Question

explain the calculation and interpretation of the cost of capital. in your response consider how this cost impact a healthcare managers decision on expansion of services

Answer 1

Cost of capital is the rate at which an organisation can raise funds for varied activities such as expansion of business into a new geography or a new product line, improvement of existing facilities, etc. It is determined by evaluating the different sources of funds available to a business such as equity funds, debt from a banking institution, debt from the debt market, etc. Cost of capital can be calculated for an entire business or a division of the business or just a new project.

The formula for calculating the cost of capital (WACC) is:

WACC = (w(d) * k(d) * (1 - Tax rate)) + (w(e) * k(e))

where,

w(d) = weight of debt in the total capital

k(d) = cost of the raising that debt

w(e) = weight of equity funds in the total capital

k(e) = cost of raising equity funds

The above mentioned formula is the weighted average cost of capital in which each source of fund is weighted basis its composition in the total capital. The debt component is multiplied by an additional factor of (1 - Tax rate), since, debt as a source of fund provides a tax shield to the organisation, in other words, the cost of debt (interest) is deductible for tax purposes and therefore, reduces the cost of debt by the element of tax rate. Cost of equity is simply multiplied with the weight of equity funds. And together they sum up to the cost of capital (WACC).

In case a decision for expansion of services is to be considered, for example, a manager is considering expansion of health care services provided by a business, he/she needs to evaluate the quantum of funds needs to be invested for the proposed expansion as well as the opportunity cost of these funds. This is done by evaluating the cash inflows from expansion at the cost of capital and determining if overall they add a positive value to the business. In case two mutually exclusive expansion opportunities are being evaluated, the manager can discount the inflows from each of these opportunities at the cost of capital for the expansion and evaluate which opportunity is likely to add a higher value to the business.