What does the cost of capital include?

When the investment project is a company, the general calculation method of capital cost is to calculate the company's weighted average cost of capital (WACC), and its basic form is: capital cost = equity cost × equity ratio+creditor's rights cost × creditor's rights ratio.

First, the cost of equity.

The cost of equity is the cost that a company faces by issuing common stock for financing. Apply the risk pricing formula:

Equity cost = risk-free interest rate+equity risk premium (ORERP).

For the estimation of equity insurance premium, most companies adopt the Capital Asset Pricing Model (ORCAPM), assuming that there is systemic risk in the market, no matter how investors diversify their investments. Unable to erase; And this part of the risk is the real risk faced by a company's equity investors.

Systemic risk widely affects all companies in a market, but the degree of influence is different for each company. In order to measure this degree, the beta coefficient (β) is introduced into the capital asset pricing model, from which the basic form of the capital asset pricing model is derived:

Equity cost = risk-free interest rate+β× equity system risk premium

Second, the cost of debt

The cost of creditor's rights is the cost borne by the company through debt financing, and there are three main determinants:

Risk-free interest rate If this interest rate rises, the bond cost will also rise;

Default spread corresponding to the company's default risk. The higher the company's default risk, the greater the premium and the higher the bond cost;

Tax incentives. Since bond interest can generally be tax deductible, the after-tax bond cost will be lower than the pre-tax cost, and the higher the tax rate faced by the company, the lower the debt cost.

Therefore, the basic form of debt cost is as follows:

After-tax bond cost = (risk-free interest rate+default premium) ×( 1- tax rate)

Third, the ratio of equity to creditor's rights.

In order to make the cost of capital reflect the overall structure of the company in proportion, investors need to give corresponding proportions to the cost of equity and creditor's rights, and these costs have been weighted and averaged. The mainstream view in academia and industry is to calculate the market value of equity and creditor's rights, not the book value. The market value of equity is usually obtained by multiplying the number of outstanding shares by the current price of the shares.

The estimation of the market value of creditor's rights is more complicated, because most companies' creditor's rights have parts that are not publicly traded, such as bank loans. For this kind of illiquid creditor's rights, companies generally only record the book value, so investors need to convert it into market value.

One of the simple methods is to treat the whole debt of the company as a coupon bond, and take the cost of the corporate bond as the discount rate to convert its present value into the market value of the corporate creditor's rights.

After calculating the market value of equity and creditor's rights respectively, the ratio can be calculated as follows:

Equity ratio = equity market value/(equity market value+creditor's rights)

Ratio of creditor's rights = market value of creditor's rights/(equity+market value of creditor's rights)

Fourth, the cost of mixed capital.

Although equity and creditor's rights are the most basic financing methods, companies sometimes raise funds by issuing some securities with both equity and creditor's rights characteristics, which are called hybrid securities.

1, preferred stock

Preferred stock has certain creditor's rights characteristics, because its dividend amount is determined at the time of issuance, and the dividend distribution order takes precedence over common stock; However, there is no tax relief for dividends of preferred shares, which makes preferred shares have the nature of common shares.

Usually, companies do not set a redemption date when issuing preferred shares. For these perpetual preferred shares, in the absence of other special circumstances, the capital cost can be calculated as follows:

Preferred stock cost = dividend per preferred stock/preferred stock price

Because the risk of preferred stock is between common stock and creditor's rights, its cost should also be lower than common stock, but higher than pre-tax creditor's rights. When calculating the proportion, the market value of preferred shares is listed separately from common shares and creditor's rights:

Preferred stock ratio = preferred stock market value/(common stock+bond+preferred stock market value)

2. Convertible bonds

The holder of convertible bonds has the right to convert creditor's rights into equity. Therefore, convertible bonds can be regarded as an interest-bearing bond and a conversion option, and when calculating their capital cost, they are included in the cost of creditor's rights and equity respectively; In the calculation of proportion, it is also classified as creditor's rights and equity by calculating the market value of the two parts respectively.

Extended data:

trait

Compared with the production and operation costs, the cost of capital has the following four characteristics:

1, the production and operation costs all offset the operating income, and the capital costs offset the operating income, such as the interest paid by borrowing from banks and issuing bonds; Some are paid from after-tax profits, such as dividends paid by issuing common shares; Others have no actual cost, only the opportunity cost of potential and future income loss, such as retained earnings.

2. Production and operation costs are calculated values of actual consumption, while capital costs are inaccurate estimates based on assumptions. If the cost rate of common stock is calculated according to the fixed growth model, it is based on the assumption that its dividend will increase on average every year.

3. The production and operation costs are mainly for accounting profits, with the focus on the consumption that has occurred in the process of production and operation. The capital cost mainly serves the enterprise's fund-raising and investment decision-making, and its focus is on the cost of raising and using funds in the future.

4. Production and operation costs are all pre-tax costs, while capital costs are post-tax costs.

References:

Baidu Encyclopedia-Cost of Capital