COST OF CAPITAL

Compiled to Fulfill the Duties of Financial Management Courses

Lecturer: Prof. Dr. Isti Fadah, M.Si.

Authored By:

RedygtaMeigyMaulana (190810201153)
Galuh Dewandaru Al Amanah (190810201154)
Gusti Jimmy Murhpy (190810201161)

DEPARTMENT OF MANAGEMENT
FACULTY OF ECONOMICS AND BUSINESS
JEMBER UNIVERSITY
2020
 CHAPTER I
INTRODUCTION

1.1 Issue Background

For decades it had been taught to evaluate corporate investments by
projecting cash flows and discounting them using the weight average cost of
capital. The weight average cost of capital is composed of cost of equity and
the cost of debt, these are weighted to reflect corporate leverage and debt is
adjusted for corporate tax. In surveys such as (Graham & Harvey 2001)
many financial managers say that they do this. So it might have an
important impact. The corporate investment model of Abel and Blanchard
(1986) is used as an organizing framework. Weight average cost of cost
enters the model through the discount factor so that, when it is high the
expected value of the future marginal benefit is reduced which reduces the
incentive to invest now. Empirically, a high capital of debt has a negative
impact on investment. High leverage also has a negative impact on
investment.
The cost of capital concept has myriad applications in business
decision-making. The standard methodology for deriving cost of capital
estimates is based on Modigliani and Miller, (1958). Analysis cost of capital
to a firm in a world in which funds are used to acquire assets whose yields
are uncertain; and in which capital can be obtained by many different media,
ranging from pure debt instruments, representing money-fixed claims, to
pure equity issues, giving holders only the right to a pro-rata share in the
uncertain venture? This has vexed at least three classes of economists: (1)
the corporation finance specialist concerned with the techniques of
financing firms so as to ensure their survival and growth; (2) the managerial
economist concerned with capital budgeting; and (3) the economic theorist
concerned with explaining investment behaviour at both the micro and
macro levels.

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 Modigliani and Miller formal analysis, relating the economic
theorist at least has tended to side-step the essence of this cost-of-capital
problem by proceeding as through physical assets-like bonds-could be
regarded as yielding known, sure streams. Modigliani and Miller (1963)
presented new proof that cost of capital affect on capital structure, and
therefore affect on value of the firm with relaxing unrealistic assumptions
that there are existing taxes, which indicate that borrowing give tax
advantage, where the interest deducted from the tax and it will result tax
shields, which in tern reduce the cost of borrowing and then maximize the
firm performance (Miller, 1977) and this require from the firm to make
trade off between the cost of debt from side and the benefits of using debt
from another side. Sequence, the researchers studied the relationship
between capital structure and the value of the firm through appearing new
theory called the agency theory which indicates to potential conflict beween
shareholders and debtors from on the other hand. Potential conflict between
shareholders and managers arises when the shareholders choose the
manager as an agent of their selves to manage the firm in order to maximize
their wealth’s but the managers concentrate on the high profitable and risky
projects to achieve their interests at first that represented incentives and
rewards, and after that concerning of shareholders benefits, all of these lead
to maximize the firm value (Jensen and Meckling 1976; Harri & Raviv
1991; Myer 2001).

1.2 Problem Formulation

1. What are the basic assumptions, concepts and sources of capital
underlying capital costs?
2. How to determine the capital cost component consisting of long-term
loan capital costs, preferred stock capital costs, ordinary stock capital
costs, retained capital costs and weighted average capital costs following
its understanding?

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 3. How are investment decisions made and what is meant by marginal
costs?

1.3 Purpose
1. Explain the understanding of the basic assumptions, concepts and sources
of capital underlying the cost of capital
2. Determine and explain the components of capital costs consisting of long-
term loan capital costs, preferred stock capital costs, common stock
capital costs, profitable capital costs and weighted average capital costs
following the understanding
3. Knowing the investment decisions made and the understanding of
marginal costs

