Determining the cost of capital

Financial management

The concept of cost of capital is one of the basic theories of financial management. The content of this concept is that, regardless of the source of funding, raising capital in the economic turnover associated with certain costs.
So, lenders have to pay interest on the loan, the bondholders - annual coupon, shareholders rely on dividends. Even when financial resources are derived from the reinvestment of profits, their involvement is not free in nature, as in any case must take into account the opportunity costs.
When the value (or price) ratio of capital to understand the cost of servicing debt capital to the value of the capital. Expressed as a percentage of capital value and shows how much you need to pay for using the unit of financial resources from a source, usually within a year.
Thus it is necessary to distinguish between cost of capital and the enterprise value of the company as a whole. If the first indicator is a relative expression of the annual cost of servicing the debt to the owners and investors, the total value of the enterprise as a subject in the capital market depends on the equity return, risk level, inflation and so on.
At the time of the sale of the enterprise as integral property complex takes into account the value of "goodwill", ie the valuation of its value, depending on time and short-term options, company image and can be both negative and positive.
Method of determining the cost of capital depends on the source of its attraction. The main sources of capital bank loans issued enterprise bonds, shares and retained earnings. Consider the features determining the value of each of these elements of capital.

The cost of capital raised through bank loans

Since interest on bank loans are excluded from the income tax base, the real value of the equity units will be lower than the rate of bank interest on the value of the tax savings. Consequently, the cost of capital raised through bank loans, should be considered on the basis of income tax.

Determine the cost of capital through bond new issue can be as follows:
In case the bonds are placed at a discount (discount on the price), is not taken nominal bonds and the price of its real accommodation less discounts. If permitted to attribute interest on the bonds on profit before tax, you need to consider the size of the tax savings, as in the case involving bank loans.

The cost of capital raised through the issuance of shares
Price of capital from this source depends not only on the term of the securities issue (new or previously made issue), but also on their type (ordinary or preference shares).

The value of the dividend on ordinary shares is not determined in advance, depending on the performance of the company. Therefore, the cost of financial resources can not be calculated with great precision. There are different methods of valuation capital raised through the ordinary shares, the most common model of Gordon and model C ARM.

The disadvantages of this model include significant sensitivity to changes in the growth rate of dividends and mis-accounting risk factor. Moreover, this formula can be applied only to corporations that pay dividends in cash.

The cost of capital raised from retained earnings
Retained earnings can be considered as delayed payments to income that owners deliberately directed to replenish the reserve funds or expansion.
The weighted average cost of capital characterizes the average cost to support the economic potential of the company for the existing structure of the sources of funds, demands of investors and creditors and adopted dividend policy. The weighted average cost of capital compared with the internal rate of return of the project. In order for the project was appropriate, average cost of capital should not exceed the internal rate of return.
The weighted average cost of capital used to estimate the prices are now involved capital. In case must prove the expediency of the future increase of capital may be determined by the marginal cost of capital formula weighted average (7.11). In this case, instead of the actual value of the cost of capital and some sources set new projected price of its involvement, and the share of the i-th source is set according to the target (the preferred enterprise) structure.
The weighted average cost of capital is also the minimum rate of return that investors expect from investing. To determine the present value of future cash flows from the investment object discount rate is usually set at the weighted average cost of capital. The main elements of the formation of WACC are risk-free part of the rate of return on investment capital, risk premium and inflation premium.