What are the factors affecting cost of capital? What is The Composite cost of capital? Example of composite costs.

Factors affecting cost of capital

There are several factors affecting cost of capital that impact the cost of capital of any company. There are various elements that affect the cost of capital for every organization. This would mean that the cost of capital for any two enterprises would not be equal. Rightly so,as These two firms would not entail the same risk.

1. General economic conditions: These include the demand for and supply of capital throughout the economy and the degree of predicted inflation. These are reflected in the riskless rate of return, which is typical of most of the firms.

2. Market conditions: The security may not be easily marketable when the investor wants to sell it, or even if a steady demand for the securities does exist, the price may differ greatly. This is business-specific.

3. A firm’s operations and financial choices: Risk also emerges from the decisions made inside the firm. This danger is often classified into two classes:

a) Business risk is the unpredictability of returns on assets and is impacted by the company’s investment selections.

b) Financial risk is the greater unpredictability of returns to common shareholders. As a consequence of employing debt and preferred stock.

4. Amount of finance required: The final element affecting the company’s cost of money is the amount of funding necessary when the cost of capital rises. when the financial needs get bigger. This rise may be related to one of two factors:

a) As ever greater public concerns are increasingly discussed in the market, Extra flotation expenses (costs of issuing the instrument) and underpricing will impact the percentage cost of the money to the company.

b) As management approaches the market for huge sums of funds,Due to the firm’s size, the investors’ needed rate of return may climb. Suppliers of Capital became unwilling to provide relatively huge quantities of money. without indication of management’s competence to absorb this cash into the business.

Generally, as the amount of risk grows, a bigger risk premium must be generated to meet the needs of the company’s investors. This, when added to the risk-free rate, equals the firm’s cost of capital.

Composite cost of capital

The composite cost of capital refers to the total or weighted average cost of capital (WACC) for a firm or a project. It indicates the average rate of return that a firm has to generate on all its sources of funding to satisfy its investors and creditors.

A firm often obtains its finances from several sources, such as equity (common stock) and debt (bonds, loans, etc.). Each source of funding has a unique cost associated with it, which indicates the projected return sought by the sources of that cash. The composite cost of capital takes into consideration these distinct charges and their relative weights in the company’s capital structure.

Factors-affecting-cost-of-capital

The formula to calculate the weighted average cost of capital (WACC) is:

WACC = (E/V * Re) + (D/V * Rd * (1 – Tc))

Where:

  • E = Total market value of equity
  • V = Total market value of the firm’s equity and debt
  • Re = Cost of equity
  • D = Total market value of debt
  • Rd = Cost of debt
  • Tc = Corporate tax rate

The components of the formula are:

  1. (E/V * Re): This part represents the cost of equity, which is the return required by the company’s shareholders.
  2. (D/V * Rd * (1 – Tc)): This part represents the after-tax cost of debt. It takes into account the tax advantage of debt, as interest payments are typically tax-deductible.

The weights (E/V and D/V) in the formula are the proportion of equity and debt in the company’s capital structure, respectively.

By calculating the WACC, a firm may establish the minimal return it needs to make from its investments or initiatives to satisfy its investors and retain the value of its shares. Projects or investments that provide returns larger than the WACC are considered value-enhancing, whereas those with returns below the WACC may diminish the total value of the firm.

Composite cost of capital example

Certainly! Let’s consider a more comprehensive example of the composite cost of capital in a table with a company that has multiple sources of financing, including equity, debt, and preferred stock. We’ll also assume different costs of capital for each source.

Assumptions:

  • Cost of Equity (Re): 12% (0.12 in decimal)
  • Cost of Debt (Rd): 6% (0.06 in decimal)
  • Cost of Preferred Stock (Rp): 8.5% (0.085 in decimal)
  • Corporate Tax Rate (Tc): 30% (0.30 in decimal)

Now, let’s create a table to calculate the composite cost of capital (WACC):

Source of CapitalMarket Value (MV)Weight (MV/Total MV)Cost of Capital (Cost * (1 – Tc))Weighted Cost
Equity (E)$1,500,0000.50$1,500,000 * 12% * (1 – 0.30)$126,000
Debt (D)$800,0000.27$800,000 * 6% * (1 – 0.30)$33,600
Preferred Stock (P)$500,0000.17$500,000 * 8.5% * (1 – 0.30)$34,650
Total$2,800,0001.00$194,250

To calculate the composite cost of capital (WACC), we sum up the weighted costs for each source of capital:

WACC = $194,250 (Total weighted cost) / $2,800,000 (Total market value of equity, debt, and preferred stock)

WACC ≈ 6.94% (approximately)

In this example, the composite cost of capital (WACC) for the company is approximately 6.94%. It means the company needs to earn a return of at least 6.94% on its investments to satisfy its investors and maintain the value of the firm’s stock.

The calculation considers the proportion of each source of capital in the company’s capital structure and the respective cost of capital for each source. The WACC reflects the weighted average of these costs, taking into account the tax benefit from the interest on debt (1 – Tc).

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