The Weighted Average Cost of Capital Methodology
The weighted average cost of capital methodology does not surprise me because calculating the cost of debt is rather simple. In this situation, the market rate is utilized to calculate the current cost of the company's debt. However, if the firm's rate differs from the market rate, an estimation is made to the market rate in order to obtain an accurate amount. In addition, the corporation gains when the tax on interest paid is subtracted. As a result, the company's net becomes a debt that is paid back with interest, resulting in tax savings (Patterson, 2012). This is the reason why the cost of debt after tax is 1-corporate tax rate (RD).
Cost of Borrowing at the Risk-Free Rate
The cost of borrowing is a term which applies to businesses particularly in financial industries enters into debts due to borrowing. It is usually the amount borrowed in currencies like euro, dollars or pounds. For the bondholders, stakeholders, and potential investors, the cost of debt is a concern when it becomes highly leveraged. It is considered rather risky because the debt financing is bigger than the owner equity which may lead to fewer profits to the firm thus making it have a large debt. The cost of equity (COE) of the company, in this case, makes sure that the stock market demands are returned to investors who tolerate the ownership risk (Ray, 2010). The COE is usually the company's structure which includes the common and preferred stocks as well as the cost of debt. When the cost of equity of a company is high, the market will view the firm as being risky. As a result, the firm might have higher return rates for the purpose of attracting investors. However, when it becomes low it will not have a higher rate. Surprisingly, it is a concern to the investors that the cost of equity may apply the capital asset pricing by attempting to balance the rewards expected against the risk of holding and buying the company's stock.
The Calculation Between the Book Values & Market Values
The calculation of the cost of capital is better when it is done with the book values because it usually has a ready balance sheet for all types of companies. On the other hand, it is a very difficult task to determine the market values, especially when acquiring the accurate data of the value of equity that is not in the list of the balance sheet. The value market, on the other hand, is considered by an analyst because the market demand of the investor would require returning the capital of the market as well as the book value (Khan, 2014). A good explanation can be used in an example. One should assume that a firm has a $10 of equity share for five years and the current market as well as the book value are $30 & $18 respectively. The company's investors, in this case, will expect a return on the market instead of the book value. However, if a new investor buys the shares of the company at $30 from the market and the company has a return of $20 from the book value, then the investor will gain a profit of 12 percent.
References
Khan, M. Y. (2014). Financial Management: Text, Problems And Cases. Tata McGraw-Hill Education.
Patterson, C. S. (2012). The Cost of Capital: Theory and Estimation. Greenwood Publishing Group.
Ray, K. G. (2010). Mergers and Acquisitions : Strategy, Valuation and Integration. PHI Learning Pvt. Ltd.
