Capital charge is the minimum return a project must achieve to cover the cost of capital, based on investor expectations. It is calculated by multiplying invested capital by the weighted average cost of capital (WACC), which is the average cost of each capital source. The cost of debt is easily determined, while the cost of equity requires calculation. The capital charge is used to calculate economic profit, which shows if a project is worthwhile for investors.
A capital charge is the return a project must realize to cover the cost of the capital it uses. It is given in monetary units and not as a percentage. This figure is based on the minimum return that investors require in exchange for the use of their funds. If the returns from a project do not meet this minimum threshold, then it may not be worth pursuing even if it has positive returns.
The capital charge depends on the return investors expect from each class of capital. It is found by multiplying the invested capital of a project by a percentage. This percentage is a weighted average of investor expectations. Before calculating the capital charge, an analyst must determine these two numbers.
Invested capital is made up of a variety of capital sources. For example, if an investor buys a share of a company in an initial public offering, the purchase price of that share contributes to the company’s capital. This is called social capital. The company can also sell bonds, which create investor loans to the company, and this type of capital is debt capital. The total amount of invested capital can be found by taking the company’s capital listed on its balance sheet and adjusting it to also show capital not reported there.
The percentage by which invested capital is multiplied is called the weighted average cost of capital, or WACC. Each type of capital has a different cost because investors treat each class of investments differently. Analysts must determine the cost of each class and then create a weighted average according to the amount of the company’s invested capital that comes from each capital class.
The cost of debt is easy to determine because the company describes it in the 10-K reports it files with the Securities and Exchange Commission. It can also be approximated by looking up a company’s debt rating, which is assigned by an independent rating agency, and the estimated cost of debt associated with the rating. The cost of equity must be calculated based on theory. For example, an analyst might use the formula prescribed by the capital asset pricing model to find the return that the asset would have to give to an investor to compensate them for the risk associated with it.
The capital charge is significant because it is used to calculate another financial concept called economic profit. This is the net operating profit after taxes, or NOPAT, less the capital charge. It shows whether the project in question has high enough returns to make it worthwhile for investors.
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