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 CHAPTER II
DISCUSSION

2.1 Understanding Of Basic Assumptions, Concepts and Sources From

Capital Underlying Capital Costs
2.1.1.Understanding Capital Costs
Each company always needs funds to finance the company. Every fund
used by his company has a capital cost that must be borne.
Capital is a production factor that is needed and like other production
factors, capital has a cost. The cost of each component is called component cost of
a certain type of capital.
The capital needed to finance the company's operations consists of foreign
capital and its own capital. Foreign capital is its capital derived from the loans of
creditors and banks. While the capital itself is capital derived from the company
both from the owner of the company (stock exchanger) and the bank that is not
distributed (retained earnings). If the company sells it to investors, then the
company is obliged to provide the return desired by the investor, for him is a cost
called capital costs such as : interest costs, securities impairment costs, and other
costs related to the acquisition of capital.
Cost of capital is the cost of capital that must be incurred by the company
to obtain funds either from debt, preferred shares or common stock, or retained
earnings to fund an investment or operation of the company. The determination of
the amount of capital is intended to determine how much the company will have
to spend to obtain the funds it needs.
According to Agus Sartono in his book Financial Management (1998:217)
said that the cost of capital is the cost that must be
issued or payable to obtain capital either from debt, preferred shares, common
stock or retained earnings to finance the company's investments.
Furthermore, Agus Sartono said that preferred shares are generally more
risky than bond debt. Guarantees on invested capital and profit payments for
preferred shareholders are after the bondholders are paid. Thus, dividend

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payments of preferred shares are paid after the payment of debt interest.
Consequently, preferred investors will ask for a higher level of return than
bondholders.
Therefore, the uncertainty of dividend payments of ordinary shares
becomes greater than the interest and dividends of preferred shares. It should be
noted that determining the size of the company's capital costs is very important
because there are three reasons.
1. Maximizing the value of the company requires the minimization of all input
costs including capital costs.
2. The right investment decision requires the right estimation of capital costs.
3. Some other decisions such as leasing, corporate repurchases and working
capital management require capital cost estimation.
Companies that use funds from retained earnings also have costs even
though the retained profit comes from the company's business. The cost of capital
derived from retained earnings is called sost of retainedearning. The fee is the
level of investment return (rate of return) required to be received by the investor.
This is because if the capital is invested in another company it will get a profit.
The amount of profit is equal to the amount of profit if the company invests the
profit fund or equal to the rate of return expected to be received from the
investment in the stock(expected rate of returnon the stock).
If the investor expects a high level of profit, which means a decrease in the
purchasing power of the money owned, then he will ask for a higher level of profit
for investment. Similarly, if it is estimated that the demand for funds will increase
then there is an oversupply and then result in investors asking for higher profits as
well, so that the balance is achieved at a higher level of profit.
Those two factors that greatly influence the return on risk-free securities
reguired rate of return for securities will also be affected by the risk free
securities. For the specific price of the letter there are four components of risk that
determine the premium risk, the four components are :
(1). Business risk,
(2). Financial risk,

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(3). Marketabiliti risk on securities later,
(4). Interest rate risk.
Capital costs can also be measured by the minimum rate of return of new
investments made by the company, of course assuming that the level of risk of the
new investment is the same as the risk of assets owned by the company today and
the understanding of capital costs is the weighted average capital cost.
Capital costs can be calculated based on the cost for each source of funds
or called individual capital costs. Individual capital costs are calculated one by
one for each type of capital. However, if the company uses several sources of
capital, the capital cost calculated is the weightedaverage cost of capital
abbreviated wacc of all capital used. Again that the concept of capital costs is
intended to determine the amount of real cost or (rill) of the use of funds from
each source of funds.

2.1.2.Factors – Factors Determining Capital Costs

Variables of important variables that affect capital costs include:
a.General circumstances of the economy. This factor determines the level of risk-
free or the level of
b.The selling power of a company's shares. If the selling power of the shares
increases, the minimum yield level of the investors will fall and the cost of the
company's capital will be low.
c.The decisions of the operations and financing made by the management. If
management approves high-risk investments or utilizes debt and special shares
extensively, the company's risk level increases. Investors then demand a higher
level of minimum yield so that the company's capital costs increase as well.
d.The amount of financing required. Large amounts of capital demand will
increase the company's capital costs.

2.1.3.The Basics of Capital Costs

The cost of capital is the rate of return that the company must achieve on
the investment of the project to maintain its market value. Capital costs can also

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be considered as the level of development desired by the fund provider to
withdraw it into the company. If the risk is constant then if the implementation of
the project with a rate of return above the cost of capital will increase the value of
the company, and if the implementation of the project with a rate of return below
the cost of capital will decrease the value of the company.

