Calculating Company’s Capital

Is the average cost of capital; we can use the examples below to better explain how companies calculate their cost.

In this example we can look at the components, which in Superior’s case would be debt and equity.

The debt capital is the cost of the debt capital that would be equivalent to the actual imputed interest rate of our company’s debt; we would then make adjustments for the tax deductibility of the interest expenses. After tax cost of debt capital = the yield to maturity on the long term debt x (1 minus the marginal tax rate in %. Then we could enter the marginal tax rate in excel by placing the tax rate in cell c10 to come up with the calculation (“How to calculate a company’s cost of capital”, n/d,).

Equity shareholders usually don’t except a return on their capital. Equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile (“How to calculate a company’s cost of capital”, n/d,). By using the “Capital Asset Pricing Model” (CAPM). The model will show us that the equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. We would calculate this by the cost of equity capital= risk free rate + market risk premium (“How to calculate a company’s cost of capital”, n/d,).

Capital structure is calculated by taking a proportion of the debt and the equity capital, by using the market values of the total debt and the equity, the investments on which the investors expect to earn a minimum return (“How to calculate a company’s cost of capital”, n/d,).

Weighting the components we would take the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This will give us the (WACC) the Weighted Average Cost of Capital, the average cost of each dollar of cash employed in the business (“How to calculate a company’s cost of capital”, n/d,).

When the markets rate companies are looking at the perceived market rate they are looking at the impact at which it would be, the cost of capital, as like today with our debt ceiling lenders may increase our interest rates if they think that we are taking on too much debt (McClure, n.d., p. 1). We would need to access what point a firm’s cost of debt or equity will change the firm’s WACC.

Then Superior would need to Estimate how much the change will be. Then we could calculate the cost of capital up to and after the points of change (McClure, n.d., p. 1).

By looking at the Marginal Cost of Capital we will be able to identify which new projects can accept or rejected.

References

McClure , B. (n.d.). *DCF Analysis: Calculating the Discount Rate*. Retrieved from http://www.investopedia.com/university/dcf/dcf3.asp

How to calculate a company’s cost of capital. (n/d). Retrieved from http://www.expectationsinvesting.com/tutorial8.shtml