Do You Know Your Cost Of Capital

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Michael T Jacobs is a professor of the practice of finance at the university of Carolina's kenanflagler business school, a former director of corporate finance policy at the U.S. Treasury Department, and the author of short

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term America.

Anil Shivdasani is the Wachovia Distinguished Professor of finance at Kenan-Flagler and a former managing director at Citi group Global Markets.

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Cost of capital..
Cost of capital is the weighted average of the required returns of the capital components that are used to finance

the firm. WACC = (E/V Re) +( D/V Rd(1 - Tc))

Example: Investment Rs 20 millions Annual cash flow - Rs 3.25 millions Time horizon -10 years Cost of capital- 10% results in NPV of break even What happens if it under-estimates or over-estimates.

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What are the practices followed by managers in calculating the investment opportunities and cost of capital? 1) DCF Method (Analysis relay on free cash flow projections

to estimate the value of an investment to a firm,

discounted by cost of capital) 2) CAPM ( which quantifies the return required by the investment on the basis of the associated risk.) What are the components of those methods?

CAPM= Rf + Rpm
DCF= (Cof ) + CF1 + CF2 + CF3 + - - - -

(1+WACC)1 (1+WACC)2 (1+WACC)3

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Moving on.
AFP -Association For the Financial Professionals

Answers to six core questions.

The questions are Whats your forecast horizon?

What is your Cost of debt?

Whats the Risk Free Rate? Whats the Equity- Market Risk Premium? Whats your beta period? Whats your debt to equity ratio?

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Results found that companies tend to use a standard, not a project-specific, time period. The problem can be mitigated by using the appropriate terminal value.

Normalized final year cash flow (WACC - Growth Rate) Finally the company need to use a project specific time period rather than using standard one.

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Further when the financial officers adjusted borrowing costs for taxes, the errors were compounded. After tax component Cost of debt = Rd(1-T) Where Rd stands for required return to the debt holders

Nearly two-thirds of all respondents (64%) use

the companys effective tax rate, whereas fewer than one-third (29%) use the marginal tax rate (considered the best approach by most experts), and 7% use a targeted tax rate. Hence, whether a company uses its marginal or effective tax rates in computing its cost of debt will greatly affect the outcome of its investment decisions.

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This results in estimating different cost of equity for similar companies as they are not using the same rate.

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Companies are not attempting to update its premium based on the economic situation. As theory prompts that the investor need more premium during crisis.

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It refers to a number that reflects the

volatility of the firms stock relative to the

market.

A beta greater than 1.0 reflects a company with greater-than-average

volatility; a beta less than 1.0 corresponds

to below-average volatility. The measurement period significantly influences the beta calculation and, thereby, the final estimate of the cost of equity

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We should not use the book value when estimating the capital structure weights for WACC.

Conclusion

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