Cost of Capital Concept and Its Purpose

Concepts

Cost of Capital is one of the central notions in the area of business analysis for both organizations and individual investors. As a rule, it refers to the level of return required to make a new investment project profitable. It consists of determining the firm’s cost of equity and the cost of debt, followed by a comparison to the potential return. At the same time, the weighted average cost of capital, or WACC, requires that a company’s cost of capital be compared proportionally to each category. A WACC calculation includes all sources of the firm’s capital, which includes bonds, stock, and long-term debt. In this case, the cost of each component is multiplied by its proportional weight in an equation, which also requires the Cost of Equity and Cost of Debt variables. The general purpose of WACC is to reflect the discount rate that can be applied to estimate the expected free cash flows. The cost of capital is used in the Capital Asset Pricing Model that shows systematic risks and expected returns for the company’s assets. It remains popular in the business environment due to its relative simplicity and effectiveness, as the Model considers non-diversifiable risks along with expected capital returns, providing the management with a clear understanding of a potential asset’s viability.

Concepts Pt 2

The primary purpose of the Cost of Capital concept is to be used in new project analysis. For example, when a firm looks to purchase a new production facility, the financial department must calculate the cost of capital in order to determine the threshold, beyond which the return of capital will suffice to ensure the viability of the investment. In other words, the level of expected return must exceed the cost of capital. The equation used in the described process requires that the company should correctly calculate its cost of equity, as well as the cost of debt. The latter is not a complicated procedure, as the firm’s debt market rate is used in calculations. Nevertheless, calculating the cost of equity can be more difficult, as share capital does not possess an explicit value. However, the fact that there is no particular equity price does not imply that it does not have a cost. Once the calculations are completed, it is possible to determine the weighted average cost of capital (WACC). WACC can be utilized in a variety of business analysis types, such as acquisition assessment or a firm’s performance evaluation. It is often debated whether WACC should be determined on the corporate level or for particular divisions. In the first scenario, substantial risks emerge, as a generalization of such calculations may lead to an unjustified perception of the firm’s performance in particular areas, making it vulnerable to negative outcomes. On the other hand, different projects and divisions demonstrate specific risks opportunity costs, making it necessary to calculate WACC accordingly in each case. Overall, the Cost of Capital can be used when a new project is considered. Its results allow stakeholders to see whether an initiative has the potential to return sufficient profits.

Cost of Capital Uses in Midland Energy Resources

Estimations of the cost of capital are crucial for completing the analysis of different aspects of Midland Energy Resources. There are at least five uses of the estimates, including capital budgeting, financial accounting, performance assessment, merger and acquisition, and stock repurchase decisions. In terms of capital budgeting, cost of capital estimations are crucial for defining if a project is worthwhile doing. The estimations of the cost of capital are put in the Discount Cash Flow model the company uses to determine net present values (NPVs) of every possible project to make the decision.

In terms of financial accounting, Midland uses the cost of capital estimations to prepare financial reports. It is also used in preparing tax payables. In performance assessment, the cost of capital helps to determine the residual wealth of the company after paying the cost of capital. In the economic value added approach, the cost of capital is deducted from net operating profit after tax to understand how much money the company has earned after all deductions. Reduced cost of capital is associated with an increased residual wealth of the company.

The cost of capital estimations are also used by Midland Energy Resources to assess firms before making M&A proposals. These estimations help to offer the right price for other firms by ensuring that the company can pay the cost of debt and the cost of equity after paying the money for acquisition. Finally, Midland uses the estimations to calculate the ultimate intrinsic value of shares and compare them to the current price. If the current price is lower than the intrinsic value, Midland makes the decision to repurchase undervalued shares.

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NerdyRoo. 2022. "Cost of Capital Concept and Its Purpose." June 17, 2022. https://nerdyroo.com/cost-of-capital-concept-and-its-purpose/.

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NerdyRoo. (2022) 'Cost of Capital Concept and Its Purpose'. 17 June.

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