The Principle of Comparability of Own and Debt Capital, Principle...

The principle of comparability of own and borrowed capital

In the process of assessing the cost of capital, it is advisable to take into account that the elements that make up it reflect in the balance sheet unequally. The borrowed capital provided to the enterprise is estimated at prices close to market prices. Own capital, as a rule, is estimated at below-market prices. In connection with the underestimation of the value of used equity, its value in the process of financial calculations is artificially overstated.

To ensure comparability of calculations, the value of the weighted average cost of capital in its own part should be expressed in the current market value.

To do this, first determine the value of the company's net assets, expressing that part of the property that was formed at the expense of its own capital:

Net assets = Assets accepted for settlement (balance asset) - Obligations accepted for settlement (balance liability).

At the second stage, the composition of net assets is established. In practice, proceed from the fact that non-current assets and part of current assets (reserves) cover at the expense of own capital:

Inventories = Net assets - Non-current assets.

At the third stage, the book value of non-current assets and stocks is reassessed (indexed), taking into account current market prices. The amount of assets after revaluation and will characterize the current market value of equity (net assets) used in comparable calculations of the weighted average cost of capital.

Principle of Dynamic Valuation of Capital Cost

Factors affecting the weighted average cost of capital are very variable. Therefore, due to fluctuations in the value of individual elements of capital, constant adjustments should also be made to the weighted average cost of capital. To estimate the value of formed capital, use actual (accounting) indicators associated with the evaluation of its individual elements. The estimation of the projected cost of capital is probabilistic, which is caused by the forecast of the financial market situation, the dynamics of financial results, own solvency, the level of risk, etc. For the forecast, you can use the parameters given in the budget for the balance sheet.

The principle of the relationship between the valuation of the current, future value and the weighted average cost of capital

This relationship is provided by the marginal cost of capital (Marginal Cost of Capital, MCC). It characterizes the growth of the weighted average cost of capital to the sum of each new unit of it, additionally attracted by the enterprise. The marginal cost (capital) of capital (CPM) expresses the expenses that the enterprise will be compelled to incur for the reproduction of the required capital structure in the conditions prevailing on the financial market.

For example, the company expects to implement a new investment project to develop the field. To do this, it is necessary to attract additional sources of funding. They can be obtained only in the financial market. In this case, the projected cost of capital, which will be considered marginal, can significantly differ from the current market valuation.

The calculation of the marginal cost of capital is carried out according to the formula

where CWR is the increase in the weighted average cost of capital in the forecast period,%; ΔΚ - increase in total capital in the forecast period,%.

Attraction of additional capital through own and borrowed funds at each stage of the enterprise development has its limits. Thus, the growth of equity capital due to profits is limited by its volume. An increase in the issue of equity securities of the stock market's overcapacity is possible only with a high level of dividend and interest payments to shareholders (the owner) and creditors.

Attracting an additional bank loan is accompanied by an increase in credit and interest rate risks for creditors. In addition, the credit resources of commercial banks are not unlimited.

The maximum cost of capital is recommended to be compared with the expected rate of return for certain operations and projects, for which implementation additional capital is required. The rule in this case applies the following: the expected rate of return must be higher than the marginal cost of capital.

The principle of determining the effectiveness of using additional attracted capital The criterion here is the marginal efficiency of capital (PEC):

where - increase in the level of return on total capital,%; ЛССК - a gain of the average weighted cost of the capital,%.

The above evaluation principles allow us to choose a system of basic indicators that express the value (price) of capital and criteria for the effectiveness of its use in the current and future periods.

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