Cost of capital - wikipedia Cost of capital In economics and accounting, the cost of capital is the cost of a company 's funds ( both debt and equity ), or, from an investor 's point of view `` the required rate of return on a portfolio company 's existing securities ''. It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. Contents 1 Basic concept 2 Cost of debt 3 Cost of equity 3.1 Expected return 3.2 Comments 3.2. 1 Cost of retained earnings / cost of internal equity 4 Weighted average cost of capital 5 Capital structure 6 Modigliani -- Miller theorem 7 See also 8 References 9 Further reading Basic concept For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital. Given a number of competing investment opportunities, investors are expected to put their capital to work in order to maximize the return. In other words, the cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk ; this is the opportunity cost of capital. If a project is of similar risk to a company 's average business activities it is reasonable to use the company 's average cost of capital as a basis for the evaluation. However, for projects outside the core business of the company, the current cost of capital may not be the appropriate yardstick to use, as the risks of the businesses are not the same. A company 's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company 's cost of capital. Importantly, both cost of debt and equity must be forward looking, and reflect the expectations of risk and return in the future. This means, for instance, that the past cost of debt is not a good indicator of the actual forward looking cost of debt. Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital ( WACC ), can be calculated. This WACC can then be used as a discount rate for a project 's projected free cash flows to firm. Cost of debt When companies borrow funds from outside lenders, the interest paid on these funds is called the cost of debt. The cost of debt is computed by taking the rate on a risk - free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases ( since, all other things being equal, the risk rises as the cost of debt rises ). Since in most cases debt expense is a deductible expense, the cost of debt is computed on an after - tax basis to make it comparable with the cost of equity ( earnings are taxed as well ). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as K D = ( R f + credit risk rate ) ( 1 − T ) ( displaystyle K_ ( D ) = ( R_ ( f ) + ( \text ( credit risk rate ) ) ) ( 1 - T ) ), where T ( displaystyle T ) is the corporate tax rate and R f ( displaystyle R_ ( f ) ) is the risk free rate. Cost of equity Main article : Cost of equity The cost of equity is inferred by comparing the investment to other investments ( comparable ) with similar risk profiles. It is commonly computed using the capital asset pricing model formula : Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta × ( market rate of return -- risk free rate of return ) where Beta = sensitivity to movements in the relevant market. Thus in symbols we have E s = R f + β s ( R m − R f ) ( displaystyle E_ ( s ) = R_ ( f ) + \beta _ ( s ) ( R_ ( m ) - R_ ( f ) ) ) where : E is the expected return for a security ; R is the expected risk - free return in that market ( government bond yield ) ; β is the sensitivity to market risk for the security ; R is the historical return of the stock market ; and ( R -- R ) is the risk premium of market assets over risk free assets. The risk free rate is the yield on long term bonds in the particular market, such as government bonds. An alternative to the estimation of the required return by the capital asset pricing model as above, is the use of the Fama -- French three - factor model. Expected return The expected return ( or required rate of return for investors ) can be calculated with the `` dividend capitalization model '', which is K c s = Dividend Payment / Share ( 1 + Growth ) Price Market + Growth rate ( displaystyle K_ ( cs ) = ( \frac ( ( \text ( Dividend ) ) _ ( \text ( Payment / Share ) ) ( 1 + ( \text ( Growth ) ) ) ) ( ( \text ( Price ) ) _ ( \text ( Market ) ) ) ) + ( \text ( Growth ) ) _ ( \text ( rate ) ) ). Comments The models state that investors will expect a return that is the risk - free return plus the security 's sensitivity to market risk ( β ) times the market risk premium. The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5 %. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6 % per year over the period 1910 - 2005. The dividends have increased the total `` real '' return on average equity to the double, about 3.2 %. The sensitivity to market risk ( β ) is unique for each firm and depends on everything from management to its business and capital structure. This value can not be known `` ex ante '' ( beforehand ), but can be estimated from ex post ( past ) returns and past experience with similar firms. Cost of retained earnings / cost of internal equity Note that retained earnings are a component of equity, and, therefore, the cost of retained earnings ( internal equity ) is equal to the cost of equity as explained above. Dividends ( earnings that are paid to investors and not retained ) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism. Cost