By definition, the cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment is an opportunity cost – the cost of foregoing the next best alternative investment (McMenamin, 1999). The term “market,” in this definition, refers to the investors who provide the funds for a particular investment.
Usually, capital or funds are provided by cash or by other assets. The cost of capital is usually expressed as a percentage: the annual amount of dollars that the investor needs to be expressed as a percentage of the amount invested. Thus, the cost of capital is the return a company must promise in order to get capital from the market, either debt or equity. A company does not set its own cost of capital, and it must go to the market to discover. Meeting the cost of capital is the main measure of a company’s performance level (McMenamin, 1999).
Bond ratings are a qualitative measure of credit risk performed by independent rating services. This is independent of the interest rate risk associated with bond price fluctuations resulting from interest rate changes (Chew, 1986). There are firms that perform bond rating services. Three such primary rating agencies are Moody’s, Standard & Poor’s, and Fitch Investor Services in the United States.
They do a formal evaluation of a company’s credit history and its ability to repay bond obligations. Ratings are then published as a measure of risk associated with those bonds. The bond rating is primarily a judgment of the investment quality of a firm’s long-term obligation (Chew, 1986). It reflects the raters’ expectations and estimates of the relevant characteristics of the quality of the investment. Historically, bond ratings have played an important role in determining a firm’s cost of capital and in assessing the potential risk of a firm from an investments perspective.
Bond ratings are used to determine how well a company can repay its debt obligations. This is measured differently by the major rating agencies. Each agency weighs the relevant variables differently depending on their “optimal” model specification. According to Rating Industrial Bonds by Hawkins, as many as 50 to 70 percent of bond ratings can be determined by a few variables, which include: the subordination status of the issue, size of the company, degree of financial leverage, profitability of the issuer, interest coverage, and the stability of the issuer’s dividends and earnings (Novar, 2003).
It appears evident that bond ratings may be forecast to a certain extent by using selected financial ratios. The forecasted ratings are more precise if the forecasting models include a larger and more equally distributed sample of bond ratings (Novar, 2003). If the forecasted rating is low, then the companies take measures to correct it before they get a rating agency to rate them because once they are rated at a low level, their cost of debt may increase. In addition, it is harder to find outside investors in their company if the rating is below investment grade.
Capital budgeting is the process of planning for purchases of long-term assets. Many formal methods are used in capital budgeting, including the techniques such as Net present value; Profitability index, internal rate of return; Modified Internal Rate of Return, and Equivalent annuity (Dayananda et al., 2002). Techniques based on accounting earnings are the accounting rate of return and “return on investment.” Simplified and hybrid methods such as payback period and discounted payback period are also used (Dayananda et al., 2002).
Capital budgeting is important to the management due to the following reasons: their long-term consequences significantly impact the company’s future activities; capital expenditure decisions often involve substantial cash outlays, and decisions once taken become difficult to reverse. If capital budgeting is not done properly, it can consume considerable resources and obligate government spending for many years into the future. The entire capital budgeting process begins with the identification of potential investment opportunities (Chew, 1986). As already seen, the amount of outstanding debt is an important factor in bond rating. Lower bond ratings result in higher debt payments for future borrowings (Chew, 1986).
Hence, capital budgeting decisions can be made based on bond ratings, higher bond ratings always being preferable. The bond scoring methodology is a method that can be used to estimate the impact of dividend policy and prospective operating results on the company’s credit standing by examining the trends of projected bond quality (Chew, 1986). The bond rating warranted under alternative dividend policies can be estimated this way (Chew, 1986).
Once this is done, management can evaluate the complex trade-offs among dividend payout, financing flexibility, and the use of low-cost debt funds in devising an optimal financing strategy which will be the framework for capital budgeting decision making. Once agreement is reached on an acceptable level of financial risk, management can select the optimal combination of debt funding and dividend policy.
In short, the cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment. The expected rate of return is measured by bond ratings. Historically, bond ratings have played an important role in determining a firm’s cost of capital and in assessing the potential risk of a firm from an investments perspective (Novar, 2003). Thus bond ratings play the mediatory role between the cost of capital and capital budgeting decision making. Capital budgeting decisions depend on the cost of capital as measured through bond ratings.
Bibliography
Novar, Michael (2003). The Predictability of Bond Ratings. Journal of Undergraduate Research. Volume 5.
Dayananda, Don; Irons, Richard; Harrison, Steve; Herbohn, John and Rowland, Patrick (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press. Cambridge, England.
Chew Jr., H. Donald (1986) Six Roundtable Discussions of Corporate Finance with Joel Stern. Quorum Books. New York.
McMenamin, Jim (1999). Financial Management: An Introduction. Routledge Publishers. London.