What does a company’s cost of capital represent? The cost of capital represents the funds that are raised for a company to use. (Gallagher and Andrew, 2003, pg 238) To raise or borrow funds costs money. It costs money because leaders of the funds demand compensation for the funds provided. (Gallagher and Andrew, 2003, pg 238) The best way to explain this is to use the example of purchasing a home. A bank or mortgage company will loan you funds to purchase a home, however they require you to pay them interest to borrow these funds, in addition, if you don’t pay back the loan with interest, they can come and take your home, your asset.
We need to look at how each type of cost of capital in order to understand how to calculate the cost. (Lawrence, 2005) The cost of debt is the interest rate after taxes. The reason we look at this as after taxes is we must calculate the savings to the company on taxes. The reason a company doesn’t use all their cost of capital in the form of debt is because of the risk analysis that is performed on a company. (Lawrence, 2005) It would make the company look bad. We calculate the cost of debt by the before-tax cost of debt multiplied by one minus the firms marginal tax rate. (Gallagher and Andrew, 2003, pg 240) The next type of cost of capital is the cost of preferred and common stock. This is not taxable. We find the cost of preferred stock by the amount of the expected preferred stock dividend divided by the current price of the preferred stock minus the flotation cost per share. (Gallagher and Andrew, 2003, pg 241) The flotation cost is the cost of issuing the new securities. (Gallagher and Andrew, 2003, pg 241) The last type of cost of capital is the cost of common equity. “This is the required rate of return on funds supplies by existing common stockholders.” (Gallagher and Andrew, 2003, pg 242) We find this figure by taking the dollar amount of common dividend expected one period divided by the required rate of return per period on this common stock investment minus the expected growth rate per period. (Gallagher and Andrew, 2003, pg 242)
How is the cost of capital calculated? We calculate the cost of capital though a weighted average cost of capital also known as WACC. The WACC is calculated by taking the weight of debt used to finance the firms assets multiplied by the after-tax cost of debt plus the weight of preferred stock being used to finance the firm’s assets multiplied by the cost of preferred stock plus the weight of common equity being used to finance the firm’s assets multiplied by the cost of common equity. (Gallagher and Andrew, 2003, pg 247)
How do market rates and the company’s perceived market risk impact its cost of capital? “Lenders may increase the interest rate they charge if they think the firm’s debt load will be too heavy” (Gallagher and Andrew, 2003, pg 248) As financial mangers we must consider the affect of the WACC as we raise funds for various reasons (expansion, need machinery etc.). (Gallagher and Andrew, 2003, pg 248) This process is known as marginal cost of capital or MCC. Financial mangers must consider “1. Assess at what point a firm’s cost of debt or equity will change the firm’s WACC. 2. Estimate how much the change will be and 3. Calculate the cost of capital up to and after the points of change.” (Gallagher and Andrew, 2003, pg 249)
By taking into consideration the MCC, financial mangers can “identify which new capital budgeting projects should be selected for further consideration and which should be rejected.” (Gallagher and Andrew, 2003, pg 253)
You can see an example of this in action by IBM. IBM says they are “Creating Value for its Owners” (IBM, 2005) IBM claims to put their strong cash flow to good use by “Our investments are designed to exceed substantially the company’s cost of capital.” (IBM, 2005)
Gallagher, Timothy J, and Andrew, Joseph D., 2003, “Financial Management Principles and Practice”, by Pearson Education Inc, Upper Saddle River, New Jersey.
Garner, Lawrence, CTU online Chat, December 4, 2005, “live chat discussion”
IBM, “How we create value for our owners”, [Electronic Version] retrieved on December 5, 2005 from http://www.ibm.com/annualreport/2004/prospectus/econ_flash.shtml