Step 3: Determine Capital Cost Rate (CCR)

In this example: CCR * = 10%

Because:

• Owners expect 13 % return* for using their money because less are not attractive to them; this is about the return that investors can get by investing long-term with equal risk (stocks, mutual funds, or other companies). Company has 940/2350 =40% (or 0.4) of equity with a cost of 13%.
• Company has also 60% debt and assume that it has to pay 8% interest for it. So the average capital costs would be:
• CCR ** = Average Equity proportion * Equity cost + Average Debt proportion * Debt cost = 40% * 13% + 60% * 8% = 0.4 * 13% + 0.6 * 8% = 10%
• * Note: CCR depends on current interest level (interest higher, CCR higher) and company’s business (company’s business more risky, CCR higher).
  ** Note: if tax savings from interests are included (as they should if we do not want to simplify), then CCR would be:
  
  CCR = 40% * 13% + 60% * 8% *(1- tax rate) =
  0.4 * 13% + 0.6 * 8% * (1 - 0.4) = 8.08 % (Using 40 % tax rate)

Slide 14 of 21