of internal equity = ( ( next year 's dividend per share / ( current market price per share - flotation costs ) ) + growth rate of dividends ) ) Weighted average cost of capital Main article : Weighted average cost of capital The weighted cost of capital ( WACC ) is used in finance to measure a firm 's cost of capital. WACC is not dictated by management. Rather, it represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. The total capital for a firm is the value of its equity ( for a firm without outstanding warrants and options, this is the same as the company 's market capitalization ) plus the cost of its debt ( the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes ). Notice that the `` equity '' in the debt to equity ratio is the market value of all equity, not the shareholders ' equity on the balance sheet. To calculate the firm 's weighted cost of capital, we must first calculate the costs of the individual financing sources : Cost of Debt, Cost of Preference Capital, and Cost of Equity Cap. Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital. Capital structure Main article : Capital structure Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity ( this is only true for profitable firms, tax breaks are available only to profitable firms ). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources ( such as retained earnings and preferred stock ) as well. Management must identify the `` optimal mix '' of financing -- the capital structure where the cost of capital is minimized so that the firm 's value can be maximized. The Thomson Financial league tables show that global debt issuance exceeds equity issuance with a 90 to 10 margin. The structure of capital should be determined considering the weighted average cost of capital. Modigliani -- Miller theorem Main article : Modigliani -- Miller theorem If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same. See also Preference share Ordinary share References Jump up ^ Brealey, Myers, Allen. `` Principles of Corporate Finance '', McGraw Hill, Chapter 10 Jump up ^ Fernandes, Nuno. 2014, Finance for Executives : A Practical Guide for Managers, p. 17. Jump up ^ Fred 's Intelligent Bear Site Jump up ^ Fernandes, Nuno. 2014, Finance for Executives : A Practical Guide for Managers, p. 32. Jump up ^ Business Valuation Glossary - WACC Calculation using an Iterative Procedure Further reading Modigliani, F. ; Miller, M. ( 1958 ). `` The Cost of Capital, Corporation Finance and the Theory of Investment ''. American Economic Review. American Economic Association. 48 ( 3 ) : 261 -- 297. JSTOR 1809766. Rosenbaum, Joshua ; Joshua Pearl ( 2009 ). Investment Banking : Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ : John Wiley & Sons. ISBN 0 - 470 - 44220 - 4. Yee, Kenton K. ( 2000 ). `` Aggregation, Dividend Irrelevancy, and Earnings - Value Relations ''. Contemporary Accounting Research. 22 ( 2 ) : 453 -- 480. doi : 10.1506 / GEH4 - WNJR - G58F - UM0U. SSRN 667781. Corporate finance and investment banking Capital structure Convertible debt Exchangeable debt Mezzanine debt Pari passu Preferred equity Second lien debt Senior debt Senior secured debt Shareholder loan Stock Subordinated debt Warrant Transactions ( terms / conditions ) Equity offerings At - the - market offering Book building Bookrunner Corporate spin - off Equity carve - out Follow - on offering Greenshoe Reverse Initial public offering Private placement Public offering Rights issue Seasoned equity offering Secondary market offering Underwriting Mergers and acquisitions Buy side Control premium Demerger Divestment Drag - along right Management due diligence Managerial entrenchment Minority discount Pitch book Pre-emption right Proxy fight Post-merger integration Sell side Shareholder rights plan Special - purpose entity Special situation Squeeze out Staggered board of directors Stock swap Super-majority amendment Tag - along right Takeover Reverse Tender offer Leverage Debt restructuring Debtor - in - possession financing Financial sponsor Leveraged buyout Leveraged recapitalization High - yield debt Private equity Project finance Valuation Accretion / dilution analysis Adjusted present value Associate company Business valuation Conglomerate discount Cost of capital Weighted average Discounted cash flow Economic Value Added Enterprise value Fairness opinion Financial modeling Free cash flow Free cash flow to equity Market value added Minority interest Modigliani -- Miller theorem Net present value Pure play Real options Residual income Stock valuation Sum - of - the - parts analysis Tax shield Terminal value Valuation using multiples List of investment banks Outline of finance Retrieved from `` https://en.wikipedia.org/w/index.php?title=Cost_of_capital&oldid=813807323 '' Categories : Financial capital Talk Contents About Wikipedia Deutsch Ελληνικά Español Hrvatski Italiano Lietuvių 日本 語 Norsk Polski Português Svenska 中文 Edit links This page was last edited on 5 December 2017, at 09 : 47. 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Question: a company’s required rate of return typically its cost of capital is called the
Answer: required rate of return on a portfolio company's existing securities