A Concise Cost of Capital Homework Guide For Students

If you are struggling to grasp the roots of cost of capital, then financial management homework and assignments can seem a significant struggle. So, here are a few handy tips for acing any cost of capital homework with ease.

1.      Always measure the cost of capital after deducting tax cost.

2.      Remember to estimate costs of capital from a firm’s perspective.

3.      Remember to take marginal weights of particular components but the weighted average cost of the capital as a whole.

4.      Use market-based weights always, not weights from the accounting books.

5.      Cost of capital depends mostly upon the type of financing a company relies upon. It may be only debt, equity or a combination of both.

6.      Weighted Average Cost of Capital allows investors to determine the capital structure of a company; the weight of each capital financing source must be in proportion to it’s contribution to the firm’s capital structure.

 The choice of financing and thus, the cost of capital are vital metrics that help in determining that structure.

7.      Cost of capital is an important figure that is used as the discount rate while calculating a company’s free cash flows.

8.      Cost of capital is used to determine the profitability and feasibility of new projects, as it helps ascertain the minimum return that investments need to make to turn a profit.

9.      Cost of Capital = Cost of Debt + Cost of Equity; if the capital is based on borrowed funding, then the payable interest is the cost of debt.

Cost of Equity is deduced by assessing and comparing the investments with other investments of similar risk profiles. The Capita pricing method is followed while calculating it.

10.  The cost of capital is the minimum rate that investors expect from an investment. Cost of capitals is a major factor that determines a company’s market share value.

11.  Specific factors that can affect the cost of capital are as follows:

à Capital Structure

à Financial and Investment Decisions

à Current income tax rates

à Interest rates

à Quality of accounting information

12.  Cost of Debt is calculated with the formulaà C₁=(Risk-free rate + credit risk rate)(1- Market Tax Rate or Corporate Tax Rate)

Cost of Equity is obtained using the following formula à C₂= Risk-Free Rate of Return + Market Risk Sensitivity * Risk Premium, where Risk Premium is the difference between the standard market rate of return and the risk-free rate of return;

 

And, that wraps up this little homework help guide to the cost of capital. Hope it offered a quick recap of the essentials. Adios!