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Financial managers aim to maximize firm value by minimizing costs including cost of capital.
According to Iramani and Hidalgo 2005, the practice of financing or funding of the company is acquired from various sources. Thus the real cost borne by the companys is the
overall cost of all financing sources are used. According to Damodaran 2001 calculating the firm‘s overall cost of capital is by the weighted average cost of capital WACC. The
firm‘s after-tax weighted average cost of capital Modigliani and Miller 1958
�
��
= +
� + +
�
Where E = market value of firm‘s equity;
D = market value of firm‘s debt; r
E
= the firm‘s cost of equity capital; r
D
= the firm‘s cost of debt capital.
a. Definition of Cost of equity capital
Damodaran 2001 defines equity as a financial instrument that has a residual claim on the firm, does not provide tax advantages from the firm‘s cash outflow, has an infinitive age,
and providing management control to its owner. According to Siregar and Ali 1995 cost of equity is the rate that should be achieved by
the company in order to fulfill the expected return which is required by the shareholders for the funds that have been invested in the company. This definition from Siregar and Ali is in
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line with the definition by Damodaran 2001 which defines the cost of equity as the expected return of investors that includes the risk premium of equity or the required rate of
return by the investor on the investment in the equity. Cost of equity capital is the cost which is taken out to fund the source of financing
Modigliani and Miller 1958. Mardiyah 2002 stated that cost of equity capital can be identified as the minimum level of return which is required by investors.
According to Riyanto 1996, the cost of equity capital is the part that should be issued by the company to give satisfaction to the investors on a particular level of risk. Stated that
companies have the duty to reveal reports regarding the company which have an impact on the costs incurred. Therefore, the cost of equity is the cost incurred by the company to
provide information to the public shareholders, investors, and the society in general. According to Chancera 2011, the cost of equity capital measurements are influenced
by valuation models used by company. One of the valuation models is Capital Asset Pricing Model CAPM Sharpe 1964; Littner 1965
� = � + � �
�
− � Where
r
F
= the risk free rate; r
M
= the return on the market portfolio; β = the firm‘s systematic risk.
b. Definition of cost of debt
Debt is defined by Damodaran 2001 as a financial tool that possess a contractual claim on the cash flows and assets of the company, resulting a tax deductable payment, has
a maturity, and has a priority claim on cash flow during the period of operation as well as
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bankruptcy. The company has the option to conduct debt financing in the form of bank loans, bonds, and leasing.
Young and O‘byrne 2001 confess that cost of debt is the interest rate that must be paid by the company if they obtain funds or capital by way of loans from the lenders or creditors.
By borrowing from outside the company, then it will raise a debt interest which became costs for the company.
Fabozzi 2007 define the cost of debt as the desired rate of return by the lender at time when they provide funding to the company. Pittman and Fortin 2004 measures the cost of
debt as interest expense paid by the company during the year divided by the average number of long-term and short-term loans during the year.
According to Brigham 1994 and Lee 1990 the relevant cost of debt is the cost of issuing new debt after taxes or interest paid by the company to new bondholders. Cost of
debt can be calculated as follow:
After-Tax cost of debt = R
d
1-t
c
Where R
d =
Interest rate of debt t
c
= corporate tax rate
5. Relationship between Environmental Risk Management and Cost of Capital