2.1.4.Basic Assumptions
The basic structure of capital costs is made with several assumptions
relating to risk and taxes:
a)Business risk, risks at which the Company cannot cover the company's
operational costs. These risks are assumed to be unchanged.
b)Financial risks, risks that companies cannot afford to cover financial obligations
such as interest, payout fees, and preferred stock dividends. This risk is assumed
unchanged.
c)The cost after tax is the relevant cost, in other words the cost of capital is
measured on a post-tax basis.

2.1.5.Basic Concept
The concept of capital cost is closely related to the concept of
understanding the required profit (requiretrate of return). The required level of
profit can actually be seen from two parties, namely the investor and the company.
From the investor's side, the high requiret rate of return is the rate of return that
reflects the level of risk of the assets owned.
If a new investment generates a greater level of return than the cost of
capital, then the value of the company will increase. Conversely, if the new
investment gives a lower level of profit than the cost of capital, then its value will
decrease.
As for companies that use funds (capital), the amount of requiret rate of
return is the cost of capital that must be spent to get the capital. The cost of its
debt, for example, is not the same as the interest paid to its creditors because to

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get the debt is not only the interest that must be issued by the company, but there
are also costs such as nottaris fees, provision costs, stamp duty costs, and others.

2.1.6.Costs from Capital Sources

The capital costs are calculated for the long-term source of funds available
to the company because the source provides it with a permanent cost. Long-term
financing supports investment in fixed assets, which are assumed to be chosen
using appropriate 'capital budgeting' techniques.
The Budget is an official report on the financial resources that have been
provided to finance the implementation of certain activities within the specified
time period. Budget is the most widely used means for planning and controlling
activities in every part of the company. The budget indicates planned expenses,
income or profit within a certain period of time in the future. The figures are
planned to be the standard for future work achievement.

2.1.7.Factors – Factors Affecting Capital Costs

i. Factors That Companies Cannot Control.
a.Interest Rates
If interest rates in perkonomian increase, then the cost of debt will also
increase because the company must pay bondholders with higher interest rates to
obtain debt capital.
b.Tax Rates
The Tax Rate is used in calculating the cost of its debt used in the WACC,
and there are other less tangible ways in which tax policy affects its costs.
ii.Factors That Can Be Controlled By The Company
a.Capital Structure Policy
Wacc calculation is based on the interest rate of each capital group with
the composition of its capital structure. So that if the capital structure changes,
then the cost of capital will be .
b.Dividend Policy

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 The decrease in dividend payment ratio may be able to reduce the cost of
capital itself increases, so that the ICC rises.

c.Investment Policy
The consequences of investment policy will bring risks. The small amount
of risk is what will affect the cost of capital.

2.2.Component Capital Cost

2.2.1.Long Term Loan Capital Cost
The long-term loan capital cost is the current after-tax cost to obtain long-
term funds through the loan. Example: funds obtained through the issuance and
sale ofobligasi.
Long-term demand for funds generally comes from companies that issue
long-term financial instruments, such as stocks and bonds. It said it was long-term
because the funds embedded in the shares meant it would be permanently
embedded in the company, while for it generally took at least five years to pay
off. The shares show proof of ownership, while the bonds are long-term bonds
issued by the company with a certain nominal nilsi, a certain period of time, and
give bungan (coupon). To calculate the amount of capital costs of long janka debt
can be used in two ways, namely:

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 CHAPTER III
CLOSING

From the review of conceptual, empirical and theoretical literature the

study emphasis on how cost of capital theory can lead to an operational definition
of the cost of capital and how the concept can be used in turn as a basis for
rational investment decision-making within the firm that enhance firm value.

From the findings, debt can increase firm value, this implies that, a firm
should have more debt for greater bargaining power and/or the market alternatives
of its suppliers. The study recommends the debt can increase firm value. This
implies that a firm should have more debt for greater bargaining power and/or the
market alternative of its suppliers.

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 REFERENCES

Ayeni Toba and Olaoye Babatunde. 2015. Cost of Capital Theory and Firm Value:
Conceptual Perspective. International Journal of Multidisciplinary
Research and Development

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