# Problems on cost of capital computation

In the same manner, arguments are given in favour of specific cost and composite cost as well as explicit cost and implicit cost and the marginal cost. Weighted average cost of capital can be computed as follows: It, therefore, creates another problem whether to consider marginal cost of capitali.

Rf — Risk-free rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The choice of using the book value of the source or the market value of the source poses another problem in the determination of cost of capital.

For public companies, you can find database services that publish betas. Different authorities have tried in different ways to quantify the expectations of the equity shareholders. The future costs should be considered. In other words, according to them, a firm can change its overall cost of capital by changing its debt-equity mix.

Both will fetch the same answer. The more you know about the financial status of the company to better. If it is not paid to them than it affects the fund raising capacity of the firm. This is due to the flotation costs. Cost of capital tells the company its hurdle rate. According to the Net Income Approach and the traditional theories both the cost of capital as well the value of the firm have a direct relationship with the method and level of financing.

In each model, the inherent problem is that atleast one of the variables is an estimate. In their opinion, a firm can minimise the weighted average cost of capital and increase the value of the firm by using debt financing.

The average may either be calculated using an arithmetic mean or a geometric mean. For example, in the Gordon growth model, we are making an assumption about the growth rate. Cost of Newly Issued Stock Cost of newly issued stock Rc is the cost of external equity, and it is based on the cost of retained earnings increased for flotation costs cost of issuing common stock.

These could be various bonds, loans and other such forms of debt. Cost of Capital and Equity Financing The cost of equity is more complicated, since the rate of return demanded by equity investors is not as clearly defined as it is by lenders.

Shareholders invest money with the hope that they will get the dividend and the firm must earn minimum rate of return to keep the market price of shares stable. Learn more in Beta: It gives a proportional weight to the different costs of capital, such as equity and debt, to derive a weighted average cost.

The cost of capital thus becomes a critical factor in deciding which financing track to follow — debt, equity or a combination of the two.

Calculating the cost of equity There are also two ways of calculating the cost of equity: This has resulted into various conceptual difficulties.

This financing decision is expected to increase dividend from Rs. The computation of cost of equity capital depends upon the expected rate of return by its investors. While the cost of capital needs to be taken with a pinch of salt and tough analysis, it is nonetheless an essential metric to learn about.

Average rate of return is found out with the help of dividend received in the past along with gain realized at the time of the sale of the shares.The cost of capital can be calculated by different methods these are discussed as below: (I) Computation of cost by specific source of finance.

1) Cost of debt: cost of debt means the interest payable on the debentures. For example, if the company issue Rs10% debentures at par in that case before tax cost of debt will be.

Cost of Capital Practice Problems 1. Why is it that, for a given firm, that the required rate of return on equity is always greater than the required rate of return on its debt?

The required rate of return on equity is higher for two reasons. (i) Compute the weighted average cost of capital based on existing capital structure. (ii) Compute the new weighted average cost of capital if the company raises an additional \$. After reading this article you will learn about about the Computation of Weighted Average Cost of Capital.

Weighted average cost of capital is the average cost of the costs of various sources of financing. Therefore, the cost of capital is often calculated by using the weighted average cost of capital (WACC). Since it analyses both equity and debt financing, it provides a more accurate picture of how much interest the company owes for each operational currency it finances.

Cost of Newly Issued Stock Cost of newly issued stock (R c) is the cost of external equity, and it is based on the cost of retained earnings increased for flotation costs (cost of issuing common.

Problems on cost of capital computation
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