Cost of Capital

Topics: Capital asset pricing model, Investment, Stock market Pages: 15 (4904 words) Published: April 5, 2013
Cost of Capital

Theory of cost of capital

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Cost of capitaltheory attempts to explain whether a company's mix of equity and debt affects its stock price. Two types of cost of capitaltheory can be distinguished: the net operating income theory and the net income theory. In the net operating income theory, the mixture of debt and equity does not directly influence a company's financial value. Under the net income theory, the manner in which a corporation structures its costofcapital has a profound impact on its market value. A company's cost of capital consists of both debt and equity, with equity being the preferred type of security to issue in most cases. Investors choose to purchase a company's stocks or bonds when they are relatively confident that a return on the investment will be received. The money that a corporation receives in exchange for issuing stocks and bonds is referred to as capital, which ends up costing the company when it must pay its investors interest. Cost of capitaltheory attempts to explain whether issuing a higher proportion of a single type of capital impacts the firm's ability to secure more investors. For example, some financial experts believe that issuing a higher proportion of bonds versus stocks will decrease a company's long-term stock value. A company's mix of debt versus equity does not influence its stock price under the net operating income cost of capitaltheory. This theory states that a corporation's financial value will be the same regardless of what the capital structure is made up of. For example, the price of the firm's stock will be the same whether it issues 60 percent stock to 40 percent debt or 90 percent debt to 10 percent stock. Even if the structure's mix fluctuates over time, it does not have an influence on the company's market value. Another type of cost of capitaltheory — the net income theory — takes the opposite approach of the net operating income theory. How much debt and equity a firm decides to issue to fund its operations will greatly influence its stock price under this theory. The net income theory takes the market value of a company's outstanding stock and adds it to the total value of the firm's debt. The operating income or income before interest and taxes is divided by the value of its existing capital to arrive at its percentage cost. While some companies may prefer to follow a particular cost of capitaltheory, many try to maintain a structure that minimizes their costs and increases any tax advantages. Interests payments on the cost of debt can be deducted from a company's gross income and reduce its tax obligations. Issuing a larger amount of bonds does carry a higher long-term risk since debt takes priority over equity if a company files for bankruptcy protection.

A way of estimating the required rate of return on a business investment such as small business ownership. Detail
The Cost of Capital represents the measure of the risk associated with a business investment. Put differently, it is the cost to the business of attracting and retaining the capital necessary to conduct its operations. This cost is determined in a competitive market since business owners must choose among the alternative investments based on each investment's risk and return profile. A Cost of Capital Model is a way to measure the return required to compensate the business owners for the risk they take. There are a number of Cost of Capital Models that are widely used by investors. The most common ones include: * Arbitrage Pricing Theory Model (APT)

* Build-Up Model
* Capital Asset Pricing Model (CAPM)
* Discounted Cash Flow Model
* Fama-French Three Factor Model
The Cost of Capital Models are important in calculating the so-called discount rate and capitalization rate which are used in business valuation under the Income Approach. Investors’ required rate of return = risk-free return + premium for risk of investment re = rf...
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