Discussion – Cost of Capital

Discussion – Cost of Capital

The book defines the cost of capital as the weighted average of all costs incurred from the different approaches to financing a company. An approach to financing a firm’s operations includes debt, equity, and hybrid equity, among others. The combination of these approaches gives rise to expense dubbed cost of capital (Damodaran, 2010). The costs can be altered by changing the composition of these techniques. Cost of capital estimates the costs incurred from debt and equity using debt and equity ratios. The levels of both debt and equity are altered until the lowest cost is attained. The company’s value is maximized at the lowest cost of capital. In simpler terms, the cost of capital is a combination of the cost of debt and equity. The textbook states that the cost of equity represents the risk posed by that stock. This risk is one that is undiversified and is included in beta in the firm’s capital structure.

From my research, the calculation of WACC was more detailed to the approaches employed as compared to those included in the book. Equity was classified into ordinary shares and preference stock (Hargrave, 2019). Debt was classified to bonds and long-term debts. Also, the definition of cost of equity from the book and online sources was different. The textbook defined it as the level of risk to shareholders, while other sources described the cost of equity as the amount of returns to shareholders who have invested in the firm. The cost of debt is the prevailing market rate at which interest is to be paid on the debt (Hargrave, 2019).  Notably, WACC is also used in discounting net cashflows in calculating the net present value. The cost of capital also helps the managers determine the optimal capital structure of the firm.

References

Hargrave .M (2019). Weighted Average Cost of Capital – WACC. Retrieved from https://www.investopedia.com/terms/w/wacc.asp

Damodaran, A. (2010). Applied corporate finance. John Wiley & Sons.

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Discussion – Cost of Capital

WACC or Weighted Average Cost of Capital has a long history in finance. Do some research on the topic and compare your findings with what is presented in the textbook in the section titled, “Cost of Capital Approach”. I recommend you search out some video presentations on WACC from www.youtube.com as well as other more professional sites.