The overall cost of capital that is the company cost of capital is the weighted cost of individual capital elements. This cost of capital is always the aggregate weighted capital elements which are used to finance the operations of the organization. Each capital element has its own cost of capital and it is a aggregated to find the cost of capital. The companies cost of capital represents the cost at which the company can raise funds and it becomes the minimum required rate of return for all the company’s investment. If a project has a lower rate of return than the overall company cost of capital then the project is rejected instantly.
In calculating the company’s cost of capital all capital elements are considered. For example, if the company has financed her operations using the following capital structure, the cost of capital will be the aggregated of the weighted of the elements in the structure.
- Equity 70,000
- Long term debt 10,000
- Preference shares 20,000
- Short term debt 10,000
In calculating the weighted average cost of capital for the company, the cost for each element in the structure will be determined. After determining the cost of the element, the proportion of each elements contribution to the capital structure is also calculated. Then the weighted cost of each element will be calculated as proportion x the cost of the corresponding capital structure element. Using the above example, the cost of overall will be calculated as follows:
The cost of each capital above is assumed. Therefore the overall cost of capital for the company is 7.2%. In the case at hand the 6% cost of capital proposed as the company cost is calculated as shown above.
In calculating the cost of capital, two factors play an important role. The market interest rate and the market risk. In order to take into consideration, the two factors market risk and interest rate prevailing market prices are used for each cost of capital. Market risk is a risk associated with the variability of returns in common stocks. Therefore the market risk issues affect common equity. It is normally caused by the perception of investors to some information relating to the company. If the company expects high profits, the price of the shares will go up and this is what is called a market risk. In calculating the market risk, various factors are taken into consideration, one such factor is the standard deviation and coefficient of variation in the market rise and this gives arise to beta. The standard deviation that is calculated is the deviations of expected returns. For example standard deviation can be calculated as shown in the case below for one stock:
Therefore this is used to measure the risks which are eventually used to estimate beta in the security market line of capital asset pricing model.
The cost of capital used by the company is always affected by the capital structure of the company in question. Mixing of capital helps the company come up with a cost which is optimal where the debt is not too high or too low.
Fischer D. E. and Jordan R.J. (2006); Security Analysis and Portfolio Management, Prentice hall PP 72 and pp.85.
McLaney E. (2003); Business Finance Theory & Practice, Prentice Hall pp. 267 – 280.