cpt cst ppt

8/7/2019 cpt cst ppt

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Meaning Theopportunity costof aninvestment.

Its the part of theAccountingandTradingsubjects.

The cost of capital determines how a company can raise

money.


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The cost ofcapital is an expected return

Capital (money) used for funding a business should earnreturns for the capital providers who risk their capital..

In other words, the risk-adjusted return on capital (that is,incorporating not just the projected returns, but the probabilities of

those projections) must be higher than the cost of capital.

The cost of capital is often used as the discount rate.


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Capital rationing

Hurdle rate

Economic value added

Commonly used terms


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Components ofcostofcapital:

Before determining the amount of a companyscost of capital, it is necessary to determine itscomponents.

1. The first component of the cost of capital isDEBT. This is a companys commitment toreturn to a lender both the interest and principalon an initial or series of payments to thecompany by the lender.


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2.The second component of the cost of capital isPREFERRED STOCK. This is a formof equity that is issued to stockholders and carriesa specific interest rate.

3.The third and final component of the cost of capitalis COMMON STOCK.A Company is notrequired to pay anything to its shareholders inexchange for the stock, which makes this the leastrisky form of funding available


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Measurementofcapital cost

1. Cost of debt: The cost of debt is computed by

taking the rate on a risk free bond whose durationmatches the term structure of the corporate debt,then adding a default premium. This defaultpremium will rise as the amount of debt increases(since the risk rises as the amount of debt rises).


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Cost of equity = Risk free rate of return + Premium expectedfor risk.

Expected return :The expected return (or required rate ofreturn for investors) can be calculated with the "dividendcapitalization model I.e

Expected Return = dividend yield + growth rate ofdividends.

CostofEquity


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Costofretained earnings

Retained earnings are a component of equity, and therefore

the cost of retained earnings (internal equity) is equalto the cost of equity as explained above.


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The Weighted Average Cost of Capital (WACC) is used in

finance to measure a firm's cost of capital.

Calculation of WACC is an iterative procedure whichrequires estimation of the fair market value of equity

capital.

Weighted average costofcapital:


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1. The cost of capital method is not truly market-consistent.

2. The cost of capital risk margin is highly dependent on thepercentage cost of capital assumed and this is difficult toderive .

3. The current shortcomings in the standard formula ofSCR are addressed in respect of: The structure of the SCR calculation. The parameterization of risk factors and correlations

between risk factors for individual lines of business.

Disadvantages


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Capital Structure

1. Because of tax advantages on debt issuance, it will be cheaper toissue debt rather than new equity.

2. At some point, however, the cost of issuing new debt will be greaterthan the cost of issuing new equity.

3. By utilizing too much debt in its capital structure, this increaseddefault risk can also drive up the costs for other sources (such asretained earnings and preferred stock) as well.


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Advantages1. The cost of capital method is used to calculate statutory

technical reserves in the Swiss Solvency Test (introducedrecently).

2

. A number of simplifying assumptions can be made whenusing the cost of capital method.

3. It is more likely to be consistent with IFRS and internationalaccounting developments than the percentile method.

4. A significant number of European insurance companies are

already using the cost of capital method to measure theuncertainty surrounding the determination of theiroutstanding claim provisions

Relatively straightforward. Transparent.

Easily verifiable and understood by supervisory authorities andother interested parties.


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CAPM helps us determine what return we deserve for putting ourmoney at risk.

Investors Need A Good WACC - Weighted average cost of capital ishard to calculate, but a solid way to measure investment quality.

An Inside Look At Internal Rate Of Return - Use this method to

choose which project or investment is right for us.

All About EVA - Looking for a formula to determine whether acompany is creating wealth? Time to learn all about Economic ValueAdded.

Objectives


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EXPLICIT COST:- The rate that the firm pays to procurefinancing.Explicit cost of any source of capital is the discount rate

that equates the present value of the cash inflows that areincremental to the taking off the financial opportunitywith the present value of its incremental cash outflows.

IMPLICIT COST:-The rate of return associated with the bestinvestment opportunity foregone.

It may be defined as the rate of return associated with thebest investment opportunity for the firm and itsshareholders that would be foregone,if the projects

presently under consideration by the firm were accepted.

Types


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1. A basic assumptions of traditional cost of capitalanalysis is that the firms business .

2. financial risks are unaffected by the acceptance &financing of projects.

3. The capital budgeting decisions determines thebusiness risk complexion of the firm .

4. The financing decision determines its financial risk.

Assumptions


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Cost of producing electricity


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The financing decision determines its financial risk .

1. In operational terms , it is defined as the weighted

average cost of capital of long term sources of finance.The major long term sources of funds are

debt preference shares

equity capital retained earnings 3.The cost of capital can be explicit or implicit.

Explicit cost of capital is associated with theraising of funds (from debt , preference shares

and equity).

Conclusion

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