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Group 11-Assignment 2
Group 11-Assignment 2
TABLE OF CONTENTS
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
the weighted-average cost of capital is or is not the appropriate rate at which the cash
flows associated with a capital budgeting project is discounted.
1. Cost of debt
We assume that funds of the firm are raised through the issuance and sale of
bonds and the bonds pay annual interest. The first step in estimating the cost of long –
term debt (bonds) is to determine the rate of return debt holders require, or kd. So the
cost of debt is referred as to the market interest rate demanded by bondholders. In
other words, it is the rate that the company would pay on new debt issued to finance
its investment projects. The cost of debt can be measured as either before-tax or after-
tax returns.
• The before – tax cost of debt kd is the rate at which the firm can issue new
debt. This is the yield to maturity (YTM) on existing debt. The before – tax cost of
debt can be obtained by using the IRR method. However, because the interest
expense is tax deductible, the after-tax cost is seen more often than the before – tax
cost of debt.
• The after – tax cost of debt, kd (1-t), is the interest rate on debt, kd, less the tax
savings from the tax deductibility of interest, kd(t), which is the same as before-
tax cost of debt multiplied by (1 – t), where t is the firm’s marginal tax rate.
After – tax cost of debt = interest rate – tax savings = kd – kd(t) = kd(1 – t)
We use the after-tax cost of debt in calculating the WACC because we are
interested in maximizing the value of the firm’s stock, and the sotock price depends on
after-tax cash flows.
Example:
Dexter, Inc., is planning to issue new debt at an interest rate of 8%. Dexter has
a 40% marginal federal-plus-state tax rate. What is Dexter’s cost of debt capital?
Answer:
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
2. Cost of equity
2.1. Cost of preferred stock (kps).
Preferred stock dividends are usually a stated dollar amount. Alternatively,
preferred stock dividends may be stated as an annual percentage rate, e.g., 7%.
Preferred stockholders often receive a stated dividend prior to the distribution of
earnings to common stockholders.
The cost of preferred (kps) is just the preferred dividend divided by the market
price of a preferred share, or the net issuing price (not “book value” of preferred
stock).
kps = Dps/P
where Dps = annual dollar dividend per share; P = market price of preferred stock.
Example:
Suppose Dexter has preferred stock that pays an $16 dividend per share and
sells for $100 per share. What is Dexter’s cost of preferred stock?
Answer:
kps = Dps/P = $16/ $100 = 0.16 = 16%
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
There are two forms of common stock including retained earnings and new
issues of common stock. The rationale here is that the firm could avoid part of the cost
of common stock outstanding by using retained earnings to buy back shares of its own
stock.
Cost of a new stock issue (kn) is the cost of expernal equity, and it is based on
the cost of retained earnings increased for flotation costs (cost of issuing common
stock). For a constant-growth company, this can be calculated as follows:
ks = D1/ P0(1-F) + g
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
where:
Ds: dividend price per share
P0(1-F): the net price per share received by the company
F: the percentage flotation cost required to sell the new stock, or (current stock price –
funds going to company)/ current stock price
(Flotation costs are the total costs incurred by the firm in issuing and selling a
security).
g: Growth rate as projected by security analysts
(g = (retention rate) x (ROE) = (1.0 – payout rate) x (ROE))
Example:
Suppose Dextex’s stock is selling for $40, its expected ROE is 10%, next year’s
dividend is $2 and the company expects to pay out 30% of its earnings. Additionally,
assume the company has a flotation costs of 5%. What is Dextex’s cost of new equity?
Answer:
ks = 2/ 40(1-0.05) + 0.07 = 0.123, or 12.3%
where:
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
wce =the percentage of common stock in the capital structure (weight common
equity)
This WACC formula is usually written assuming the firm’s capital structure
includes just two classes of securities, debt and equity. If there is another class, say
preferred stock, the formula expands to include it :
In other words, we would estimate kps, the rate of return demanded by preferred
stockholders, determine wps, the fraction of market value accounted for by preferred,
and add kps × wps to the equation. Of course the weights in the WACC formula always
add up to 1.0. In this case wd + wps + wce = 1.0
Answer:
We have: wd = 0,45; wps = 0,05; wce = 0,50; kps = 0,84; kce = 0,12
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
How a company raises capital and how they budget or invest it are considered
independently. Most companies have separate departments for the two tasks. The
financing department is responsible for keeping costs low and using a balance of
funding sources: common equity, preferred stock, and debt. Generally, it is necessary
to raise each type of capital in large sums. The large sums may temporarily
overweight the most recently issued capital, but in the long run, the firm will adhere to
target weights. Because of these and other financing considerations, each investment
decision must be made assuming a WACC which includes each of the different
sources of capital and is based on the long-run target weights. A company creates
value by producing a return on assets that is higher than the required rate rerum on the
capital needed to fund those assets.
