HOW COMPANIES COMPUTE THEIR COST OF CAPITAL

Efficient portfolios and Efficient frontier
10/09/2019
Industry
10/09/2019

HOW COMPANIES COMPUTE THEIR COST OF CAPITAL

Instructions

1) Original Post = 300 words

2) 3- Responses needed = each response should 150 words

3) 3 References

4) Citations with in the body

 

Cost of Capital

In the links below, you will explore how companies compute their cost of capital by computing a weighted average of the three major components of capital: debt, preferred stock, and common equity. The firm’s cost of capital is a key element in capital budgeting decisions and must be understood in order to justify capital projects.

Cost Capital= https://www.youtube.com/watch?v=B8JZhQofRTs

 

For this Discussion, imagine the following scenario:

You are the director of operations for your company, and your vice president wants to expand production by adding new and more expensive fabrication machines. You are directed to build a business case for implementing this program of capacity expansion. Assume the company’s weighted average cost of capital is 13%, the after-tax cost of debt is 7%, preferred stock is 10.5%, and common equity is 15%. As you work with your staff on the first cut of the business case, you surmise that this is a fairly risky project due to a recent slowing in product sales. As a matter of fact, when using the 13% weighted average cost of capital, you discover that the project is estimated to return about 10%, which is quite a bit less than the company’s weighted average cost of capital. An enterprising young analyst in your department, Harriet, suggests that the project is financed from retained earnings (50%) and bonds (50%). She reasons that using retained earnings does not cost the firm anything since it is cash you already have in the bank and the after-tax cost of debt is only 7%. That would lower your weighted average cost of capital to 3.5% and make your 10% projected return look great.

Based on the scenario above, post your reactions to the following questions and concerns:

What is your reaction to Harriet’s suggestion of using the cost of debt only? Is it a good idea or a bad idea? Why? Do you think capital projects should have their own unique cost of capital rates for budgeting purposes, as opposed to using the weighted average cost of capital (WACC) or the cost of equity capital as computed by CAPM? What about the relatively high risk inherent in this project? How can you factor into the analysis the notion of risk so that all competing projects that have relatively lower or higher risks can be evaluated on a level playing field?

Reponse-1(Ray)

 

I think Harriet has a good suggestion because since it is cash you already have in the bank and the after-tax cost of debt is only 7% that is a bad deal in the big picture and could end up being much cheaper. This process could end up lowering financial cost; you can also be able to make periodic payments. These on going payments allow the company to keep some of their profits because they are only required to pay what they owe. There are also some benefitting rules with regards to taxes for the use of debt payments.

According to investopedia Weighted average cost of capital is used to access an investors’ return on investment.  “The average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds, and any other long-term debt.” Cost of equity determines the rate of return on a project. I think the project should use the Weight of average of capital because it is used as a good appraisal to proceed or not proceed in a new project and is good for doing comparison with other firms.

Risk is crucial part of business that you must pay attention too, with regards to cost of capital I did some research on it and according to an article on small business chronicle they gave some advantages to risk. With regards to risk you need to pay attention to the spending of capital, you need to have a right evaluation of what you are spending is worth it. An economic condition of the country is important because it can affect a company. The corporate cash flow is something you need to pay attention too. The buying climate of the customer is very important especially in this case when you care about selling. Improvement in technology can be good or bad, a company must keep up to stay afloat.

Response-2(Shiva)

 

An obligation is a less expensive wellspring of financing when contrasted with value. Organizations can profit by their obligation instruments by costly the intrigue installments made on existing obligation and in this way lessening the organization’s assessable pay. These decreases in duty obligation are known as expense shields. Assessment shields are urgent to organizations since they help to safeguard the organization’s money streams and the absolute estimation of the organization (Lambert, R., Leuz, C., & Verrecchia, R. E. (2007)).

In any case, eventually, the expense of issuing extra obligation will surpass the expense of issuing new value. For an organization with a great deal of obligation, including new obligation will build its danger of default, the powerlessness to meet its money related commitments. A higher default hazard will build the expense of obligation, as new loan specialists will request a premium to be paid for the higher default chance. Moreover, a high default hazard may likewise drive the expense of value up in light of the fact that investors will probably additionally anticipate a premium for going for broke. In spite of its greater expense (value speculators request a higher hazard premium than moneylenders), value financing is alluring on the grounds that it doesn’t make a default hazard to the organization. Likewise, value financing may offer a simpler method to raise a lot of capital, particularly if the organization does not have broad acknowledge set up for loan specialists. Nonetheless, for certain organizations value financing may not be a decent choice, as it will diminish the control of current investors over the business (Modigliani, F., & Miller, M. H. (1963)).

Computing the Cost of Debt: 

The expense of obligation for a business firm is typically less expensive than the expense of value capital. This is on the grounds that the intrigue cost on an obligation is charge deductible for the business firm. This is the reason numerous independent company firms except if they have speculators, use obligation financing (Easley, D., & O’hara, M. (2004)).

The littlest of organizations may utilize momentary obligation just to buy their advantages. For instance, they may utilize provider credit as records payable. They could likewise simply utilize momentary business credits, either from a bank or some elective wellspring of financing. Bigger organizations may utilize transitional or long haul business advances or may even issue securities to fund-raise for financing. Obligation and value make up the capital structure of the firm, alongside different records on the right-hand side of the company’s asset report, for example, favored stock. As organizations develop, they may get financing from obligation sources, regular value (held profit or new normal stock) sources, and even favored stock sources. To compute an improved expense of capital for the firm, first audit the association’s present capital structure and ascertain its extent of obligation and value. At that point weight the expense of obligation and the expense of value by the subsequent rates when computing the expense of capital. Next, entirety the weighted expenses of capital and obligation to get the WACC

Response-3 (Anubhav)

 

Duty is a progressively moderate wellspring of financing when showed up contrastingly in connection to regard. Affiliations can profit by their dedication instruments by over the top the intrigue segments made on existing responsibility and along these lines decreasing the affiliation’s assessable compensation. These decreases in evaluation duty are known as cost shields. Evaluation shields are sincere to relationship since they help to safeguard the affiliation’s money streams and the all out estimation of the affiliation.

Notwithstanding, unavoidably, the expense of issuing extra duty will beat the expense of issuing new regard. For a relationship with a ton of duty, including new responsibility will expand its danger of default, the powerlessness to meet its money related obligations. A higher default risk will gather the expense of responsibility, as new credit experts will request a premium to be paid for the higher default probability. Furthermore, a high default hazard may in addition drive the expense of huge worth up in light of the manner in which that monetary masters will in all likelihood in like way predict a premium for putting everything at stake. Ignoring its progressively significant cost (regard inspectors request a higher hazard premium than banks), regard financing is drawing in light of the fact that it doesn’t make a default peril to the affiliation. Correspondingly, regard financing may offer an increasingly clear procedure to raise a lot of capital, particularly if the affiliation does not have extensive perceive set up for development specialists. Regardless, for explicit affiliations worth financing may not be a decent choice, as it will diminish the control of current examiners over the business.

Learning the Expense of Responsibility

The expense of responsibility for a business firm is normally more reasonable than the expense of critical worth capital. This is in light of the way that the intrigue cost on duty is charge deductible for the business firm. This is the reason different private undertaking firms beside if they have scholars, use responsibility financing.

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