Determining the Cost of Capital
Part of the Managerial Economics For Dummies Cheat Sheet
Investing in factories, machinery, and equipment — capital — requires money. Those funds can be borrowed (external equity), or the business can raise the funds internally, equity either from the firm’s or the owner’s financial resources.
The cost of using external equity or debt capital is the interest rate you pay lenders. However, because interest expenses are tax deductible, the after tax cost of debt (kd) is the interest rate (r) multiplied by 1 minus the firm’s marginal tax rate (t) or
Internal equity from the firm or the firm’s owners also has a cost. The opportunity cost of funds you invest in the firm is the interest you could have earned if you invested those funds elsewhere. You can choose from among three alternatives to determine the cost of internal or equity capital.
Risk premium method: The risk premium method assumes that you incur some additional risk in the investment. This method’s cost estimation uses a risk-free rate of return, rf, plus an additional risk premium, rp, or
where ke is the cost of equity capital. The U.S. Treasury Bill rate is often used as the risk-free rate of return.
Dividend valuation method: The dividend valuation method is based on shareholder attitudes. A shareholder’s rate of return equals the dividend (D) divided by the stock price per share (P), plus any expected earnings growth (g). Using this shareholder return as the cost of equity capital results in
Capital asset pricing method: The final method for determining the cost of internal equity is the capital-asset-pricing method. This method incorporates a risk premium for variability in a company’s return — stocks with greater variability in return have higher risk premiums. The cost of internal equity using the capital-asset-pricing method is
where rf is the risk free return, km is an average stock’s return, and β measures the variability in the specific firm’s common stock return relative to the variability in the average stock’s return. If β equals 1, the firm has average variability or risk. β values greater than 1 indicate higher than average variability or risk, while values less than 1 indicate below-average risk. The term β(km - rf) gives the risk premium for holding the firm’s common stock.
Many firms finance capital investment with a combination of external and internal funds. The composite cost of capital (kc) is a weighted average of the cost of internal equity and the cost of external or debt equity. In the following equation
we and wd are the weights or proportions of internal equity and debt you use to finance the project.