Determining the Cost of Capital
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.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
