Cost of capital

Costs are internal variables that evaluate the use of production factors in the production of services in such a way that it is possible to make mathematical decisions that are compatible with the company's objective. Costs therefore assess the consumption of resources and the provision of capacities for the provision of services, that is, the provision of asset items.

In addition to factors such as work, energy, material and preliminary work, the creation of business services requires assets to be available. It was always a business question how the use of assets should be assessed in terms of costs. In the past, there have only been isolated answers to this. One related to wear and tear and depreciation was included in the calculation as a cost. Another related to certain risks associated with the assets, and of course the risks, especially technical risks, were taken into account as costs.
However, the provision of assets that were financed is also offset by capital.
Cost of capital is an imputed approach for the demands of the capital provider and they therefore evaluate the use of the assets in the provision of services.
Cost of capital is nothing new in the calculation when it comes to the use of outside capital. Interest and costs for the procurement of outside capital, for example for the issue of a bond, were also part of the calculation in the past.

The difference between services and costs (including borrowing costs) was used in the operating accounting to represent the result as a kind of profit. If the difference was positive, a measure such as selling a product was considered beneficial.
This type of calculation had provided information about whether the profit would be positive or not, but it was not shown whether or not the amount of the profit would satisfy or even surprise the beneficiaries.

Early work on the “target profit” did not catch on because the emerging capital market research opened up a new approach.

Capital market research is based on the mobility of capital. Investors compare the returns offered by various investment opportunities and have become agile. Their preferences and their behavior were modeled by portfolio theory. In particular, investors expect a return that, in addition to the pure provision of capital over time (interest rate), also rewards the risks associated with an engagement. The expected return on an investment is therefore equal to the interest rate plus a risk premium.
1. How exactly the risk is to be measured and what the relationship between risk and risk premium looks like is described by the models of capital market research.

2. A good model should 1. result from theoretical considerations, 2. be as simple as possible, and 3. reflect the empirical data well.

3. It is not to be hoped that an event as complex as the behavior of investors and the associated pricing will be captured by an ideal model.

4. But there is a model that comes pretty close to the (non-existent) ideal, even if, especially as far as the empirical content is concerned, some compromises have to be made. It is the Capital Asset Pricing Model (CAPM).

5. The CAPM states that equity investors expect a return which, in addition to the interest rate, includes a risk premium that is proportional to the so-called beta.

6. Of course, investors expect an even higher return if the investment is not very liquid or if there is also the risk of total failure.
All of these considerations can be made from an outside perspective without looking into the company.
The question now arises for management as to how a calculation with capital costs is specifically structured. In other words: How do we have to make the decisions in the company so that the equity investors, when they observe our decisions, think that their return expectations are being met?
The answer is: All decisions in the company must be calculated as if the use of assets or capital costs as much as the investors expect as a return. With this maxim, the cost of capital is as high as the expected return. Both sizes are like the two sides of the same coin. The expected return relates to the external perspective, the cost of capital to the internal perspective.

Three examples:

Der Preis von Produkten muß so hoch sein, daß auch der Einsatz des betrieblichen Vermögens (Anlagevermögen und Umlaufvermögen) sowie der Einsatz von Wissen und Know-how (Intangibles, Intellektuelles Kapital), mit Kapitalkosten bewertet, gedeckt wird. Ist die erzielte Leistung ebenso hoch wie die Kosten unter Einschluß der Kapitalkosten, dann sind die Investoren gerade zufrieden und beurteilen die Investition als marktgerecht. Ein ganzes Jahr gesehen war eigentlich nur gerade zufriedenstellend, wenn der ökonomische Gewinn die Kapitalkosten deckt. Projekte müssen, um als vorteilhaft betrachtet werden zu können, eine Rendite haben, die wenigstens so hoch ist wie der Cost of capital. Ist die Projektrendite genauso hoch wie der Kapitalkostensatz, dann sind die Investoren wieder gerade zufrieden und beurteilen die Investition als marktgerecht. Möchte nun die Unternehmung eine Kapitalerhöhung durchführen, dann werden die Investoren indifferent sein. Denn es gibt bereits genug Möglichkeiten, Geld zur marktüblichen Rendite anzulegen.

Sind die beiden eben genannten Differenzen sogar positiv, liegt eine echte Outperformance vor. In diesem Fall wird die Unternehmung, sobald die entsprechenden Sachverhalte im Capital market bekannt werden, weitere Investoren anziehen. Der Aktienkurs steigt. Die Aktionäre entdecken, daß die Rendite sogar über dem marktüblichen Niveau liegt. Das Management hat es leicht, Kapitalerhöhungen zu verwirklichen.

The DCF method is the best practice for assessing projects based on the cost of capital, as far as the structure of the calculation for assessing the profitability is concerned. Although certain objections can be raised against the DCF method from a theoretical point of view, it has become the standard.
It should be noted here that the question is not just: How much capital must be used? The question is also: How risky is this capital invested?

In the DCF method, a distinction is made between the equity method and the entity method. With the equity method, only the cost of equity appears directly. With the entity method, equity providers and debt capital providers are combined into a single group of capital providers. From the internal perspective of the company, your combined return requirements are referred to as the average cost of capital. The abbreviation WACC (weighted average cost of capital) is very common.

REK stands for the cost of equity and iFK the letter is intended to remind you of interest for the cost of debt. If, for example within the group of lenders, there are sub-groups with different return requirements, the list should be expanded accordingly. The weights in the formula are the relative proportions of equity capital (EK) and debt capital (FK).

These values are market values, not book values, nor are they a description of substitute values for asset positions, for two reasons: firstly, the returns also relate to market values and, secondly, each shareholder decides on each trading day whether he or she would like to remain invested with the market value. That amount of money that is used economically profitable is the market value.

It goes without saying that the cost of equity rEK is higher than the cost of debt capital iFK. That leads to the temptation to the capital co
to reduce most by the fact that more external financing is used.

Here, however, one is subject to a fallacy. The project risks are not reduced by outside financing, and the same risk must be borne by the less equity capital if there is more outside capital. The market-driven risk premium is based on the amount expressed in euros and therefore increases with increasing external financing. A few simple calculations, which are not detailed here, show that the beta, and thus the cost of equity, increases with increasing external financing.

Both effects of external financing - the "cheaper" external capital is given greater weight in the formula for the WACC and the cost of equity increases to compensate for each other. The average cost of capital is therefore just as high as the cost of equity that would result from purely self-financing. This knowledge goes back to MODIGLIANI and MILLER. Taxes are an exception, but only if they are not financing-neutral.

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