Calculating Various Relative Costs of Capital

¶ … capital covers a number of elements regarding a company's investment and return rates. A company's cost of capital is essentially the rate of return on capital invested in the company and "the market's required rate of return on that invested capital" (4). Cost of capital covers both debt and equity capital considerations. It covers the costs of the returns from those capital investments given external market and industry factors. Companies that use a combination of both debt and equity to finance their operations use the weighted average cost of capital, which is basically an averaged number of the debt and equity resources.

There are a number variables that Exxon Mobil (XOM) should consider when determining the cost of capital for making new investment decisions. First and foremost, executives need to ensure that any investment decisions are ultimately adding value for shareholders. To do this, the company would need to understand the value driving the positive side of the cost of capital. Moreover, Exxon Mobil must consider the size of the investment needed in order to pull the most favorable earnings results from its financing operations. There should be no decision making before all risks of investment are fully defined and mitigated, as no company should be making obviously risky financing decisions.

9-3. As previously stated, firms calculate their weighted average cost of capital when they are using both debt and equity in their financing strategies. The weighted average simplifies the concept of how much the investment is costing in a way that makes it easier to understand and package in corporate strategy. It combines the cost of various financing investments in order to provide a workable average that can then be used to make further management decisions.

9-4. In computing the cost of capital, there are a number of sources of capital that should be considered. First, there is debt. A company can borrow or sell long-term and short-term bonds. Bonds typically are calculated by considering the principal payment along with the future interest. Companies that borrow or sell will have to account for the accumulated interest in the cost of capital. Additionally, there is the cost of preferred stock, which is another option. This is calculated by taking the preferred stock dividend and dividing it by required rate of return of the preferred stockholder. In order to satisfy the required rate of return, preferred stock options must meet a certain optimal level.

9-5. Tax rates do have an impact on a company's cost of capital. Money a firm borrows can write off the expense of interest payments in its federal tax calculations. Such tax write offs can lower the cost of borrowing the capital. Moreover, when companies sell bonds, they must also pay to cover flotation costs. These can raise the cost of raising the capital, which does decrease from shareholder value in returns.

9-6. a.) Internal common equity is seen in the retained earnings of a company. These earnings have not been paid out to shareholders in dividends yet. The company holds on to this capital for longer periods of time. On the other hand, new common stock refers to the raising of funds through selling new stocks. This disperses more of the ownership of the company.

b.) There is a cost to internal common equity because as more money is being raised by the company through retained earnings, that company will often use some of that capital to pay off other creditors and preferred shareholders. Thus, retained earnings must match any cost of internal common equity to keep the value.