COST OF CAPITAL
Cost of capital is a company's calculation of the minimum return that
would be necessary to justify undertaking a capital budgeting project,
such as building a new factory.
The term cost of capital is used by analysts and investors, but it is
always an evaluation of whether a projected decision can be justified by
its cost. Investors may also use the term to refer to an evaluation of an
investment's potential return about its cost and its risks.
Many companies use a combination of debt and equity to finance
business expansion. For such companies, the overall cost of capital is
derived from the weighted average cost of all capital sources. This is
known as the weighted average cost of capital (WACC)
Understanding Cost of Capital
The concept of the cost of capital is key information used to determine a
project's hurdle rate. A company embarking on a major project must
know how much money the project will have to generate to offset the
cost of undertaking it and then continue to generate profits for the
company.
The cost of capital, from the perspective of an investor, is an assessment
of the return that can be expected from the acquisition of stock shares or
any other investment. This is an estimate and might include best- and
worst-case scenarios. An investor might look at the volatility (beta) of a
company's financial results to determine whether a stock's cost is
justified by its potential return.
Weighted Average Cost of Capital (WACC)
A firm's cost of capital is typically calculated using the weighted average cost of
capital formula that considers the cost of both debt and equity capital.
Each category of the firm's capital is weighted proportionately to arrive at a
blended rate, and the formula considers every type of debt and equity on the
company's balance sheet, including common and preferred stock, bonds, and other
forms of debt.
Finding the Cost of Debt
The cost of capital becomes a factor in deciding which financing track to follow:
debt, equity, or a combination of the two.
Early-stage companies rarely have sizable assets to pledge as collateral for loans,
so equity financing becomes the default mode of funding. Less-established
companies with limited operating histories will pay a higher cost for capital than
older companies with solid track records since lenders and investors will demand a
higher risk premium for the former.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) describes the relationship between
systematic risk and expected return for assets, particularly stocks. CAPM is widely
used throughout finance for pricing risky securities and generating expected
returns for assets given the risk of those assets and cost of capital.
, Investors expect to be compensated for risk and the time value of money. The risk-
free rate in the CAPM formula accounts for the time value of money. The other
components of the CAPM formula account for the investor taking on additional
risk.
The beta of a potential investment is a measure of how much risk the investment
will add to a portfolio that looks like the market. If a stock is riskier than the
market, it will have a beta greater than one. If a stock has a beta of less than one,
the formula assumes it will reduce the risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return
expected from the market above the risk-free rate. The risk-free rate is then added
to the product of the stock’s beta and the market risk premium. The result should
give an investor the required return or discount rate they can use to find the value
of an asset.
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when
its risk and the time value of money are compared to its expected return.
For example, imagine an investor is contemplating a stock worth $100 per share
today that pays a 3% annual dividend. The stock has a beta compared to the market
of 1.3, which means it is riskier than a market portfolio. Also, assume that the risk-
free rate is 3% and this investor expects the market to rise in value by 8% per year.
The expected return of the stock based on the CAPM formula is 9.5%:
9.5% =3%+1.3* (8% - 3%)
The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding period. If
the discounted value of those future cash flows is equal to $100 then the CAPM
formula indicates the stock is fairly valued relative to risk.
Problems With the CAPM
There are several assumptions behind the CAPM formula that have been shown
not to hold in reality. The modern financial theory rests on two assumptions: (1)
securities markets are very competitive and efficient (that is, relevant information
about the companies is quickly and universally distributed and absorbed); (2) these
markets are dominated by rational, risk-averse investors, who seek to maximize
satisfaction from returns on their investments.
Despite these issues, the CAPM formula is still widely used because it is simple
and allows for easy comparisons of investment alternatives.
Including beta in the formula assumes that risk can be measured by a stock’s price
volatility. However, price movements in both directions are not equally risky. The
look-back period to determine a stock’s volatility is not standard because stock
returns (and risk) are not normally distributed.
The CAPM also assumes that the risk-free rate will remain constant over the
discounting period. Assume in the previous example that the interest rate on U.S.
Treasury bonds rose to 5% or 6% during the 10-year holding period. An increase in
the risk-free rate also increases the cost of the capital used in the investment and
could make the stock look overvalued.
