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Explanation to "Cost of capital" question

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What does a company's cost of capital represent and how is it calculated? How do market rates and the company's perceived market risk impact its cost of capital, and how does the company's debt to equity mix impact this cost of capital? You are leading the review of these elements in a meeting with managers and accountants.

Objective:
must define the cost of capital and explain why marginal capital is important. An understanding of the Capital Asset Pricing Model (CAPM) and the inter-relationship between a company's perceived market risk (as defined by beta) and the market risk-free rate and risk premium is essential. Cost of capital is a firm's borrowing rate (AKA Ke, hurdle rate, discount rate) and marginal is important because it illustrates what our next venture's cost of capital will be.

Solution Preview

What does a company's cost of capital represent and how is it calculated?

The rate we use to discount a company's future cash flows back to the present is known as the company's required return, or cost of capital.

A company's cost of capital is exactly as its name implies. When a company raises capital from its lenders and owners, both types of investors require a return on their investment. Lenders expect to be paid interest on their loans, while owners expect a return, too.

The rate you would use to discount cash flows if using the "cash flow to the firm" method is actually a company's weighted average cost of capital, or WACC. A company's WACC accounts for both the firm's cost of equity and its cost of debt, weighted according to the proportions of equity and debt in the company's capital structure. Here's the basic formula for WACC:

(Weight of Debt)(Cost of Debt) + (Weight of Equity)(Cost of Equity)

The cost of debt is relatively straightforward: It's the interest rate a company must pay to borrow money, based on the current yield on any of the bonds the company has issued. Just as a person with an excellent credit rating can borrow from banks at lower rates than someone who has missed payments in the past, financially strong and stable companies can borrow at lower rates than riskier firms.

The cost of equity is a little more complicated and is often a topic of debate in both academia and the business world. Modern finance theory says that a given company's cost of equity is determined by measuring the risk-free rate investors can achieve (typically the ...

Solution Summary

What does a company's cost of capital represent and how is it calculated? How do market rates and the company's perceived market risk impact its cost of capital, and how does the company's debt to equity mix impact this cost of capital? You are leading the review of these elements in a meeting with managers and accountants.

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