The WACC as we have described it is the cost of financing firm assets. We can
view this cost as an opportunity cost. Consider how a company could reduce its costs
if it found a way to produce its output using fewer assets, say less working capital. If
we need less working capital, we can use the funds freed up to buy back our debt and
equity securities in a mix that just matches our target capital structure. Our after-tax
savings would be the WACC based on our target capital structure, times the total
value of the securities that are no longer outstanding.
For these reasons, any time we are considering a project that requires
expenditures, comparing the return on those expenditures to the WACC is the
appropriate way to determine whether undertaking that project will increase the value
of the firm. This is the essence of the capital budgeting decision. Since a firm's
WACC reflects the average risk of the projects that make up the firm, it is not
appropriate for evaluating all new projects. It should be adjusted upward for projects
with greater-than-average risk and downward for projects with less-than-average risk.
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
1. Project evaluation
Example:
ATL limited is having an expansion project which will generate a rate of return
at 8%. Should this project be run? Given the following information:
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
A note here is that the cost of capital must be based on what investors are
actually willing to pay for the company’s outstanding securities—that is, based on
the securities’ market values.
Therefore, let’s start with evaluating the market values of bond and share.
(1 + k ) n −1 ParV
PVbond = PVA + PV = CF0 +
k (1 + k ) n
(1 + k ) n
Rd = 6% (given)
D 3
PVshare = r − g = = $42.8571
e 0.1 −0.03
Re = 10% (given)
D E
WACC = × (1 − Tc ) × Rd + × Re
V V
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
3. EVA Determination
Another thing that draws our attention is that WACC plays an irreplaceable
role in calculating Economic Value Added (EVA). Let’s have a look at the below
chart for EVA’s formula
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
An EVA ratio is greater than zero suggests that the after-tax economic cash-
generating ability of a company exceeds its cost of capital. The reverse holds true for a
negative value generation. If EVA is equal to zero, the project’s cash flows are just
sufficient to give debt-holders and shareholders the returns they require.
This is likely to resemble our first point but here we’d like to emphasize on the
importance of value added. Capital or other sources of funds have cost. The cost for a
project is the rate or return its owners are seeking, with special consideration on the
risks inherent in the project. Projects or investments need to earn returns greater than
its cost of capital and value added for the investors to be satisfied. Any investment
which weighted average cost of capital does not cover its cost reduces investors funds
as the funds may be better invested elsewhere, even if it produces profitability.
One of the methods for calculating this is the Weighted Average Cost of
Capital (WACC). Simply put, this is the calculation of a firm’s cost of capital in
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
The company's WACC is a very important number, both to the stock market
for stock valuation purposes and to the company's management for capital budgeting
purposes. In an analysis of a potential investment by the company, investment projects
that have an expected return that is greater than the company's WACC will generate
additional free cash flow and will create positive net present value for stock owners.
These corporate investments should result in an increase in stock prices. These
projects are good things! Investments that earn less than the firm's WACC will result
in a decrease in stockholder value and should be avoided by the company.
Capital or other sources of funds have cost. The cost for a project is the rate or
return its owners are seeking, with special consideration on the risks inherent in the
project. Projects or investments need to earn returns greater than its cost of capital and
value added for the investors to be satisfied. Any investment which weighted average
cost of capital does not cover its cost reduces investors funds as the funds may be
better invested elsewhere, even if it produces profitability.
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This also brings us to the end of our assignment. We have tried
our best to deliver the meaning as well as the importance of “Cost
of capital”. We do hope that this document is a valuable report as it
contains our strict researches.
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Group 11_A2_HQ class_ K46_ BA COST OF CAPITAL
REFERENCE
Investment decision making in the private and public sectors, Henri L. Beenhakke.
1. Level 1 Book 4: Corporate finance, portfolio management, and equity
4. http://lexicon.ft.com
5. http://news.morningstar.com
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