Cost of capital

 

                                            Theme: « Cost of capital»

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

                                                Almaty 2012

Contents:

Introduction

Chapter 1: Economic nature and classification of capital ventures

Chapter 2: Cost of Capital: the nature and character of its assessment

Chapter 3: The cost of capital as an indicator of financial performance

Chapter 4: Calculation part

 

Conclusion

References

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Introduction

Each company has financial resources needed to finance their production and trading activities.

Based on the duration of the operation in this particular form of assets and liabilities are classified as short and long term. Mobilization of a source of funds related to the company for certain costs incurred:

1) Shareholders should pay dividends;

2) The owners of corporate bonds - interest;

3) Banks - interest on loans granted by them, etc.

The total amount of funds that should pay for the use of a certain amount of financial resources, expressed as a percentage of this volume is called a "price" of capital.

Ideally, it is assumed that current assets funded in order not to reduce its market value.

In practice, we must distinguish two concepts:

Short-term liabilities and non-current assets, due to long-term commitment. Therefore, optimizing the total acquisition costs of various sources

1) The concept of "price" is the key to the theory of capital. It characterizes the rate of return of investment capital, which should provide venture capital cost of this enterprise;

2) The current price of the whole enterprise as an economic entity in the capital market;

The first concept is expressed quantitatively in the way the company relative annual cost of servicing the debt to the owners (auctioneers) and creditors. The second is expressed in different parameters, in particular asset prices, the volume of equity capital and profit, etc.

Both terms are quantitatively related. For example, if a company participates in an investment project, profitability is below the "price" of capital, the price of the company after the completion of this project will go down. Therefore, the "price" of capital is taken into account managers of the company in making investment decisions.

In the passive balance reflects both its own and borrowed sources of funds. The structure of these sources varies significantly by type of enterprises and areas of business. Is not the same as the price of each source of funds, so the "price" of capital of the enterprise usually calculated on a weighted arithmetic mean.

The main difficulty is to calculate the unit cost of capital resulting from a particular source of funds. For some sources, the "price" of capital can be determined accurately. For example, the price of the share capital, bank loan, etc.

According to other sources to perform such calculations is difficult. For example, for profit, is payable. Knowing the approximate value of the "price" of capital can make a comparative analysis of the effectiveness of advances, including an assessment of investment projects.

Average Cost of Capital (SSC) is the minimum rate of return that investors expect from their investments. Selected for the project must provide at least not lower profitability than the SSC

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Chapter 1:  Economic nature and classification of capital ventures

The activities of any company depend on many factors, including a material nature. There are three basic factors of production: capital, natural resources, including land and labor resources. By their nature they are the productive resources and, consequently, their use in production due to the costs that must be incurred to bring the resource (dividends, interest, and wages).

Any commercial organization needs a source of funds to finance their activities, both from the standpoint of perspective, and in terms of current operations. Depending on the duration of existence in this particular form of company assets, as well as sources of funds can be divided into short and long term. Involvement of a funding source is connected to the company at a cost: the shareholders to pay dividends, the banks - interest contributors for their loans to investors - interest on investments made by them, etc. The total amount of money you want to pay for the use of a certain amount of financial resources expressed as a percentage of this volume is called the cost of capital {cost of capital). Ideally, it is assumed that, as a rule, current assets are financed through short-term, and capital assets - at the expense of long-term sources of funds, this optimizes the total cost of rising

As noted above, the terminology in many sections of the market economy is in flux. In particular, the national literature can be found another name for the considered concepts, namely "price" of capital is sometimes suggested, the term "value" of capital. Without exception, the names mentioned are conventional and not without drawbacks, as correct, it would probably be talking about the cost of capital. Preferring the term "cost of capital, we are guided by the following arguments.

First of all, the name of the indicator should reflect its costly nature, because it is forced to expense (actual or potential). The term "value" to a large extent has hue not expensive, and profitability, so there is hardly expedient to use.

In most cases, costs can be evaluated only relative, especially when it comes to the total assessment in relation to all sources. With regard to individual sources, it is obvious that, depending on market conditions, success of the firm's cost sources such as common stock and retained earnings can vary significantly, i.e. assessment of the relative costs and multivalued conditional. So, at the time of obtaining bank loans can not exactly predict the interest rate that the bank will offer, as it may significantly vary depending on the creditworthiness of the borrower, the bank's policy, etc.

