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Cost of Capital: Coc Is A Combined Cost of Each Type of Source by Which A Firm Raises Funds
Cost of Capital: Coc Is A Combined Cost of Each Type of Source by Which A Firm Raises Funds
Cost of Capital: Coc Is A Combined Cost of Each Type of Source by Which A Firm Raises Funds
CoC
Also referred to as cut-off rate, target rate,
Importance of CoC
Capital Budgeting Decisions
Designing the Corporate Financial Structure
Deciding about the method of financing in
Measuring CoC
A realistic measure of CoC should have the following
qualities of capital expenditure decisions:
1. It must account for the general uncertainty of
expected future returns from investment
proposals.
2. It must allow for the various degrees of
uncertainty of expected future returns associated
with different uses of funds.
3. It must allow for the effects of uncertainty
associated with an incremental investment and
the uncertainty of returns from the entire asset
portfolio of the firm.
4. It must account for a variety of financing means
available to a firm.
5. It must allow for the differential effects of
financing combination on the amount and quality
of residual net benefits accruing to shareholders.
6. It must reflect the changes in the capital market.
Cost of Equity
Most difficult and controversial cost to work out.
Conceptually, the cost of equity ke may be
defined as the minimum rate of return that a
firm must earn on the equity financed portion
of an investment project in order to leave
unchanged the market price of the shares.
The cost of equity capital is higher than that of
preference and debt because of greater
uncertainty of receiving dividends and
repayment of principal at the end.
2 approaches to measure
Ke
1. Dividend approach dividend valuation
model: assumes that the value of a share
equals the present value of all future
dividends that it is expected to provide
over an indefinite period.
Ke accordingly is defined as the discount
rate that equates the present value of all
expected future dividends per share with
the net proceeds of the sale (or the current
market price) of a share.
Formula
N
= D1(1+g)n-1/(1+ke)n
n=1
Po(1-f) = D1/(keg) or
Ke = (D1/Po) + g; where
D1 = expected dividend per share
Po = net proceeds per share/current market price
g = growth in expected dividends
(1+g2)/(1+ke)3 .+
Note 2: if we limit the dividend payment upto N
years, then,
Po(1-f)or Po=D1/(1+ke) + D1(1+g)/(1+ke)2 ++
Ke=15/200(1-0.10)+[25/200(1-0.10)](115/25)=15/180+(25/180)(0.40)=.1388=13.9%
Under new tax laws:
Po=D1/(Ke-g)
OR Ke=D1/P0+g
But 10% tax is paid by company out of profits.
Thus, retained earnings or g alone is affected.
Thus, revised formula for g is:
g=EPS/P0[1-DPS(1+dt)/EPS] or g=[EPSDPS(1+dt)]/P0
where, dt is dividend tax
For existing issue, Ke=D1/P0+[EPS-DPS(1+dt)]/P0
Ke=15/200+[25-15(1+0.1)]/200=15/200+[2516.5]/200=15/200+8.5/200=.1175=11.75%
= 2*1.10(1.1)n-1/(1+ke)n +
n=1
10
D6(1.08)n-1/(1+ke)n +
n=6
D6(1.06)n-1/(1+ke)n +
n=11
Systematic/Non-diversifiable risk: is
Market Portfolio
Systematic risk can be measured in
Formula
ke = rf + (km rf);
Where,
ke = cost of equity capital;
rf = the rate of return required on a risk free
asset/security/investment
km = required rate of return on the market
portfolio of assets that can be viewed as
the average rate of return on all assets
= the beta coefficient.
for market portfolios is 1, while it is 0 for
risk-free investments.
ke
rm
rf
1
reflected in beta.
CAPM model suffers from the problem of
collection of data.
Beta measures only systematic risk.
Example: =1.4, rf=8%, km=12%
ke=8%+1.4(12%-8%)
=8%+1.4*4%=13.6%
Cost of Preference
Capital
They are a hybrid security between debt and equity.
A. Irredeemable (perpetual)
kp=dp/P0(1-f); where,
dp=constant annual dividend,
P0=expected sales price of preference share
f= floatation costs
Example: a 12% irredeemable preference share of
face value of Rs.100, f=5%. What is kp if
preference share issued at i. par, ii.10% premium,
iii. 10% discount
i. At par, kp=12/100(1-0.05)=12/95=12.63%
ii. At 10% premium, kp=12/110(1-0.05)=11.48%
iii.At 10% discount, kp=12/90(1-0.05)=14.03%
Cost of Debt
Debt is the cheapest form of long-term
Cost of Debt
It is the interest rate which equates the
Cost of Debt
Cost of debt is the after-tax cost of long-
at
done in
n=1
installments
Steps in Calculation of
WACC
(Ko) to specific costs.
Assigning weights
Multiplying the cost of each sources by the
appropriate weights.
Dividing the total weighted cost by the total
weights.
cost kp=13%
Ko=WACC= wiki=30%*8%+30%*13%+40%*14%
=2.4%+3.9%+5.6%=11.9%
Note: ko calculated on the basis of market value is likely
to be greater than the one calculated on the basis of
book value since market values of equity and
preference shares is usually higher than book value and
hence their weight is more with respect to debt. For
example, in the above example, market values are:
Advantages of BV
weights
1. The capital structure targets are usually
fixed in terms of book value.
2. It is easy to know the book value.
3. Investors are interested in knowing the
debt-equity ratio on the basis of book
values.
4. It is easier to evaluate the performance of
a management in procuring funds by
comparing on the basis of book values.