Cost of capital refers to the rate of return which a company must earn or get on its investments to sustain its market value as well as attract funds (Miller, 2009). There are some factors beyond the control of a firm, yet affect its cost of capital. They include taxes and investor’s risk aversion.
The level of interest rates can affect or impact the cost of debt as well as the cost of equity. For instance, if interest rate increases it causes an increase on the cost of debt, which leads to the increase on the cost of capital. In addition, tax rates affect or impact after-tax cost of debt. When the tax rates increase, it leads to decrease on the cost of debt, which decreases the cost of capital (Shubber & Alzafiri, 2008).
Investor’s risk aversion is another factor beyond the control of a company but affect cost of capital. If investors may forecast variations within dividend growth, they price stocks at a low or high multiple of existing dividends based on whether the growth of dividend is projected to be low or high (Yuan & Chen, 2012).
Weighted average cost of capital refers to the cost of capital utilized to complete a project (Miller, 2009). Rate of return can be defined as the earnings from an investment or a project (Shubber & Alzafiri, 2008). Suppose a company invested $100 in stock, this becomes cost of capital. A year later if this investment yields $120. Then the rate of return for this investment can be calculated by applying a formula proposed by Ramirez (2011): ((Return- Capital) ÷ Capital) × 100%
Thus,
(($120- $100) ÷ 100% = 20%
The rate of return is 20% and such an investment adds value. This company should expand because it increases the shareholder value. From a financial viewpoint, in case the return from an investment is greater than the cost of capital, it should be undertaken.
References
Miller, R. A. (2009). The weighted average cost of capital is not quite right: Reply to M. Pierru. The Quarterly Review of Economics and Finance, 6(2), 7.
Ramirez, J. (2011). Handbook of corporate equity derivatives and equity capital markets. Chichester: Wiley.
Shubber, K., & Alzafiri, E. (2008). Cost of capital of Islamic banking institutions: an empirical study of a special case. International Journal of Islamic and Middle Eastern Finance and Management, 4(1), 6. doi:10.1108/17538390810864223
Yuan, B., & Chen, K. (2012). Impact of investor’s varying risk aversion on the dynamics of asset price fluctuations. Journal of Economic Interaction and Coordination, 1(1), 3.
