Determining The Cost Of Capital Essay example

Determining The Cost Of Capital Essay example

Length: 1055 words (3 double-spaced pages)

Rating: Better Essays

Open Document

Essay Preview

If the company has used different methods of financing, then the cost of capital is calculated by the weighted average cost of capital. The above formulas are also needed in this method.

The method for calculating WACC is often expressed in the following formula:

WACCC = percentage of financing that is equity * cost of equity + percentage of financing that is debt * cost of debt * (1 – corporate tax rate)

In order to calculate the percentage of financing that is equity, you need the following formula:

Percentage of financing that is equity = market value of the firm’s equity / total market value of the firm’s financing (equity and debt)

To calculate the percentage of financing that is debt, you can use the following formula:

Percentage of financing that is debt= market value of the firm’s debt / total market value of the firm’s financing (equity and debt)

The WACC will increase if the beta (risk measure) and the rate of return on equity increases. This is because a growing WACC denotes a drop in valuation and growth in risk.

You can also find out the above information from this informative YouTube video:

An example calculation

To make the above formulas a bit less daunting, here’s an example calculation of WACC. The below calculation is a rather simplified version of the different factors that might influence the rates used in the calculation. To ensure you come up with the most accurate figure for the cost of capital, you also need to check out the common problems in calculating it in the following section.

In our example, the crucial figures in WACC are as follows:

The company’s total equity = $10,000
The company’s total debt = $3,000

The percentage of financing that is equity + 12.5%
The percentage of financing tha...


... middle of paper ...


...Limitations of WACC

Finally, you also need to keep in mind the limitations of WACC.As well as the above issues; overall, it is crucial to remember the elements used in the formula are not consistent. These subtle differences can be apparent in the basic calculations of how the company calculates its debt as well as its equity.

The final ratio you receive with WACC should therefore not be taken as an ultimate truth. Instead, you want to use the cost of capital as an important indicator, but also add other financial metrics to your analysis and decision-making process. This is also an important point to remember if you are considering investing in a company.

The more you know about the financial status of the company to better. While the cost of capital needs to be taken with a pinch of salt and tough analysis, it is nonetheless an essential metric to learn about.

Need Writing Help?

Get feedback on grammar, clarity, concision and logic instantly.

Check your paper »

Evaluating The Cost Of Capital Essay

- When evaluating the cost of capital, it is the cost of obtaining funds either through debt or equity to finance an investment. Evaluating the cost of capital is used to determine if new projects will yield the minimum return that investors expect for providing the capital to the company. The cost of capital is used when making financial decisions and in capital budget decision making. Comparing the cost of capital and determining if the rate of return will be greater than the cost of the capital is something financial managers must evaluate....   [tags: Investment, Finance, Rate of return]

Better Essays
834 words (2.4 pages)

Determining A Capital Budgeting Plan Essay

- The first step in determining a capital budgeting plan is estimate the future revenue and expenses, which includes driver costs, repairs, and maintenance for the buses and miscellaneous other expenses. After taking the income and deducting the expenses, the cash flow per year (or period) can be established, however, due to the time value of money these future figures need to be readjusted for their Present Value. Utilizing the Present Value formula, take Year 1 as an example; PV is what is being solved for, and FV is the future value expecting to have, which in this case would be the cash inflow for this period ($159,000.00)....   [tags: Net present value, Rate of return]

Better Essays
1215 words (3.5 pages)

Essay on The Cost Of The Ink Bought

- The numbers from the above table correspond to the working notes below. Working notes: 1) As the production manager sees no alternative use for the paper, this means that it would not be replaced; as a result scraping the earnings made from stock - £5000. 2) The full cost of the ink bought must be charged to the cost of the leaflets, due to the surplus ink being inaccessible - in terms of not being able to be sold or used. 3) The staff (direct) are presently employed, which means the cost of their wages are reclaimed from the consumer....   [tags: Costs, Cost, Variable cost, Economics]

Better Essays
991 words (2.8 pages)

