The problems to estimate the cost of capital
MASTER IN MANAGEMENT – FINANCIAL MANAGEMENT
LECTURE 6 – FINANCIAL ARCHITECTURE
The problems to estimate the cost of capital
Before starting to describe the problems associated to the estimation of the cost of capital, it is extremely relevant to describe its meaning: according to Investopedia, it is “the cost of funds used for financing a business”. In order to carry out this process, the companies can only be financed through equity; only through debt; or using a “combination of debt and equity” - in this particular case it is a “overall cost of capital derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC) (...)”
(Investopedia, 2013). The estimation of the cost of capital depends on several factors, such as the “operating history, profitability, credit worthiness, etc.”. It means, of course, the most recent companies will face higher costs of capital because their risk is higher when compared to solid companies (Investopedia, 2013).
It is now important to describe a few and the most important problems regarding the estimation of the cost of capital:
(i) Assumptions about the costs of equity and debt: these assumptions deeply affect
“the type and the value of the investments a company makes.” (Jacobs and
Shivdasani , 2012). It will make the managers decide whether they invest or not in a project and also if a company will be successful financially. Thus, if the company has made an underestimation to its capital cost, it will may see “a flashing green light” in terms of the Net Present Value; on the other hand, if there is an overassumption regarding the capital cost, the project might “be cast aside”, as it will show a loss or a lower Net Present Value than the real one (Jacobs and Shivdasani, 2012).
In a more precise way, there are two main problems regarding the assumptions done:
- The first one is about estimating the cost of equity in which two different methods can
be
LECTURE 6 – FINANCIAL ARCHITECTURE
The problems to estimate the cost of capital
Before starting to describe the problems associated to the estimation of the cost of capital, it is extremely relevant to describe its meaning: according to Investopedia, it is “the cost of funds used for financing a business”. In order to carry out this process, the companies can only be financed through equity; only through debt; or using a “combination of debt and equity” - in this particular case it is a “overall cost of capital derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC) (...)”
(Investopedia, 2013). The estimation of the cost of capital depends on several factors, such as the “operating history, profitability, credit worthiness, etc.”. It means, of course, the most recent companies will face higher costs of capital because their risk is higher when compared to solid companies (Investopedia, 2013).
It is now important to describe a few and the most important problems regarding the estimation of the cost of capital:
(i) Assumptions about the costs of equity and debt: these assumptions deeply affect
“the type and the value of the investments a company makes.” (Jacobs and
Shivdasani , 2012). It will make the managers decide whether they invest or not in a project and also if a company will be successful financially. Thus, if the company has made an underestimation to its capital cost, it will may see “a flashing green light” in terms of the Net Present Value; on the other hand, if there is an overassumption regarding the capital cost, the project might “be cast aside”, as it will show a loss or a lower Net Present Value than the real one (Jacobs and Shivdasani, 2012).
In a more precise way, there are two main problems regarding the assumptions done:
- The first one is about estimating the cost of equity in which two different methods can
be