The concept of cost of capital is one of the basic theories of capital. It is not limited to the calculation of the relative value of cash payments, which need to list owners to provide financial resources, but also characterizes the level of profitability (return) of capital invested, which should provide the company not to reduce its market value.

One should distinguish the concept of "cost of capital the firm" from concepts such as "capital appreciation", "firm value", etc. In the first case we are talking about some specific characteristics of the source of funds. The cost of capital is expressed quantitatively in the way of the relative annual costs of servicing its debt to the owners and investors, i.e. a relative measure, measured as a percentage. Of course, that this characteristic may be given in respect of a separate source, and in relation to their set, here comes the concept of the average cost of capital. In the second case we are talking about different absolute value terms, for example, the value of equity in any assessment (book and market) value of funds raised the total valuation of the firm, etc. Thus, if a company participates in the investment projects which yield fewer than the cost of capital, then the capitalized value at the end of this project will decrease. Thus, the cost of capital is a key element of the theory and practice of making an investment character.

Determining the cost of capital is not an end in itself. First, this index characterizes the activities of a commercial organization with the position long term. Thus, the cost of equity capital of a commercial organization shows its attractiveness to potential investors with the opportunity to become its co-owners, the cost of borrowing some sources characterized by the possibility of a commercial organization to attract long-term capital (it is obvious that, for example, the value of the source "bond issue" may be different for different companies and this is naturally reflected in the profit and profitability). Second, the average cost of capital the firm is one of the key indicators in the preparation of capital budget.

Any company is usually financed at the same time from multiple sources. Since the cost of each of the different sources of funds, cost of capital of a commercial organization are in accordance with the weighted arithmetic mean. The index is calculated as a percentage and is usually based on annual data. The main difficulty in the calculation of calculating the unit cost of capital derived from a particular source of funds. For some sources, it can be calculated quite easily (for example, the cost of bank credit), for a number of other sources to make it pretty hard, and the exact calculation is impossible in principle. Nevertheless, even an approximate knowledge of the capital cost of a commercial organization is very useful for comparative analysis of the effectiveness of advances in its activities and to implement its own investment policy.

It should be noted that the use of weighted arithmetic mean formula assumes a comparable terms, in particular the comparability of the methodology of calculation. And here there are some problems, namely: on what basis - before tax or after tax - should perform calculations. Not all sources of funds in this respect are equal. For example, dividends paid from profits, i.e. cost source of equity is calculated after the tax base. On the contrary, interest payable on certain types of debt capital are debited to the cost, so the assignment of the amount of interest paid to the value of funds in this case gives the index, calculated on to the tax base. Consequently, the inclusion of these two indicators in the formula of weighted arithmetic mean is not a methodologically valid.

Thus, the economic interpretation of the indicator 'cost of capital "is fairly obvious - it characterizes how much money should pay for the attraction of a unit of capital from this source. This assertion should not be taken literally. If in relation to the ordinary product of its value at the time of the transaction represents an absolute estimate in the sense that the buyer pays and seller receives the same specified amount in the form of prices of goods, in respect of certain sources of funds typically equal value from the position of the seller and the buyer in a sense, violated. So, getting a bank loan, the company has to pay a specified percentage, which from the standpoint of the lender will be a price it receives for services rendered, and expresses the cost of this service. However, from the standpoint of the buyer, i.e., borrower, is considering a loan in the context of several funding options, the real value of this source will vary downward from the price paid, i.e., of the nominal value. This difference stems from the influence of the corporate profits tax.

The financial manager must know the cost of capital of the company for many reasons. Firstly, the cost of equity capital, is essentially a return on capital invested in the company's activities and resources can be used to determine the market valuation of equity (for example, using the Gordon model) and predicting the possible changes in stock prices firm in response to changes expected value of profits and dividends. Second, borrowing costs associated with pay interest, so you should be able to choose the best opportunity of the few options for raising capital. Third, to maximize the market value of the firm, which, as noted above, is a major challenge for management personnel is achieved as a result of several factors, in particular by minimizing the cost of all sources used. Fourth, the cost of capital is one of the key factors in the analysis of investment projects.

Chapter 2: Cost of Capital: the nature and character of its assessment

2.1 Summary of Cost of Capital

The cost of capital (also called cost of capital or the cost of capital) is the rate of return that an investor expects to earn on its investment, taking into account the risks associated with it. Each kind of invested in the company capital (e.g. investments in ordinary shares, preference shares or provided long-term loans, as well as retained earnings) has a cost.

