Assessing cost of capital - Free Essay Example

The cost of capital is the minimum return that investors expect for providing capital to a company. If the goal of a firm is to remain profitable any use of capital must return at least its cost of capital. The cost of capital is determined by summing the cost of various Components of capital. The weighted average cost of capital is frequently used as a benchmark when evaluating new projects or busineses, the weighted average cost of capital is the total of the cost of each component of capital. (Patterson, 1995) Capital has the following components, common stock, preferred stock, bonds and retained earnings. The cost of capital is generally calculated on a weighted average basis. Common stock are securities that represent equity ownership, providing voting rights and entitling the holder dividends from the company but not necessary in that the company choose when to pay out dividends and when not to pay out dividends. The price of common stock is projected by establis hing the rate at which the shareholder discounts the anticipated dividends to establish the share value. Preferred stock is superior to common stock and generally has dividends that must be paid out. The cost of preferred stock is calculated by dividing the annual preferred stock dividends by net proceeds from the issuance. The long term debt is made through the issue of bonds. The earnings of the bonds are condensed by the expenses sustained in the issue and sale of the security. Bonds have a specific time period that they must be paid and they carry a maturity date. Retained earnings are earnings earned by the company which can either be kept by the company or paid out as dividends to the shareholders. The cost of retained earnings is the same as the cost of companys common stock. Weighted average cost of capital is determined by taking into account the weight of each component of the company capital structure. Market value of the components is used rather than the book values. (P atterson, 1995) Weighted average cost of capital =E/V-Re+Rd- (1-Tc) Where; Re= is the cost of equity Rd =is the cost of debt, E= is the market value of the firms debt, V=E+D, E/V is the proportion of funding that is equity D/V= is the fraction of funding that is debt Tc= is the corporate tax rate. Cost of capital also includes cost of equity which is associated with market risk. Market risk is the risk that the investment value will decrease due to changes in market factors. When shareholders want to invest in a company they want to see more equity than debt. As market changes so does the cost of capital. The increase or decrease of cost of capital is according to how the market is doing. The debt to equity mix must be right, because if a company has too much debt, the investors might not invest in the company. The objective of the financiers is to find the right mix to provide highest expected long-term shareholder value. Risk can be measured in two ways; one is by using modern portfolio theory and the capital asset pricing and second is to look at other risk factors that affect the business. Basically in order to use the capital asset pricing to determine the proper discount rate, one must know the stocks beta, the nominal risk free rate, and the anticipated return on the marketplace. Stocks with betas greater than 1 are more risky. CAPM = Where is the required return, R (F) is the risk free rate return, b is the beta coefficient and r(m) is the return on the market assets.( Bragg,2007) Modern portfolio theory reduces portfolio risk by selecting balancing assets based on statistical techniques that quantify the amount of diversification by calculating expected returns, the main objective of this theory is to find which portfolio has the maximum return for a specific risk, or the minimum risk for a given return. The second way to measure risk is to start by taking into account the effects of the following risks e.g. financi al risk which involves companys capital structure, business risk which involves the future of the business like how the company will look in the next ten years. (Bragg, 2007) Standard deviation is a quantitative statistical measure of the variation of particular returns to the average of those returns. Here r(j) is the j-th outcome of return, the Pr(j) is the probability of the j-th outcome and the n is the number of outcomes. (Gaughan, 2007) The greater the standard deviation the greater the risk however standard deviation cannot be used in comparison of investments unless they have the same comparable returns. Coefficient of variation indicates risk per unit. It is a better measure of risk, hence allows comparison of different investments. The investments with smaller return have the greater risk. While standard deviation measures the dispersion of returns, the coefficient of variation measures their relative dispersion. The coefficient of variation is or standard devi ation of returns divided by, which is expected value of average return. According to me the choice of 6% cost of capital is to get returns on capital and sustain our market value. Don may be correct that in these economic times it is better to only invest in projects with higher expectations for returns. The choice of the appropriate discount rate to use should be based on the riskiness of the target and the volatility of the project, the target cash flows are focused as they reflect the value of the investment. So in use of 6% or 7% should take into account then above reasons. The riskier the investment the higher the discount rate should be used. The higher the discount rate the lower the present value of the projected cash flow .so the use of 7 % will lower the expected returns. (Gaughan, 2007)