COST OF CAPITAL

Cost of Capital



Table of Contents

Introduction1

Discussion1

Reasons behind calculating Cost of Capital2

Difficulties faced by Chief Financial Officer when trying to calculate the Cost of Capital using the Suggested Models2

Choosing the Right Method for Calculating the Cost of Capital4

Methods of calculating the Weighted Cost of Capital4

Difficulties and Disadvantages of using WACC method7

Cost of Equity7

Dividend Growth Model8

Difficulties, Mistakes with Dividend Growth Model, using Numerical examples9

Appendix- 215

Appendix- 317

Appendix- 418

Cost of Capital

Introduction

During the course of its life, a company has to undertake many crucial decisions in the best interest of the company. Computing the cost of capital of a project is one of these crucial decisions that can either “make” or “break” a company, leading it to different scenarios. Hence, while companies engage in these computations on almost a daily basis, they are very concerned about the pros and costs of these costs. It is the concern for future productivity of the company that apprehends the Chief Financial Officer and other concerned personnel about calculating the cost of capital, taking important decisions on its foundational understandings.

This assignment based on discussing, in detail, the major difficulties in calculating the cost of capital in a company's lifetime. Although companies engage in such a practice regularly, they are concerned about the potential issues involved in such an action. We will evaluate the reasons behind calculating the cost of capital, difficulties faced by the CFO in such a practice, and assessing the right method to choose while computing this cost.

Discussion

Capital is the money that tied up in a business. All companies in the modern corporate sector are concerned with the blockage of this capital since money is not a free resource (Senbet, 1979, 468). A project's cost of capital is the minimum rate of return that companies see from a future project, in order to attract the money required. A company is willing to invest in a new project as long as it increases the shareholder's wealth and generates a reasonable return over the cost of procuring the capital.

Reasons behind calculating Cost of Capital

The importance of calculating the cost of capital in determining the economic feasibility of investment projects is quite substantial. In the standard net present value of the use of the cost of capital rate, discount in the prevailing rate of return procedure used the cost of capital in the interest of the company, because it allows them a greater number of opportunities for profitable investments (Sercu, 1980, 95). There are two ways of thinking about the cost of capital. These are:

Financial cost of capital (the main focus of this briefing note), and

Economic cost of capital.

The economic cost of capital is the value of that scarce capital if it invests in the best alternative use (Samuel, 1989, 187-210). A company might decide that the social benefit of choosing to invest in the latter sector was worth the economic cost of forgoing the investment in the former - but the economic cost still exists (See Appendix 4 for an idea about ...