The Cost of Capital

Question: What is the most important principle to be considered when implementing the cost of capital? Explain in detail with 1 example. Answer: Important principle to be considered when implementing the cost of capital The crucial factor in the implementation process of cost of capital is the consistency among the components taken into consideration for WACC and free cash flow. This needs to be ensured by considering opportunity cost from various origins such as debt, equity and so on. The importance of the security must be weighted in accordance with the market based target weight and the computation process must be done after including corporate taxes. It should be further ensured that the denomination is done in same currency and nominal terms when needed. (Brealey et al. 2012) The capital funding of the company is mainly composed of debt and equity. The cost of debt is referred to as the borrowing of the funds from financial institutions and the interest which is to be paid on the borrowed amount is referred to as cost of debt. The computation of this amount is done by considering the risk free rate of the bond by matching a suitable term structure and added it with the premium amount. The cost of the equity is done on the basis of comparing of similar risk profiles, which is done by implementation of CAPM model. The Weighted Average cost of capital is able to predict the return from both equity owners and the debt holders. (Fernandes 2014) Example: The weighted average cost of capital in a Warehouse Systems equals 8.4%. The majority of capital amount is held by equity holders (89.3%); whose Capital Asset Pricing model based required return is 8.3%. The remaining capital amount is borne by debt holders at 1.7% of an after-tax basis. The Cost of Capital: Warehouse Systems Origin of Capital Distribution of capital Cost of capital Corporate tax rate After tax opportunity cost Proportion distributed to weighted average Debt 10.7 3.8% 35.6% 1.7% 0.6% Equity 89.3% 8.3% 8.3% 7.8% WACC 100% 8.4% Reference List Brealey, R.A., Myers, S.C., Allen, F. and Mohanty, P., 2012. Principles of corporate finance. Tata McGraw-Hill Education. Fernandes, N., 2014. FINANCE FOR EXECUTIVES: A practical guide for managers. NPVPublishing.