Capital Charge

Definition

A capital charge is the cost of using capital, such as debt or equity, to fund a project or business operation. It represents the opportunity cost of the capital employed, reflecting the expected return that investors or lenders would require for providing the funds.

5 Must Know Facts For Your Next Test

1. The capital charge represents the minimum return required by investors and lenders to compensate them for the risk of providing capital to a project or business.
2. Calculating the capital charge involves multiplying the WACC by the amount of capital employed in the project or business segment.
3. The capital charge is a critical component in evaluating the financial performance of a project or business segment using metrics like Return on Investment (ROI) and Residual Income.
4. Minimizing the capital charge is important for improving the overall profitability and value creation of a project or business segment.
5. Accurately estimating the WACC is crucial for determining an appropriate capital charge, as it reflects the true cost of capital for the organization.

Review Questions

• Explain how the capital charge is used to evaluate the performance of an operating segment or project.
  • The capital charge is used to evaluate the performance of an operating segment or project by deducting it from the operating income or profit to calculate the residual income or economic value added (EVA). Residual income represents the amount of income that remains after compensating investors and lenders for the capital employed, while EVA measures the value created by the project or segment after accounting for the cost of capital. By incorporating the capital charge, these metrics provide a more comprehensive assessment of the true profitability and value generation of the business activity.
• Describe the relationship between the capital charge, the weighted average cost of capital (WACC), and the amount of capital employed.
  • The capital charge is directly proportional to both the WACC and the amount of capital employed in the project or business segment. The WACC represents the blended cost of the different sources of capital, such as debt and equity, used to fund the operations. The capital charge is calculated by multiplying the WACC by the capital employed, which includes both debt and equity financing. Therefore, a higher WACC or a greater amount of capital employed will result in a higher capital charge, which must be deducted from the operating income to determine the true profitability and value creation of the business activity.
• Analyze how the capital charge can be used to improve the financial performance of a project or business segment.
  • By understanding the capital charge, managers can make more informed decisions to improve the financial performance of a project or business segment. This involves minimizing the capital charge through strategies such as optimizing the capital structure (debt-to-equity ratio), reducing the cost of capital (WACC), and efficiently managing the capital employed. Lowering the capital charge allows a greater portion of the operating income to be retained as residual income or EVA, which enhances the overall profitability and value creation of the business activity. Additionally, analyzing the capital charge can help identify areas where capital is being underutilized or where investments in new projects or assets can generate a higher return on capital employed.

Related terms

Weighted Average Cost of Capital (WACC): The weighted average of the costs of a company's different capital sources, including debt and equity, used to calculate the capital charge.

Residual Income: The amount of income that remains after deducting the capital charge from the operating income of a project or business segment.

Economic Value Added (EVA): A performance measure that calculates the value created by a company by deducting the capital charge from the operating profit.