In order to avoid these issues with your calculation, here are some of the most common problems you should try to avoid.

The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. In other words, the change in the debt-equity ratio does not affect the total cost of capital.

At the most it can be estimated with a reasonable range of accuracy. It would require an upward adjustment if it has to be used to calculate NPV of projects which are riskier than the company's average projects and a downward adjustment in case of less risky projects.

The before-tax rate can be calculated by two different methods. Since there are different views, therefore, a finance manager has to face difficult task in subscribing and selecting an appropriate approach.

The market value weighted average cost would be overstated if the market value of the share is higher than the book value and vice-versa. It is the minimum rate of return which a company must earn to keep its common stock price from falling. According to the traditional theorists, the cost of capital of a firm depends upon the method and level of financing.

The finance manager is confronted with a large number of problems, both conceptual and practical, while determining the cost of capital of a firm. The results would be different in each case. These subtle differences can be apparent in the basic calculations of how the company calculates its debt as well as its equity.

The future costs should be considered. Computation of cost of equity The determination of the cost of equity capital is another problem. Since perfect capital market does not exist in practice, hence the approach is not of much practical utility.

At the most it can be estimated with a reasonable range of accuracy. In the same manner, arguments are given in favour of specific cost and composite cost as well as explicit cost and implicit cost and the marginal cost.

The corporate tax rate is 30 per cent and shareholders personal income tax rate is 20 per cent. On the other hand, the cost of debt refers to situations where the company has funded itself through debt alone.

In the same manner, arguments are given in favour of specific cost and composite cost as well as explicit cost and implicit cost and the marginal cost.

Therefore, its WACC would be 0. This would mean the company has financed all of its operations simply by lending from creditors. In case the company is solely financed through equity, the cost of capital would refer to the cost of equity. Having all the necessary inputs, we can plug the values in the WACC formula to get an estimate of 9.

The choice of using the book value of the source or the market value of the source poses another problem in the determination of cost of capital.

Generally, the after-tax cost is more widely used. Using the wrong investment time horizon The first issue often comes when companies select their forecast periods for variables such as cash flow.

But the quantification of the expectations of equity shareholders is a very difficult task because there are many factors which influence their valuation about a firm. Problems in Determination of Cost of Capital Problems in Determination of Cost of Capital It has already been stated that the cost of capital is one of the most crucial factors in most financial management decisions.

First we need to calculate the proportion of equity and debt in Sanstreet, Inc. Determination of Cost of Capital: You are required to compute the weighted average cost of capital.

Calculating the cost of equity There are also two ways of calculating the cost of equity: I Computation of cost by specific source of finance 1 Cost of debt: Trouble selecting the right risk-free rate As you remember, the cost of equity formula dealt with risk-free rates. However, the determination of the cost of capital of a firm is not an easy task.The computation of the over-all cost of capital involves the following steps: Calculate the cost of specific source of funds such as the cost of debt, cost of preference capital.

The computation of cost of equity capital depends upon the expected rate of return by its investors. But the quantification of the expectations of equity shareholders is a very difficult task because there are many factors which influence their valuation about a firm.

Cost of Capital Practice Problems 1. Why is it that, for a given firm, that the required rate of return on equity is always greater than the required rate of return on its debt?

The required rate of return on equity is higher for two reasons. The computation of cost of equity capital depends upon the expected rate of return by its investors. But the quantification of the expectations of equity shareholders is a very difficult task because there are many factors which influence their valuation about a firm.

Therefore, the cost of capital is often calculated by using the weighted average cost of capital (WACC). Since it analyses both equity and debt financing, it provides a more accurate picture of how much interest the company owes for each operational currency it finances.

Therefore, the cost of capital is often calculated by using the weighted average cost of capital (WACC). Since it analyses both equity and debt financing, it provides a more accurate picture of how much interest the company owes for each operational currency it finances .

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