Abc System And The Cost Of Selling And Making Products Essay examples

- First we will talk about activity based costing and we will start by giving the definition of it ; Activity based costing means refining the costing system by concentrating on individual activities as essential or primary cost object or tool . ABC system has a lot of benefits and we will discuss them now, ABC helps in understanding overhead much better and the percentage of prim cost and overhead is the same in both ABC and traditional system; but what gives advantage of ABC over traditional is by using ABC system it helps to know the detail of overhead so that it can identifies how is the activity to avoid....   [tags: Cost, Costs, Activity-based costing, Cost driver]

Better Essays
1271 words (3.6 pages)

Capital Punishment Should Not Be Legal Essay

- According to the National Geographic, there has a been a steady decline of capital punishment around the world as there were only twenty-one countries out of 195 that still practiced the death penalty as of 2012. Many people around the world are foregoing capital punishment and have turned to more civil means of justice. All countries around the globe have flaws in their justice system which leaves too much room for error when capital punishment is implemented. Also, when societies turn to the death penalty to solve their problems, they teach their younger generations immoral behaviour as well as hypocritical values....   [tags: Crime, Capital punishment, Prison]

Better Essays
1162 words (3.3 pages)

Essay on Capital Punishment And Its Effect On Society

- The use of capital punishment dates back for centuries from hangings, burnings and even the crucifixion of Jesus Christ. Ancient society would use capital punishment such as stoning, crucifixion and other forms of torture as a way for the government to display its power to its citizens and a way to bring justice to the accused. Capital punishment has been enforced by governments worldwide in order to establish justice and protect their citizens (Muhlhausen). In today’s modern era the moral and economic question has been raised on whether or not this century old punishment is still an effective way to punish the worst of the worst....   [tags: Crime, Capital punishment, Prison]

Better Essays
1294 words (3.7 pages)

The Fundamentals Of Capital Budgeting Essay example

- Chapter 10 focuses on the fundamentals of capital budgeting and why these decisions are the most important investment decisions made by the firm. The overall goal of capital budgeting decisions is to increase the value of the firm. With this objective, the financial department must strategically select which investments will create the most value for the firm. These capital investments are essentially the primary source of revenue generation for firms. These capital investments are essentially investment projects with three different classifications: independent, mutually exclusive, and contingent projects....   [tags: Net present value, Investment, Capital budgeting]

Better Essays
701 words (2 pages)

The Moral, Legal, and Economical Aspects of Capital Punishment Essay

- Capital punishment has long been a topic for heated debate throughout the United States of America and the civilized world. For many politicians, the death penalty has been a key pillar to winning a state or election; and, to some extent, politics have been a key influence in America’s justice system. Many nations have outlawed capital punishment, with the United States included between 1972 and 1976. In the United States, there has been a renewed movement for this “eye for an eye” method, citing such arguments as “deterrence” and “victims’ rights.” This movement begs a single question – is there any economical, legal, or statistical support for the ultimate punishment....   [tags: Capital Punishment, Death Penalty]

Better Essays
1500 words (4.3 pages)

Essay on Capital Asset Pricing Model ( Capm )

- Security market line (SML) is a line on a chart representing the capital asset pricing model (CAPM). The security market line plots risk versus expected return of the market. The security market line is a useful tool in determining the relationship between risk and return for individual securities. If a security plots the security market line, it indicates a higher expected return for a given level of risk than the market. The security market line shows a positive linear relationship between returns and systematic risk as measured by beta (Boundless, 2016, para.2)....   [tags: Capital asset pricing model, Financial markets]

Better Essays
933 words (2.7 pages)

Capital Punishment Undermines The Goals Of The Justice System Essay

- Capital punishment degrades negates the goals of the justice system. This goal serves that once convicted and incarcerated, an individual needs to become a reformed member of society. Once released, one needs to be able to function and be a functioning individual that contributes to society. Capital punishment strips an individual of this process. Those who are in favor of capital punishment uphold the deterrence effect. However, research is showing that this goal is not achieved. Those who observe the public proceedings of an execution are experiencing a rationalization effect....   [tags: Capital punishment, Crime, Lethal injection]

Better Essays
835 words (2.4 pages)