Cost of capital is a company's calculation of the minimum return that
would be necessary to justify undertaking a capital budgeting project,
such as building a new factory.
The term cost of capital is used by analysts and investors, but it is
always an evaluation of whether a projected decision can be justified by
its cost. Investors may also use the term to refer to an evaluation of an
investment's potential return about its cost and its risks.
Many companies use a combination of debt and equity to finance
business expansion. For such companies, the overall cost of capital is
derived from the weighted average cost of all capital sources. This is
known as the weighted average cost of capital (WACC)
Understanding Cost of Capital
The concept of the cost of capital is key information used to determine a
project's hurdle rate. A company embarking on a major project must
know how much money the project will have to generate to offset the
cost of undertaking it and then continue to generate profits for the
company.
The cost of capital, from the perspective of an investor, is an assessment
of the return that can be expected from the acquisition of stock shares or
any other investment. This is an estimate and might include best- and
worst-case scenarios. An investor might look at the volatility (beta) of a
company's financial results to determine whether a stock's cost is
justified by its potential return.
Weighted Average Cost of Capital (WACC)
A firm's cost of capital is typically calculated using the weighted average cost of
capital formula that considers the cost of both debt and equity capital.
Each category of the firm's capital is weighted proportionately to arrive at a
blended rate, and the formula considers every type of debt and equity on the
company's balance sheet, including common and preferred stock, bonds, and other
forms of debt.
Finding the Cost of Debt
The cost of capital becomes a factor in deciding which financing track to follow:
debt, equity, or a combination of the two.
Early-stage companies rarely have sizable assets to pledge as collateral for loans,
so equity financing becomes the default mode of funding. Less-established
companies with limited operating histories will pay a higher cost for capital than
older companies with solid track records since lenders and investors will demand a
higher risk premium for the former.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) describes the relationship between
systematic risk and expected return for assets, particularly stocks. CAPM is widely
used throughout finance for pricing risky securities and generating expected
returns for assets given the risk of those assets and cost of capital.
, Investors expect to be compensated for risk and the time value of money. The risk-
free rate in the CAPM formula accounts for the time value of money. The other
components of the CAPM formula account for the investor taking on additional
risk.
The beta of a potential investment is a measure of how much risk the investment
will add to a portfolio that looks like the market. If a stock is riskier than the
market, it will have a beta greater than one. If a stock has a beta of less than one,
the formula assumes it will reduce the risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return
expected from the market above the risk-free rate. The risk-free rate is then added
to the product of the stock’s beta and the market risk premium. The result should
give an investor the required return or discount rate they can use to find the value
of an asset.
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when
its risk and the time value of money are compared to its expected return.
For example, imagine an investor is contemplating a stock worth $100 per share
today that pays a 3% annual dividend. The stock has a beta compared to the market
of 1.3, which means it is riskier than a market portfolio. Also, assume that the risk-
free rate is 3% and this investor expects the market to rise in value by 8% per year.
The expected return of the stock based on the CAPM formula is 9.5%:
9.5% =3%+1.3* (8% - 3%)
The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding period. If
the discounted value of those future cash flows is equal to $100 then the CAPM
formula indicates the stock is fairly valued relative to risk.
Problems With the CAPM
There are several assumptions behind the CAPM formula that have been shown
not to hold in reality. The modern financial theory rests on two assumptions: (1)
securities markets are very competitive and efficient (that is, relevant information
about the companies is quickly and universally distributed and absorbed); (2) these
markets are dominated by rational, risk-averse investors, who seek to maximize
satisfaction from returns on their investments.
Despite these issues, the CAPM formula is still widely used because it is simple
and allows for easy comparisons of investment alternatives.
Including beta in the formula assumes that risk can be measured by a stock’s price
volatility. However, price movements in both directions are not equally risky. The
look-back period to determine a stock’s volatility is not standard because stock
returns (and risk) are not normally distributed.
The CAPM also assumes that the risk-free rate will remain constant over the
discounting period. Assume in the previous example that the interest rate on U.S.
Treasury bonds rose to 5% or 6% during the 10-year holding period. An increase in
the risk-free rate also increases the cost of the capital used in the investment and
could make the stock look overvalued.
