assumption of Cost of Capital

This text explains the theory behind the cost of capital, which is the return a company must pay to its investors (like stockholders and lenders). Here's a simplified breakdown:

Main Idea

The cost of capital is based on certain assumptions. The most important assumption is that the company's business and financial risks are stable.

Breaking It Down

* Business Risk: This is the risk that a company's profits will change. It's measured by how much the company's earnings before interest and taxes (EBIT) fluctuate when sales change.

* Financial Risk: This is the risk that a company can't meet its financial obligations. The text gives an example of a debenture holder (someone who has loaned money to the company). If the company takes on a riskier project, it's more likely that they might default on their payments. To compensate for this increased risk, the debenture holder would demand a higher interest rate. The same logic applies to equity holders (stockholders)—if the company becomes riskier, they will expect a higher return (dividend) to compensate.

* The Formula: The text says that the cost of capital (k) is made up of three parts:

* The risk-less cost of financing (r_f): This is the basic cost of money without any risk. Think of it like the interest rate on a government bond, which is considered very safe.

* The business risk premium (b): This is the extra return investors demand because of the company's business risk.

* The financial risk premium (f): This is the extra return investors demand because of the company's financial risk.

* So, the formula is: k = r_f + b + f.

* The Change in Cost of Capital: The text concludes by saying that if the business and financial risks are assumed to be constant, then the cost of capital for each type of financing (e.g., debt vs. equity) is only affected by changes in the supply and demand for that specific type of funding.

In simple terms, the cost of capital is the minimum return a company must generate to satisfy its investors, and this return is influenced by how risky the company is and how available money is in the market.