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How to determine a firm's overall cost of capital essay

cost of capital / company / investments / cost of equity / weighted average cost

Essay Topic:

The scheme of the formula of calculation of a firms overall cost of capital.

Essay Questions:

Why is so necessary to calculate the cost of capital?

How is budget-planned long-term capital investments of the company related to the overall cost of the companys capital?

What impact does the cmpanys weighted average cost of all capital have on the companys business relations?

Thesis Statement:

The cost of capital originally has two forms: ROE (the cost of equity to the business) and WACC (the Weighted Average Cost of all Capital in the business).

 

How to determine a firm's overall cost of capital essay

Introduction: Cost of capital is the rate of return on share and promissory obligations to companies on stock market. From the standpoint of a company expenses present the cost of capital. The cost of capital is a required income from budget-planned long-term capital investments of the company. The cost of capital is used as the minimum rate of revenue capital investments. The cost of capital originally has two forms: ROE (the cost of equity to the business) and WACC (the Weighted Average Cost of all Capital in the business).ROE is the cost of equity to a business - evaluates the equity in a business and afterwards the cost of this equity. This cost is the rate of return that could be earned elsewhere and the risk to the business that is being considered. WACC - the Weighted Average Cost of all Capital is literally debt and equity in a business.

The second form is the one that will be viewed below. This is very individual for each company.To analyze the calculation of WACC it is very important to understand what components are included in this concept. They are: common stock,preferred stock, bonds (debt) and retained earnings. The general understanding of what percentage of debt is comes from this components. Before to put them together in the cost of capital it is important to evaluate each component properly.

The cost of issuing common stock:

= Cost of issuing the actual stock + the cost of retained earnings. Where: Cost of issuing the actual stock consumption materials: ink, printing, paper, computers and so on.

Cost of retained earnings money gained, and invested back in the company.

Next comes the Cost of Preferred Stock with the formula:

Cost of Preferred Stock= Dividend/ Price - Underwriting Costs

And the Cost of debt:

R d=Cost of Debt= Coupon rate on the bonds- The Tax Savings

WACC=E/V*Re+D/V*Rd*(1-Tc)

Re = cost of equity

Rd = cost of debt

E = the market value of the firm's equity

D = the 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 = the corporate tax rate

Conclusion: The main purpose of the calculation of the cost of capital is to estimate how much interest the company has to pay for every dollar it borrows. After the percent cost of each component is evaluated, comes the turn of calculating the percent of capital structure of each component. The percent summery of the capital components makes the cost of the capital of a firm. Or you the cost of capital can be calculated by another formula. It is different, but the main concept it the same. So the cost of capital will always depend on the kind of company and on any additional components, which cannot be foreseen by one universal formula. The cost of capital defines the cutoff point for capital budgeting and the real growth prospects for the firm.

 

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