As an initial basis for evaluating the minimum cost of equity is often used profits to which the shareholder can expect by investing in any alternative project with a similar level of risk (eg, putting money in the bank for deposit). Estimate of the cost of borrowed funds is carried out at interest, which expects to receive an investor-lender, providing for the use of their funds. For an organization to which the shareholder has invested their money, the profit potential of the shareholder on the alternative project called the opportunity cost of capital. Since project alternatives can be many, the importance of alternative yield must be calculated for each of them separately. In this regard, frequently uses the term "average cost of capital»  (Weighted Average Cost of Capital - WACC), which refers to "alternative" value of the company's debt and the interest of its shareholders (i.e., common shares, preferred shares and retained earnings) taking into account the specific weight of each of these components in the overall capital structure. Accordingly, the product of percentage of the value WACC in the amount of money invested in a company shareholder, will show the size of the potential profits that would get the "average investor", if invested in alternative investment projects.

Average Cost of Capital (WACC), is typically used:

- For budgeting capital expenditures;

- Application of the net present value for the evaluation of investment projects, which involves the use of capital as the discount rate when calculating the present value of future cash flows (earnings) in cash;

- Using the method of internal rate of return, which involves the use of capital to make decisions in favor of or refusal to implement a project. For these purposes, the cost of capital compared with the internal rate of return, which the company expects to benefit as a result of the project in question. Decision on the adoption of the draft was adopted in the case where the internal rate of return exceeds the cost of capital.

When deciding on the use of any resource on an important point is to assess the cost (or price): how costly his involvement. This assessment is essential for financial resources. Individual components of financial resources have different costs, as purchased in different markets (stock, cash, and merchandise). Components of financial resources can be estimated from the structure of financial sources. The source of any increase in assets - an increase of one or more components of the funds.

The relative magnitude of the costs of maintenance of capital items is called the cost of capital (cost of capital). Individual elements of the capital have a different value. This cost is reflected in relative terms as the interest rate (annual interest). The value of the cost of capital is determined by the yield required by the owner of the capital.

It should be noted that the cost of capital depends not only on the source of much of the riskiness of the operation's assets and benefit from them. The greater the risk of this activity, the greater the yield required the owners of capital and thus more expensive capital of the corporation. In a competitive market, capital owners have an opportunity to relate risk and return of different investment options. The cost of capital will be determined by the current risk-free return on investment for a similar period of time, expected inflation and pay for the risk.

The owner of capital is considering various options for investment of funds in different markets and risk-adjusted required rate of return on a certain amount initially invested.

Market valuation of capital of the corporation will not fall if the corporation would be able to provide the owners of capital required return. When making financial decisions the manager will assess the value of each element of capital and the combination of different elements of capital in total capital of the corporation. This overall cost of capital of the corporation, as the discount rate when converting the future cash flows of the date hereof, will provide ongoing evaluation of the capital.

Evaluation and comparison of costs of various elements of capital allow you to choose the cheapest way of long-term financing, i.e. to form a target capital structure. Not only the different elements have different capital costs, but also one and the same element value changes over time, as it can change the market risk assessment and market return.

2.2. Capital of the organization

The composition of economic resources used by the organization is different. Of particular importance to the success of the organization is having some headroom durables - capital. Capital is one of the factors of production along with natural and labor resources. Capital - the value of advances in production for profit.

The term "capital" is treated ambiguously in the economic literature. On the one hand, the mean amount of capital under the share capital, share premium and retained earnings. On the other hand, under the capital involve all long-term sources of funds. In the first case, the capital - is the interest of owners of the organization. The value of capital is calculated as the difference between the valuation of assets of the organization and its indebtedness to third parties (creditors, the state's own workers, etc.). Depending on what estimates (prices) are used in the calculation (accounting or marketing), the quantity of capital can be calculated in different ways. This approach has been widely circulated among accountants.

The term "capital" and is often used to describe the organization's assets, dividing them into the major (long-lived assets, including work in progress) and working (all current assets of the organization) capital. This approach is widespread among economists. It also occurs in the definition of capital as the total amount of funds in cash, tangible and intangible forms, invested in the formation of the organization's assets. In this case, capital is regarded as a property complex, whereby the owner assumes earn income in the future, i.e., that can generate income in the future. At this interpretation of capital exists in a material object-and value forms. Capitals in its domain-name form a material foundation. Valuation of assets is called the means.

