (2001) Toward an Implied Cost of Capital.
Journal of Accounting Research, 39, 135-176.

Easton, D. (2004) PE Ratios, PEG Ratios, and Estimating the Implied Expected Rate of
Return on Equity Capital. The Accounting Review, 79, 73-95.

Ohlson, J.A. and Juettnernauroth, B.E. (2005) Expected EPS and EPS Growth as
Determinants of Value. The Review of Accounting Studies, 10, 349-365.

Claus, J. and Thomas, J. (2010) Equity Premia as Low as Three Percent? Evidence from
Enalysts’ Earnings Forecasts for Domestic and International Stock Markets. Journal of
Finance, 56, 1629-1666.

Jiang, F. and Lu, Z. (2006) The Relationship between Diversification and Cost of Capital—
Evidence from China’s Stock Market. The Accounting Research, 48-55.

Luo, Q. and Wang, Y. (2015) Real Earnings Management and Cost of Equity Capital—An
Analysis Based on the Difference in Corporate Growth. The
Financial Research, 178-191.

Li, Y., et al. (2016) IFRS, Financial Analysts, Institutional Investors and Cost of Equity
Capital—Based on Information Governance Perspective. The Accounting Research, 26-33.

Lin, Z., et al. (2015) Environmental Uncertainty, Diversification and Cost of Capital. The
Accounting Research, 36-43.

Wang, P., et al. (2014) Core Reconstruction of Executive Compensation Incentive: Capital
Cost Constraint View. The China’s Industrial Economy, 109-121.

4
College of Business and Accountancy Special Term, SY 2021-
2022

Zhang, S. and Yang, H. (2014) Accounting Conservatism Choice, Capital Cost and
Enterprise Value. The Macroeconomic Research, 97-106.
Shen, H. (2007) Market Segmentation, Cross-Border Listing and Expected Capital Cost-
Empirical Evidence from Ohlson-Juettner Model. The Financial Research, 146-155.

Wang, P., et al. (2015) Study on Differences of Capital Cost with Heterogeneous
Shareholders—Also on the Financial Basis of Mixed-Ownership Reform. China’s Industrial
Economy, 129-144.

Botosan, C.A. and Plumlee, M.A. (2005) Assessing Alternative Proxies for the Expected
Risk Premium. The Accounting Review, 80, 21-53.

Fama, E.F. and French, K.R. (1999) The Corporate Cost of Capital and the Return on
Corporate Investment. Journal of Finance, 54, 1939-1967.

Zhang, Z., et al. (2004) Cost of Capital and Investment Return of a-Share Listed
Companies—From the Perspective of Internal Rate of Return. The Economic Research, 74-
84.