What is the Nominal Cost of Capital?

Meaning of Nominal Cost of Capital

The nominal Cost of Capital is inclusive of Inflation. It means the Nominal cost of capital calculation is without adjustment of general Inflation. In comparison to the real cost of capital, it comes after the adjustment of general inflation.

The cost of Capital is important for reviewing the organization’s financial performance. For Evaluation, the Organization Compare Cost of Capital with Standard Return to check how viable this project is. Cost of Capital is generally known as Weighted Average Cost of Capital (WACC).

“Lower the Cost of Capital (WACC) is better.”

Let see the example for proper clarification, the Inflation rate is 4.8% and the real cost of capital Is 2.6%.

So, what is the Nominal Cost of Capital?

Nominal cost of capital = (1+Inflation) (1+realcoc)

= (1+4.8%) (1+2.6)

= 1.0752 or 7.5% approx.

realcoc = Real Cost of Capital 

It Is advisable to use the Real Cost of Capital rather than the Nominal Cost of Capital because the Real cost of capital comes after the adjustment of general inflation, and it shows the actual picture to the organization.

In Nominal Cost of capital inflation is included, but in Real Cost of Capital Inflation is not included. 

How to Calculate Cost of Capital?

Cost of Capital comes after the averaging of debt, equity, and preference share in their weights.

The Formula of Cost of Capital is:

(Cost of debt x weightage of debt) + (Cost of equity x weightage of equity) + (cost of preference x weightage of preference)

It is derived in percentage form

See also  Is Additional Paid-in Capital Debit or Credit?

*Reference of this formula taken from Institute of Chartered Accountant of India Intermediate Book/Financial Management Subject/Chapter4/Heading4.10/WACC/ https://resource.cdn.icai.org/66670bos53808-cp4.pdf

Step-by-step calculation of the cost of capital

1. Cost of Debt (Kd)

Cost of debt is the simple interest rate effectively paid by the company on its        borrowing/debt and creditors’ liabilities with a tax rate adjustment. Cost of debt derived in the percentage form. The cost of debt formula is:

Cost of debt = Interest expenses x (1-tax rate) 

For Example: Interest Expenses = $1000, Tax Rate = 20%, Total Debt = $10000

                       Kd = [Interest Expenses x (1-Tax rate)]/Total debt

                       Kd = $1000(1-20%)/$10000

                       Kd = 8%

2. Cost of Equity (Ke)

Cost of Equity is the return that is required by the individual or organization on the amount invested in the company or project. Cost of equity derived in the percentage form. There are many methods to calculate the cost of equity, which are as follows:

CAPM (Capital Asset Pricing Model):

In this model, the expected return is calculated based on the level of risk. The formula of the Capital Asset Pricing Model (CAPM) is:

= RF + B(RM-RF)

RF = Risk-free rate of return

B = Beta of Asset (with the help of this we measure risk) 

RM = Market Return 

For Example: RF = 1.5%, RM = 6.5%, B = 0.8

CAPM = RF + B(RM-RF)

CAPM = 1.5% +0.8(6.5%-1.5%)

CAPM = 5.5%

Dividend Discount Model (Constant Growth):

In this model, we assume dividends grow at a constant rate over the year.

See also  Perpetuity and Deferred Perpetuity: What are the Different?

The formula of the Dividend Discount Model is:

= D1/(P0+g)

D1 = Next Year Dividend Value

P0 = Current Year Share Price

G = growth rate

For Example: D1 = $8, P0 = $100, g = 2%

Ke = D1/(P0+g)

Ke = $8/($100+2%)

Ke = 7.84%

3. Cost of Preference (Kp)

It is calculated by the dividend amount of preference divided by the total preference amount. Cost of preference derived in the percentage form. The formula of cost of preference is:

= preference dividend/Total Preference Amount

For Example: Dividend = $100, Total Preference = $1000

                       Kp = Dividend/Total Preference

                       Kp = $100/$1000

                       Kp = 10%

How to Calculate Weightage?

Weightage of debt, preference, and equity is calculated with the base value of the Total Capital amount.

Total Capital = Debt/Borrowing + Amount of Preference share + Amount of Equity (market value) 

  • Weightage of debt = amount of debt/Total Capital
  • Weightage of equity = Market Value of equity/Total Capital
  • Weightage of preference = Amount of Preference/Total Capital

Use of Cost of Capital in business

With the help of the Cost of Capital, we calculate the Net Present Value of an organization after discounting Free cash flows with the Cost of Capital. It is used to review the Investment opportunity in the organization for the individual or company. In Layman means, with the help of this Organization evaluate the financial performance of the company.  

Example of Cost of Capital

Extract from ABC Incorporation Financial Statement for the year 2019-2020

See also  HOW DO YOU RECORD OWNER CONTRIBUTIONS AND INVESTMENT JOURNAL ENTRIES?

 Extract from Balance Sheet 

ParticularsAmount in ($)
Equity Share capital400,000,000
Preference Share Capital100,000,000
Debt/Borrowing (Outstanding)250,000,000

Additional Information:

Risk free rate of Return (Government Bond) 3.5%

Market Return (New York Exchange Industrial Data) 12.5%

Beta of the ABC Inc. Is 1.2

Tax rate 30%

Interest Expenses $ 25,000,000

Preference Dividend $ 5,000,000

General Inflation 3.8%

Company Return is 14 %

Calculate Cost of Capital (Nominal Cost of Capital and Real Cost of Capital both)

Solution:

CALCULATION OF COST OF CAPITAL

Cost of Capital =

(Cost of debt x weight of debt) + (cost of equity x weight of debt) + (cost of preference x weight of preference)

S.No.ParticularsAmount in $ million
ADebt/Borrowing250
BEquity400
CPreference100
DInterest Expenses25
EPreference Dividend5
FTax rate30%
GRisk Free Return3.50%
HMarket Return12.50%
IBeta1.2
   
JTotal Capital (a+b+c)750
   
KCost of Equity (CAPM) [(g)+(i*(h-g))]14.30%
LWeightage of Equity (b/j)0.53
   
MCost of Preference (e/c)5.00%
NWeightage of Preference (c/j)0.13
   
OCost of Debt {[d(1-f)]/a}7.00%
PWeightage of debt (a/j)0.34
   
   
 Cost of Capital [(k*l) + (m*n) + (o*p)]10.61%
   
 Nominal Cost of Capital10.61 %
 General inflation3.8 %
 Real Cost of Capital after Inflation adjustment (1+realcoc) = (1+NCOC)/(1+Inflation)6.57%
   
 Real COC = Real Cost of Capital 
 NCOC = Nominal Cost of Capital 

Comment: Cost of Capital is lower than the Company Return, So it is advisable to invest in this company.