Cost of capital A fuel to robust the impressive investment

Abstract
There seems to be a great debate on cost of capital and its relevance consideration in todays
dynamic business environment. Though firms make huge money out of their normal course of
business, question lies if in case, they do not distribute profits in the name of dividends to their
shareholders. What is the most expected way to make use of such earned revenues or reserved
earnings, so called retained earnings? Even in the case of investment on any of the proposal may
certainly demand for consideration of right cost of capital to ensure the positive net present
value, to accept the project and then to carry on to make good deal out of available investments.
The two reference articles revolve around the best possible cost of capital determination and its
implication. This paper makes an attempt to review the articles on how cost of capital is relevant
in capital budgeting and how it is seen and observed by the finance professionals, say financial
managers of an organization.
Keywords: cost of capital, capital budgeting, investment proposal, net present value

Literature review
In order to ensure the quality and strength of this article, a detailed and a thorough literature
review has been done.
Michael T. Jacobs and Anil Shivadasani: July-August 2012, Harvard Business Review: in this
article, the authors have made an analysis on the survey conducted by Association for Financial
Professionals (AFP) and drawn very interesting results how cost of capital is calculated or
considered for a new projects to estimate the acceptance or rejection based on discounted cash
flow techniques or Capital Asset Pricing Model (CAPM). They conclude that no business follow
a certain standard policy to consider the cost of capital, risk free rate, market premium, cost of
debt as universal law. It depends on the nature of the business and the capability of finance
professional within the organization.
Franco Modigliani and Merton H. Miller: June 158, the cost of capital, corporate finance and
the theory of investment. This article ensures the traditional perspective of cost of capital
consideration. It attempts to consider the essence of cost of capital problem by considering
physical assets like bonds, as yielding known streams. The authors concluded that, the rate of
interest on bonds is the cost of capital for the firms owners. By considering the proposition of
firms basic objective; profit maximization and wealth maximization, concluded to a theoretical
definition of cost of capital and how that concept is used in turn as a basis for rational investment
decision making by the finance managers.
F. and V. Lutz: This article depicts marginal cost of borrowed funds to draw the supply curve of
borrowed funds to the firm, as an advanced treatment of the certainty method in the
consideration of cost of debt to calculate the optimum capital structure.

Hypothesis
Authors have conducted a study in order to identify know how the cost of capital is considered in
various organizations by taking into account cost of debt, risk free rate, cost of debt, market
premium, discounted cash flow technique and capital asset pricing model.
Proposition of firms basic objective; profit maximization and wealth maximization, concluded
to a theoretical definition of cost of capital or has relevance on capital budgeting.

Data and Findings

From the review of survey conducted by Association for Financial Professionals (AFP), it is
clear that following observations or the findings has been drawn

80% of more than 300 respondents and 90% of those with over $1 billion in revenues use

discounted cash flow analysis in evaluating a new project.

To estimate the cost of equity, almost 90% of the respondents use the capital asset pricing
model (CAPM), which measures the return required by an investment on the basis of the

associated risk and 79% of the respondents belong to Canada U.S.

46% of the respondents consider 5 years, 34% of the respondents consider 10 years and

6% for 15 years in case of evaluation of future cash flows estimation for project duration.
In case of cost of debt, 37% of the total respondents consider current rate on outstanding

debt, 34% on forecasted rate on new issuance and 29% on average historical rate.
In case of Risk Free (Rf) rate, 16% of the respondents consider 90 days treasury bills, 5%
on 52 weeks T-Bills, 12% on 5 years TBs, 46% on 10 years TBs, 4% on 20 years TBs and
11% of the respondents over 30 years TBs rate for Rf.

 In case of the equity market risk premium, 11% of the respondents consider less than 3%,
23% consider between 3% - 4%, 49% of the respondents between 5%-6% and 17%
consider 7% or greater.
In case of Beta period, 29% consider one year, 13% for two years, 15% for three years
and 41% for five years.
In case of Debt-Equity ratio, 30% of the respondents consider current book debt to equity,
28% on targeted book debt to equity, 23% on current market to equity and 19% on
current book debt to current market equity.
Investment decisions are to be based on risk adjusted or certainty equivalent yield with the
market rate of interest.
Cost of capital has become a subjective concept; utility approach has serious drawbacks for
normative as well as analytical purposes.
Interest rate on bonds can be considered to be the market rate of capitalization for the expected
value of the uncertain streams of the generated class of firms as cost of capital.
Market value of any firm is independent of its capital structure and is given by capitalizing its
expected return at the rate.
Expected yield of a share of stock is equal to the appropriate capitalization rate for a pure equity
stream plus a premium related to financial risk equal to the debt-equity ratio.

Conclusion

Thus, from the review of articles, it is very clear that no firm follow a specific formula in
deriving a cost of capital which is a robust tool used in the capital budgeting process to evaluate
a promising investment on project proposal. Every firm and the finance manager or the finance
professional has got the independence upon their capability to consider the rates which are
suitable for the project cash flows evaluation. If one firm goes with a discounted cash flow
technique, on the other hand, another firm may follow capital asset pricing model. It is studied
that according to traditional financial management, the basic objectives; profit maximization and
wealth maximization was focused and firms follow and considered bond interest rates as cost of
capital.

Implications for finance professionals

There is a greater demand for the finance professionals to consider the rates on various grounds
but the strength lies in identifying the best project proposal which yield better returns in the near
future. However, to identify that, challenge is with identifying the desirable rates upon his or her
experience in deciding the factor. If in case, a 1% increase in discounting factor, may end up with
undesirable outcome whereas, in case of decrease in 1% discount factor, may end up with false
positive numbers. Therefore, it is necessary for a finance professional to study the nature of the
business and consider the best evaluation technique upon the size and availability of investment
opportunities.