The cost of capital, explanation and calculation
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The following is a response to the question on the 'cost' of capital with an explanation of the calculation.
Explanation of the calculation
Before Bad Boys, Inc. put their capital into use, it is paramount to comprehend in details concerning how to finance various investments offers to its operations. That demands accurate calculation of the 'cost' of capital with full knowledge of its meaning.
Cost of capital and what it implies
Cost of capital refers to the 'cost' of funds Bad Boys, Inc. will use to fund as well as finance the working. The 'cost' of capital often falls under two different modes of financing, which are debt and equity. Bad Boys, Inc. must be having its unique 'cost of capital' just like any other company influenced by factors such as the operating history of their operations, their profitability as well as credit trustworthiness (Harvey, 2005).
The implication of the 'cost' of capital for Bad Boys, Inc
The 'cost' of capital will be among the fundamental components of Bad Boys, Inc.'s financing master plan, as it might help them to make more informed decisions on funding and investment, which is a fundamental requirement for its general financial health (Harvey, 2005).
If Bad Boys, Inc. financed its operations solely through equity, the 'cost' of capital would be the 'cost' of equity. However, if the organization funds its working by debts only, the 'cost' of capital would refer to the 'cost' of debt.
As most organizations blend debts and equity in financing their operations, the 'cost' of the capital comes from the weighted average of their capital sources, which is called the Weighted Average Cost of Capital.
How the 'cost' of equity defers from the 'cost' of debt
Cost of equity refers to the source of the capital where the company directors or shareholders put in their equity. In that case, the 'cost' of equity constitutes the return the market must bring to compensate the organization's assets. Contrastingly, the 'cost' of debt happens where the organization solely depends on debts from creditors to finance its operations. The 'cost' of debt in that context implies the optimal rate the organization ought to repay its debt (Harvey, 2005).
A company might consider combining debt and equity in financing its operations with a target to minimize the gross 'cost' of capital in either case. Naturally, it is more efficient to finance a company's operations through debts as opposed to equity. The only disadvantage of debt is high leverage. That means the interest rates at times can escalate when the risks of debts increase. That explains why mixing both debts and equity offers the most economical 'cost' of capital (Harvey, 2005).
Defining the weighted average 'cost' of capital
The weighted average 'cost' of capital is arrived at through the following formula:
The weighted average 'cost' of capital= 'cost' of equity + 'cost' of debt (after deducting tax)
A company can hardly ever finance its operations from only one source, which explains the need to calculate the cost of capital as a weighted average cost of capital. The weighted average 'cost' of capital factors in debt financing and equity during financial analysis and therefore gives a high degree of accuracy on the picture of the interest the organization is obliged to pay for all the operational currencies it is financing (Jinnah and Sattar, 2015).
Every cost of capital like equity and debt gets its proportional weight in the derivation of a weighted average cost of capital. Every capital component is a multiple of its proportion weight before adding up together the sums. Therefore, when Bad Boys, Inc. mentions the cost of capital, it would be after calculating it using the weighted average cost of capital (Jinnah and Sattar, 2015).
For instance, a company might have a lender that needs a 10% return on proceeds. Additionally, the stakeholders of the organization might need an additional minimum of 16% on their investments. On average, therefore, the capital must generate a return of 13% to meet the demands of both debt and equity members, implying that the weighted average cost of capital is 13%. That would mean the organization's investments must generate a return of 13% every year to service back both its creditors as well as its shareholders.
The importance of calculating the cost of capital
Cost of capital for a company helps the leadership in decision-making during budgeting as it sheds light on the minimum rate of return the organization needs while investing. Likewise, it helps the management in preventing investments that would not generate quick minimum returns for the organization. Since the cost of capital is a fundamental requirement in designing market fluctuations, a company with a reliable cost of capital can build reliable financial structures. The organization might also use the cost of capital in understanding its financial performance and evaluating the performance of its Financial Structures (Jinnah and Sattar, 2015).
Calculations on the cost of capital
Cost of equity and cost of debt is arrived at using specific formulas, which also apply in calculating the weighted average cost of capital.
