Cost of Capital for a Business Essay Example Pdf - Free Essay Example

The cost of capital is an expected return that the provider of capital plans to earn on their investment. Capital used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital. The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous. Cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments with similar risk profiles to determine the market c ost of equity. The cost of capital is often used as the discount rate, the rate at which projected cash flow will be discounted to give a present value or net present value. Cost of debt The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this is used for large corporations only. The formula can be written as (RF + credit risk rate) (1-T), where T is the corporate tax rate and Rf is the risk free rate. Cost of equity Cost of equity = Risk free rate of return + Premium expected for risk Expected return The expected return (or required rate of return for investors) can be calculated with the dividend capitalization model, which is That equation is seen as, Expected Return = dividend yield + growth rate of dividends. Industry Cost of Capital: In layman language industry cost of capital is the average cost of the industry. It includes large firms to small firms cost in the same industry. There are advantage and disadvantage of considering the industry cost of capital. Advantage: When a new company wants to start a business or enter into particular industry they do not know the cost of capital. Because there are many hidden cost is involved in it. So it is advisable to start a business taking into consideration of industry cost of capital. Disadvantage: Many a times it happens that industry cost of capital is high as many large player are into business. So the average becomes high. For taking into consideration that if small company wants to enter into business and they take a industry cost of capital as a benchmark than decision may prove wrong. So, I have taken a example of automobile ancillary business for calculation of industry cost of capital. AUTOMOBILE ANCILLARY UNITS I have studied the capital structure of the automobile ancillary smes in NCR region . Company % of % of cost of cost of WACC Remark as name equity Debt equity Debt per industry Denso auto 11.91 88.08 45.03 0.3438 5.66 Below Motherson 76.08 23.91 12.75 1.71 10.01 Below Harigh 73.21 26.89 0 17.26 4.64 Below ANG auto 36.55 64.44 72.15 6.92 30.82 Above Roto pumps 67.61 32.38 0.33 5.78 2.09 Below Subros ltd. 32.97 67.02 41.37 30.18 33.86 Above Amtek auto 36.59 63.40 0.0647 0.6011 0.394 Below Amtek India 53.10 46.89 0.4307 0.3803 40.70 Above Bharat seets 56.17 43.28 0.0143 14.08 6.1 Below Clutch auto 7.86 92.14 3.35 39.22 62.46 Above TOTAL 452.05 548.43 175.45 116.47 196.8 AVERAGE 45.2 54.8 17.5 11.6 19.6 The cost of equity is 17.5 that means industry is paying higher interest to their equity shareholders. That indicates the industry is attractive in terms of investment. The cost of debt is 11.6 which imply that industry is getting loan on a moderate rate. Private firms There are three major differences between public and private firms in terms of analyzing optimal debt ratios. One is that unlike the case for publicly traded firms, we do not have a direct estimate of the market value of a private firm. Consequently, we have to estimate firm value before we move to subsequent stages in the analysis. The second difference relates to the cost of equity and how we arrive at that cost. Although we use betas to estimate the cost of equity for a public firm, that usage might not be well diversified. Finally whereas publicly traded firms tend to think of their cost of debt in terms of bond ratings and default spreads, private firms tend to borrow from banks. Banks assess default risk and charge the appropriate interest rates. To analyze the optimal debt ratio for a private firm, we make the following adjustments. First, we estimate the value of the private firm by looking at how publicly traded firms in the same business are priced by the market. Thus, if publicly traded firms in the businesses have market values that are roughly three times revenues, we would multiply the revenues of the private firm by this number to arrive at an estimated value. Second, we continue to estimate the costs of debt for a private firm using a bond rating, but the rating is synthetic, based on interest coverage ratios. We tend to require much higher interest coverage ratio is to arrive at the same rating, to reflect the fact that banks are likely to be more conservative in assessing default risk at small, private firms. Company cost of capital: company cost of capital is the rate of return expected by the existing capital provider. It reflects the business risk of existing asset and the capital structure currently employed. If a firms wants to use its companys cost of capital, popularly called weighted average cost of capital, for evaluating a new investment. Two conditions should be satisfied. The business risk of the new investment is the same as the average business risk of existing business. In other words new investment will not change the risk complexion of the firm. The capital structure of the firm will not be affected by the new investments. Put differently, the firm will continue to follow the same financing policy. Firms specific factors Firms Tax rate The tax rate benefits from debt increase as the tax rate goes up .in relative terms, firms with higher taxes rates will have higher optimal debt ratios than will firms with lower tax rates, other things being equal. It also follows that a firms optimal debt ratio will increase as its tax rate increases. At a 0 percent tax rate, the optimal debt ratio is zero for all three firms. Without the benefits that accrue from taxes, the rationale for using debt disappears. As the tax rate increases, the optimal debt ratios increase for all three firms but significant at different rates. Pretax returns on the firm The most significant determinant of the optimal debt ratio is a firms earnings capacity. In fact, the operating income as a percentage of the market value of the firm is usually good indicator of the optimal debt ratio number is high the optimal debt ratio will also be high. A firm with higher pretax earnings can sustain much more debt as a proportion of the market value of the firm because debt payments can be met much more easily from prevailing earnings. Variance in operating income The variance in operating income analysis in two ways. First it plays a role in determining the current beta: firms with high variance in operating income tend to have high beta. Second the volatility in operating income can be one of the factors determining bond ratings at different levels of debt ratings drop off much more dramatically for higher variance firms as debt levels are increased. It follows that firms with higher variance in operating income will have lower optimal debt ratios the variance in operating income also plays a role in the constrained analysis , because higher variance firms are much more likely to register significant drops in operating income. Consequently the decision to increase debt should be made much more cautiously for these firms. Comparing to industry average Firms sometimes choose their financing mixes by looking at the average debt ratio of other firms in the industry in which they operate, the operating at a debt ratio slightly higher than those of other firms in the industry in both market and book value terms, where as a market debt ratio slightly higher than the average firm but a book debt ratio which is slightly lower. That firms is comparison are that firms within the same industry are comparable and that, on average , these firms are operating at or close to their optimal .firms within the same industry can have different product mixes , different amounts of operating risk, different tax rates and different project returns . Comparable firm A firm similar to the firm being analyzed in terms of underlying risk, growth and cash flows patterns. The conventional definition of comparable firm is one that is in the same business as the one being analyzed and of similar size. There is a data set online that summarizes market value and book value debt ratios by industry, in addition to other relevant characteristics. Conclusion: It is a advisable for the new company to calculate industry cost of capital rather than cost of capital estimated for a single firm. Industry cost of capital show true as well as overall nature of business in the industry. While firms cost of capital is the mirror of only single firm. As we have seen many variation in the every firm in the same industry. So, it is better to calculate industry cost of capital rather than firms cost of capital. Many times it happens many firms do not show their true and fair view of cost of capital. It may Access or sometimes less. We have always probability that single firm may manipulate the number. Hidden cost may not see in their calculation. So that is why the industry cost of capital is better for decision making.