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What Is Real Cost of Capital?

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  • Written By: Kenneth W. Michael Wills
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 11 April 2014
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The term real cost of capital is often used to stress the leveraging of non-traditional methods to figure the cost of capital for a business or project, stressing an attempt to offset some incongruities found in the traditional capital asset pricing model that furnishes the figures for the weighted average cost of capital formula. Cost of capital describes calculating the costs associated with both debt and equity of a project initiative, or for a business to determine the best methods of raising capital, arriving at a weighted average cost. Capital asset pricing model is the traditional method commonly used to figure cost of capital, though it often produces inconsistencies in the final weighted average cost of capital results. In order to overcome those inconsistencies and arrive at a more accurate cost capital, the term real cost of capital refers to the use of methods that may arrive at more accurate figures, while attempting to eliminate intuition and subjective inferences.

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Finance of business ventures, projects or initiatives often relies on various potential sources of capital. Those sources of capital may include debt oriented financing like loans, preference shared capital like preferred stock and equity share capital like common stock. Figuring the cost of acquiring capital from each of these sources can help a business determine whether a project, initiative or new business venture is worth channeling resources into. As well, determining cost of capital also allows the business to compare sources of capital as applied to specified projects to ascertain the best source of equity overall. Arriving at the real cost of capital helps the business understand the accuracy of the final figures, without relying on subjective inferences based on experience or intuition, which often happens when using the traditional capital asset pricing model.

Reliance on experience and intuition when deploying the capital asset pricing model is often the result of inaccuracies produced by the model when concluding discount rates. Furthermore, this is often cited as most evident in the beta element of the capital asset pricing model formula when trying to figure equity. Measuring the beta element translates to judging market sensitivity or volatility, which when quantified, appears to produce discount rates that are not aligned to market conditions or usual market reactions, prompting analysts to make subjective adjustments or inferences. Researchers have suggested that using an alternative method to the capital asset pricing module can offset these potential inaccuracies and subjective adjustments, arriving at a real cost of capital when those figures are used in the weighted average cost of capital formula.

One such method developed is the market-derived capital pricing model, for example. Eliminating the correlation history of the stock market and replacing it with attempts to estimate volatility in the options markets, proponents of the method have provided research they feel produces a real cost of capital when applied to the weighted average cost of capital formula. Additionally, there are other methods used to include the Fama-French three factor model and various modified versions of the capital asset pricing model.

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