“Cost Of Capital- Clarify your Basics”

Hi Friends! Hope my last post on myth behind numbers helps you in developing insight to look beyond numbers while making a decision about company or projects because numbers are often illusory in nature, one can easily twist and manipulate it as per one’s advantage. Hence, be careful while taking decision just on the basis of numbers.

Let’s start today’s post from the point where I left my fourth post. I think after getting through my previous posts you can easily calculate the FCFF or FCFE, if the balance sheet of the company is given. But the real problems lie in calculating or making assumptions about the factors that I had mentioned in my fourth post. These factors are quite important for calculating the enterprise value. Today, I am going to explain to calculate one’s such factor that is how to calculate Cost of Capital. Please keep in mind that it is the same cost of capital/WACC that is used to discount all the future cash flows to find enterprise values. Since, it involves many sub factors; it will take minimum 5 to 6 post to cover the whole concepts. Now, before getting into the details please look at the factors essentials to consider before calculating Cost of capital or WACC. These factors are as follows:

Factors Consideration
Models used If you are using FCFF for your calculation then use cost of capital for discounting else use cost of equity for FCFE. Any mismatching will lead to erroneous results
Currency used The currency used for estimating cash flows and discount rate should be same.
Inflation If you consider inflation in your cash flow i.e. calculating Nominal cash flow then discount rate should be nominal and vice versa.

 

. The formula to calculate WACC is given by

WACC = (E/V) * Ke + D/V * ( Kd) * (1-Tc)

Where:
Ke = cost of equity
Kd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

From, the formula it is clear that while calculating firm’s cost of capital each category of capital is proportionately weighted. Generally, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

The first thing that we will have to consider in order to calculate Cost of Capital is Cost of Equity. The most common method used to calculate Ke is CAPM Model. It basically describes the relationship between risk and expected return and that is used in the pricing of risky securities.The formula is given by

Ke = Rf + Beta* ( Rm-Rf)

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (Rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-Rf). Please remember that there are many complexities while calculating Ke, which I will discuss in my next post.

Hope this post helps you in understanding the basics of Cost of capital. Be ready to enter the world of risk free rate in my next post.

 

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2 Comments

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2 responses to ““Cost Of Capital- Clarify your Basics”

  1. Asit Jain

    Good post ..Keep it on

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