Cost of Capital

PRESENTED BY:ANITA AGNANI BHAVNA RABARI NIDHI BHATT KINJAL JETHWANI

Basic Skills: (Time value of money, Financial Statements) Investments: (Stocks, Bonds, Risk and Return) Corporate Finance: (The Investment Decision - Capital Budgeting)

Assets Current assets Fixed assets

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

The investment decision



Corporate Finance: (The Financing Decision) Cost of capital Leverage Capital Structure Dividends



The financing decision



Assets Current assets


Assets Current assets


Capital Structure

For Investors, the rate of return on a security is a benefit of investing. For Financial Managers, that same rate of return is a cost of raising funds that are needed to operate the firm. In other words, the cost of raising funds is the firms cost of capital.

Bonds Preferred Stock Common Stock Each of these offers a rate of return to investors. This return is a cost to the firm. Cost of capital actually refers to the weighted cost of capital - a weighted average cost of financing sources.

For the issuing firm, the cost of debt is: the rate of return required by investors, adjusted for flotation costs (any costs associated with issuing new bonds), and adjusted for taxes.

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

Now, suppose the firm pays $50,000 in dividends to the stockholders.

EBIT - interest expense EBT - taxes (34%) EAT - dividends Retained earnings

with stock 400,000 0 400,000 (136,000) 264,000 (50,000) 214,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000

After-tax % cost of Debt

=

Before-tax % cost of Debt

x

1

Marginal tax rate


=


x

1d

Marginal tax rate

Ki

=

k (1 - t)


=


x

1d

Marginal tax rate

K

i

= =

k (1 - t) .10 (1 - .34)

.066

Prescott Corporation issues a $1,000 par, 8 %, 20 year bond whose net proceeds are $940. The tax rate is 40%.What is the pre-tax and aftertax cost of debt for Prescott Corporation?

Pre-tax cost of debt: Use approximate method of YTM on a Bond. I + (M V) / n

kd =

(M + V) / 2

=

80 + (1000 940) / 20 (1000 + 940) / 2

Where, I = annual interest M = par value per bond V = value or net proceeds form sale of a bond n = bond years

83 = = 8.56% 970

After-tax cost of debt K = k (1 -t) i d = 8.56% (1 - 0.4) = 8.56% (0.6) K = 5.136% i

On an almost 9% before-tax cost, the after-tax cost of debt is 5.14%.

Most corporations that issue preferred stock fully intend to pay the stated dividend. The required rate of return for this stock, or simply the yield on preferred stock, serves as the estimate of the cost of preferred stock. Because such stocks have no maturity date.

It is represented as:kp Dp = Po

Dividend = Price

Where, D p is the stated annual dividend and Po is the current market price of the preferred stock. It also means net proceeds from the sale of the stock.

Suppose that the Carter Company has preferred stock that pays a $13 dividend per share and sells for $100 per share in the market. The flotation (or underwriting) cost is 3%, or $3 per share. What is the cost of preferred stock?

D1 k = p NPo

=

Dividend Net Price

= =

$13$100 - $3

$13 $97

=

13.4%

There are 2 sources of Common Equity:

1) Internal common equity (retained earnings), and 2) External common equity (new common stock issue) Do these 2 sources have the same cost?

Since the stockholders own the firms retained earnings, the cost is simply the stockholders required rate of return. Why? If managers are investing stockholders funds, stockholders will expect to earn an acceptable rate of return.

1) Dividend Growth Model

1) Dividend Growth Model D1 k = e Po +g


2) Capital Asset Pricing Model (CAPM)


2) Capital Asset Pricing Model (CAPM) Rj

=

Rf

+

b

j

(Rm - Rf )

Where, Rj = required rate of return Rf = risk-free rate Rm = expected r.o.r. for market portfolio bj = beta coefficient for stock jFrom markets aversion to systematic risk, greater the Beta of a stock, the greater its required return. The risk-return relationship in the form of an equation is also known as the security market line. It implies that in market equilibrium, security prices will be such that there is a linear trade-off between required r.o.r. and Systematic risk, as measured by Beta.

Systematic Risk: Risk factors that affect the overall market, such as changes in nations economy, tax reforms, or a change in the world energy situation. These are risks that affect securities overall where an investor who holds a well-diversified portfolio will be exposed to this type of risk. Unsystematic Risk Flotation Costs: The costs associated with issuing securities, such as underwriting, legal, listing, and printing fees.

Types Of Securities - Risk free Securities - Risky Securities Ways to measureBeta co-efficient Standard deviation Co-efficient of variation Sensitivity analysis

Risk-Return Relationship A higher risk security must offer a higher forecast return than a lower risk return security. Basic assumptions

Limitations

An alternative approach to measuring the cost of common stock. The steps are: Estimate the risk-free rate, Rf. Estimate the stocks beta coefficient, b, which is an index of systematic (or non diversifiable market) risk. Estimate the r.o.r. on the market portfolio, Rm, such as the Standard & Poors 500 Stock Composite Index. Use the CAPM equation to find required r.o.r.

Assume that the market price of a companys stock is $40. Dividend to be paid at end of the coming year is $4 per share and is expected to grow at a constant annual rate of 6%. What is cost of common stock?

ke =

D1

Po

+ g

$4 = + 6% = 16% $40

Assume that risk-free rate is 7%, beta is 1.5, and market portfolio r.o.r. is 13%. Then what is cost of common stock?

Rj

=

Rf

+ b j(Rm - Rf )

= 7% + 1.5(13% - 7%) = 16%This 16% cost can be viewed as consisting of a 7% riskfree rate plus a 9% risk premium, reflecting firms stock price as 1.5 times more volatile than market portfolio to factors affecting systematic risk.

Dividend Growth Model


D1 k = NP e o

+g


D1 k = NP e o

+gNet proceeds to the firm after flotation costs!

Assume that the market price of a companys stock is $40. Dividend to be paid at end of the coming year is $4 per share and is expected to grow at a constant annual rate of 6%. The company is trying to sell new issues and its flotation cost is 10%. What is cost of common stock? D1 $4 + 6% ke +g = NPo $36

=

= 11.11% + 6% = 17.11%

Security Market Line It provides a framework of measuring the systematic risk of an individual security. This risk is measured by Beta. It represents relationship between Beta-factor and Expected rate of return of security.

The weighted cost of capital is just the weighted average cost of all of the financing sources. K = wi k i + wp k p+ we k e

Where, Wi = % of total capital supplied by debt Wp= % of total capital supplied by preferred stock We = % of total capital supplied by equity

Source debt preferred common

Cost 6% 10% 16%

Capital Structure 20% 10% 70%

(20% debt, 10% preferred, 70% common)

Weighted cost of capital =

0.20 (6%) + 0.10 (10%) + 0.70 (16%) = 13.4%

Assume the following capital structure of a Company:

Specific (Rs.in lakhs) cost Debentures 50 6% Preference share capital 20 8% Equity share capital 60 12% Retain earnings 70 10% 200 100% lakhs

Calculation of Weighted Average Cost Of CapitalSource Total Amount specific cost weighted cost

Debt Ps Es Re Totals

50,00,000 20,00,000 60,00,000 70,00,000 2,00,00,000

6.00% 8.00% 12.00% 10.00%

3,00,000 1,60,000 7,20,000 7,00,000 18,80,000

Weighted Average Cost of Capital

=18,80,000 2,00,00,000

x 100 = 9.4%

Which companies and industries calculate? It depends on three sources of capital: - Equity - Reserve - Borrowings

- Fertilizer - Toothpaste - Automobile - Shipping - Textile

THANK YOU

Cost of Capital

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