Calculations on the cost of debt
Concerning this formula, debt refers to all forms of debts like bonds and loans the organization uses in financing its operations. Since debt involves interest, which one can deduct from tax payments, the alternatives would be to calculate the cost of debt after or before the tax. The common practice is to calculate the cost of debt after tax (Jeon and Jeong, 2015).
One method of calculating the before-tax rate is to multiply the interest rate of the organization's debt by the principal. For instance, if a company has a $100,000 debt bonds bearing 5% pre-tax interest rate, the cost of debt would be $100,000 X 0.05 = $5,000.
Another method applies the after-tax rate-regulated interest rate and the organization's tax rate. Even if one has to apply the after-tax rate, there is still a need to use the before-tax rate (Jeon and Jeong, 2015). The following is the formula to arrive at the after-rate tax
Cost of debt = before-tax rate X (1-marginal tax rate)
Calculations on the cost of equity
The cost of equity is calculated in two ways either using the traditional divided capitalization model or the capital asset pricing model (CAPM), which is more modern (Eckles, Halek, and Rongrong, 2014).
The formula for the dividend capitalization model
Cost of equity = + growth rate of dividends
The formula for the capital asset pricing model
Cost of equity = risk-free rate + risk measure X [Expected market return-risk free rate]
The formula for the weighted average cost of capital (WACC)
This formula applies when the organization finances its operations using different methods. The above Formulas also apply in this method (Harvey, 2005).
WACC = % of financing that is equity X cost of equity + % of financing that is debt X cost of debt [ 1 – corporate tax rate ]
Calculation of the percentage of financing that is equity
%of financing that is equity = market value of the organization's equity/total market value of the organization's financing, which includes equity and debt.
Calculation of the percentage of financing that is debt
%of finances that is debt = market value of the organization's debt/ total market value of the organization's financing, which includes equity and debt.
The case of Bad Boys, Inc
Bad Boys, Inc. is assessing its cost of capital. After consulting, Bad Boys anticipate to supply new debt at face value with a coupon charge of eight percent and to supply new preferred stock with a $2.5 per share dividend at $25 per share. The organization's common stock is at the moment selling for $20.00 for a Share. The organization anticipates recompensing a dividend of $1.5 per share in the new financial year. According to an equity analyst, there is a projected growth in dividends at a rate of 5% annually. The organization's marginal rate is 35%. If the Company increases capital by applying 45% debt, 5% preferred stocks, and 50% common stock, calculate the cost of capital for Bad Boys, Inc.?
Cost of capital (WACC )= % of financing that is equity X cost of equity + %of finances that is debt X cost of debt [ 1 – corporate tax rate ]
Where,
Percentage of financing that is equity = 55% (5% preferred stock + 50% common stock)
Cost of equity = + growth rate of dividends
= + 0.05 (five percent) = 0.075 + 0.05 =0.125
Percentage of financing that is debt = 45%
Cost of debt = before-tax rate X (1-marginal tax rate)
= 0.08 (coupon rate of 8%) X [1-0.35 (the marginal tax rate)] = 0.08 x 0.65 = 0.052
Therefore,
Cost of capital (WACC) = 0.55 X 0.125 + 0.45 X 0.052 = 0.06875 + 0.0234 = 0.09215
If the Company increases capital applying 30% debt, 5% preferred stocks, and 65% common stock, calculate the cost of capital for Bad Boys, Inc.?
Cost of capital (WACC )= % of financing that is equity X cost of equity + %of finances that is debt X cost of debt [ 1 – corporate tax rate ]
Where
Percentage of financing that is equity = 70% (5% preferred stock + 65% common stock)
Cost of equity = + growth rate of dividends
= + 0.05 (five percent) = 0.075 + 0.05 =0.125
Percentage of financing that is debt = 30%
Cost of debt = before-tax rate X (1-marginal tax rate)
= 0.08 (coupon rate of 8%) X [1-0.35 (the marginal tax rate)] = 0.08 x 0.65 = 0.052
Therefore,
Cost of capital (WACC) = 0.7 X 0.125 + 0.30 X 0.052 = 0.0875 + 0.0156 = 0.1031