Essentials of Corporate Finance

The Cost of Capital

Caucasus University
School of Business

Tinatin Bakashvili
Diana Giorgadze
Merab Gegechkori
Tornike Kevlishvili
Tamar Machitadze 12/27/2020

Nino Panjikidze
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Nowadays there is an increasing
competition among companies at the
market moreover there is a tendency of
strong connectivity among individual
economies, both abovementioned
processes can be considered as
significant effects of globalization.
 The general description of the topic.

Role of cost of capital in corporate finance?

Researches based on literature: scientific researches,

modern tendencies.

Main conclusions

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The cost of capital can be considered as weighted
average of the costs of raising funding for an
investment which is in the form of debt or equity.
Businesses are faced by some dilemmas. They have scarce
resources, therefore have to decide:
whether and where to invest scarce resources (the investment
decision)
 what mix of debt and equity to use in funding these businesses
(financing decision)
 how much cash to return to the owners of the business (the
dividend decisions)

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A company's cost of equity refers to the
compensation the financial markets require
in order to own the asset and take on the
risk of ownership.
To calculate the cost of equity using CAPM,
multiply the company's beta by its risk
premium and then add that value to the risk-
free rate

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Cost of Equity vs. Cost of Capital
A company's cost of capital refers to
the cost that it must pay in order to
raise new capital funds.
Cost of equity is the percentage return
demanded by a company's owners, but
the cost of capital includes the rate of
return demanded by lenders and
owners.

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Dividend Growth Model
The easiest way to estimate the cost of equity capital is to use the dividend growth model.

D0 - the dividend just paid

D1 - the next period’s projected dividend
g – dividends constant growth rate
RE (E stands for equity) for the required return on
the stock - RE = D1/P0 + g
Because RE is the return that the shareholders
require on the stock, it can be interpreted as
the firm’s cost of equity capital.

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The SML Approach
E(RE)=Rf +βE ×[E(RM)−Rf]
Rf - the risk-free rate,
E(RM) − Rf - The market risk premium.
β - The systematic risk of the asset relative to that in an average risky asset

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Cost of debt
Cost of debt is one part of a
company's capital structure, which
also includes the cost of equity.
Capital structure deals with growth
through different sources of funds,
which may include debt such as
bonds or loans, among other types.

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The Cost of Preferred Stock

Preferred stockholders have prior

claim to the assets of a corporation
over common stockholders.

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THE WEIGHTED AVERAGE COST
OF CAPITAL
When the cost of capital for different securities has been determined, the next step is to
calculate the weighted average cost of capital. (WACC)

WACC=(E/V)×RE +(D/V)×RD ×(1−TC) Re = Cost of equity

Rd = Cost of debt
E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = E + D = Total market value of the firm’s
financing
E/V = Percentage of financing that is
equity
D/V = Percentage of financing that is debt
Tc = Corporate tax rate

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 • In corporate finance it is the cost of
capital that has the role of benchmark
that has to be used for an investment
to be categorized as a good
investment.
• The second component in corporate
finance is to find a mix to optimize
business value and that is the mix of
debt and equity.
• Another factor on which the cost of
capital plays an important role is the
dividend policy.
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 Cost of Capital for Investing Cost of Capital for Business

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Cost of Capital for Investing
Consider a stock market trader or real estate
investor that invests $10,000 into a particular
opportunity. The opportunity cost is the difference
between any profit actually earned, and the profit
that could have been earned. Let's say the investor
earned a 5% profit on the actual investment but
could have earned 10% on the investment
opportunity not chosen. The difference between
the profit earned on Opportunity "A" and
Opportunity "B" (5%) is the actual cost of capital.

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Scientific Researches
CAPM model was developed by W.
Sharpe and J. Lintner around 1965 .The
CAPM model is considered as a basic
model for determination the
relationship between market risk and
return of financial investments

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Some thoughts of calculating cost of equity
During research we found several methods
for calculating cost of equity. New methods
evolved and those replaced the formers.

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Modern Tendencies

To move to the modern times and tendencies

nowadays companies deploy a range of
performance metrics in measuring performance
in their incentive plans, attempting to earn an
acceptable quantity and quality of earnings.

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Main Conclusions
Estimating a company’s WACC is a thoughtful
and beneficial exercise in corporate finance, and
it has many applications that management can
employ in testing the reasonableness of many
investment opportunities. Determining a
company’s WACC is an important step in testing
the validity of a company’s return targets for
annual and long-term incentives

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