Often the term "capital" used in reference as to the source of funds and the assets. With this approach, describing the sources speak of a "passive equity", and describing the assets, they talk about "active capital, dividing it into fixed capital (current assets, including construction in progress) and working capital (this includes all current assets).

In Western literature, the capital is understood by all sources of funds used to finance the assets and operations, including short-and long-term debt, preferred and common stock (passive balance).

2.3. Cost of capital of the organization

Every organization needs a source of funds, both short and long term to finance its activities (both from the standpoint of perspective, and in terms of current operations). Involvement of a particular source of funds associated with certain costs incurred by the company: the shareholders have to pay a dividend, banks - interest contributors for their loans to investors - interest on investments made by them, etc. As a result, fees for use investment account for a significant portion of the costs the organization.

The total amount you want to pay for the use of a certain amount of financial resources, expressed as a percentage of this volume is called the cost of capital (Cost of Capital, SS), i.e. cost of capital - is the ratio of the amount of money you need to pay for the use of financial resources from a particular source, the total volume of funds from this source, expressed as a percentage. In the domestic literature one can find another name under consideration concepts: the price of capital, the value of capital, cost of capital, etc.

Figure "cost of capital" has a different economic sense for individual business entities: a) to investors and creditors, the level of capital characterized by their requested rate of return on capital is made available for use b) for business entities that form the capital to productive use or investment, the level of its value characterizes the specific costs to attract and service use of funds, ie price they pay for the use of capital. Organization of this index assesses how much money should pay for the attraction of a unit of capital (like from a particular source of funds, and for the whole organization, from all sources).

The concept of cost of capital is one of the basic theories of capital organization. The cost of capital characterizes the level of return on invested capital required to achieve high market value of the organization. Maximization of the market value of the organization is achieved largely at the expense of minimizing the cost of the sources used.

The indicator value of capital used in the process of evaluating the effectiveness of investment projects and portfolio organization. The indicator value of capital used in the process of evaluating the effectiveness of investment projects and portfolio organization. The adoption of many decisions of a financial nature (policy of financing current assets, the decision to use the leasing, planning operating profit organizations, etc.) based on an analysis of the cost of capital.

2.4. Capital valuation

Any organization finances its activities, including investment from various sources. As payment for the use of advanced in the organization of financial resources, it pays interest, dividends, fees, etc., i.e. bears some reasonable expenses incurred in maintaining its economic potential. As a result, each source of funds has a cost as the sum of the costs of providing this source.

In assessing the cost of capital, first by the valuation of individual elements of equity and debt, and then determined the weighted average cost of capital.

Determining the value of assets of the organization carried out in several stages: 1) identifies the major components that are sources of capital formation of the organization; 2) makes up the price of each source separately, and 3) is determined by the weighted average cost of capital based on the proportion of each component in the total amount of invested capital; 4) development activities to optimize capital structure and the formation of its target structure. Next, we consider the characteristics and methodological tools for assessing the cost of capital at each stage.

An important aspect in determining the value of assets of the organization is the selection of the base on which to carry out all calculations: to tax or after tax. Since the purpose of organization management is to maximize net profits, then the analysis takes into account the effect of taxes.

It is equally important to determine what price the source of the funds should be taken into account: the historical (at the time of raising the source) or new (marginal to indicate the marginal cost to attract funding). Marginal costs provide a reasonable estimate of future costs of the organization necessary for the preparation of its investment budget.

2.5. Factors determining the cost of capital

The cost of capital depends on its source (owner) and is determined by the capital market, i.e. supply and demand (if demand exceeds supply, the price is set at a higher level). The cost of capital depends on the amount of capital employed.

The main factors that influenced that make up the cost of capital of the organization are:

    1) The general condition of the financial environment, including financial markets;

    2) Commodity markets;

    3) The average lending rate prevailing in the market;

    4) Availability of various sources of funding for the organizations;

    4) The profitability of operating activities of the organization;

    5) The level of operating leverage;

    6) The concentration of equity;

    7) The volume ratio of operating and investment activities;

    8) The degree of risk in operations;

    9) Branch features of the organization, including the duration of the operating cycle, etc.