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Cost of Capital
Topics Covered ------
• Overview of cost of capital
• Cost of Equity
Cost of capital_09 2
Cost of Capital--
Cost of capital_09 3
--Cost of Capital
return.
opportunity cost.
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Why Cost of Capital is Important
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Weighted Average Cost of Capital
(WACC)
WACC = weke + wpkp + wdkd (1 – tc)
we = proportion of equity
ke = cost of equity
wp = proportion of preference
kp = cost of preference
wd = proportion of debt
kd = pre-tax cost of debt
tc = corporate tax rate
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Company Cost of Capital and Project
Cost of Capital--
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--Company Cost of Capital and Project
Cost of Capital
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Cost of Debt
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Cost of Debt
n I F
P0 = ∑ +
t=1 (1 + kd)t (1 + kd)n
P0 = current price of the debenture
I = annual interest payment
n = number of years left to maturity
F = maturity value
kd is computed through trial-and-error. A very
close approximation is:
I + (F – P0)/n
rD =
0.6P0 + 0.4F
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e.g.:
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e.g.:
Approximate yield :
11 + (100 – 95) / 5
= 12.37 percent
0.6 x 95 + 0.4 x 100
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Cost of Equity
The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm.
Equity finance comes by way of
(a) retention of earnings , and
(b) issue of additional equity capital
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Note:
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Approaches to Estimate Cost of Equity
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Security Market Line Approach
ke = rf + βe [E(km) – rf ]
Where,
re = required return on the equity of the
company
rf = risk-free rate
βe = beta of the equity of the company
E(km) = expected return on the market
portfolio
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e.g.:
rf = 7%, βe = 1.2, E(km) = 15%
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Inputs for the SML--
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-- Inputs for the SML
• The market risk premium may be estimated
as the difference between the average return
on the market portfolio and the average risk-
free rate over the past 10 to 30 years.
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Bond yield plus Risk Premium Approach
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Dividend Growth Model Approach--
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-- Dividend Growth Model Approach
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e.g.:
Suppose that a company is expected to pay a
dividend of Rs. 1.50 per share next year. There
has been a steady growth in dividends of 5.1%
per year and the market expects that to
continue. The current price is Rs. 25.
Compute the cost of the equity.
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e.g.:Suppose that a company is expected
to pay a dividend of Rs. 1.50 per share
next year. There has been a steady
growth in dividends of 5.1% per year and
the market expects that to continue. The
current price is Rs. 25. Compute the cost
of equity.
Solution: 1 .50
ke = + .051 = .111
25
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Getting a handle over g
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Advantages and Disadvantages of
Dividend Growth Model
Advantage
– easy to understand and use
Disadvantages
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth
rate (an increase in g of 1% increases the
cost of equity by 1%)
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e.g.:
Suppose the company has a beta of 1.5. The
market risk premium is expected to be 9% and
the current risk-free rate is 6%. We have used
analysts’ estimates to determine that the market
believes our dividends will grow at 6% per year
and our last dividend was Rs. 2. Our stock is
currently selling for Rs. 15.65. What is the cost of
equity?
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Solution:
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Earnings-Price Ratio Approach--
Cost of equity = E1 / PO
where,
E1 = the expected EPS for the next year
PO = the current market price
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--Earnings-Price Ratio Approach—
This approach provides an accurate measure
in the following two cases:
• When the EPS is constant and the dividend
payout ratio is 100 percent.
• When retained earnings earn a rate of
return equal to the cost of equity.
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Weighted Average Cost of Capital
• We can use the individual costs of capital
that we have computed to get our “average”
cost of capital for the firm.
• This “average” is the required return on the
firm’s assets, based on the market’s
perception of the risk of those assets.
• The weights are determined by how much
of each type of financing is used.
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Determining the Proportions or Weights--
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--Determining the Proportions or Weights
• Market values are superior to book values
because in order to justify its valuation the
firm must earn competitive returns for
shareholders and debt holders on the
current (market) value of their investments.
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e.g.:
Suppose you have a market value of equity equal to Rs.
500 million and a market value of debt Rs. 475 million.
What are the capital structure weights?
Solution:
V = Rs. 500 million + Rs. 475 million = Rs. 975 million
we = E/V = 500 / 975 = .5128 = 51.28%
wd = D/V = 475 / 975 = .4872 = 48.72%
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e.g.:
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Weighted Marginal Cost of Capital Schedule--
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--Weighted Marginal Cost of Capital Schedule--
TFj
BPj =
wj
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--Weighted Marginal Cost of Capital Schedule
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e.g.:
ABC Ltd. Wishes to use equity, preference and debt capital in the
following proportions:
Equity: 0.45 , Preference: 0.05, Debt: 0.50
As per the estimates of ABC Ltd., the cost of each of its three
sources of financing for various levels of usage are as follows:
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Solution--
We have,
Source Cost (%) Range of new Breaking Points Range of total new
financing (in cr.) (Rs. in cr.) financing (in cr.)
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--Solution--
Range of total new Source Proportions Cost (%) Weighted Cost (%)
financing (Rs. In cr.)
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--Solution--
Range of total new Source Proportions Cost (%) Weighted Cost (%)
financing (Rs. In cr.)
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--Solution
---
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--Divisional and Project Cost of Capital
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Pure Play Approach
• Find one or more companies that specialize
in the product or service (that we are
considering)
• Compute the beta for each company and
take an average
• Use that beta along with the CAPM to find
the appropriate return for a project of that
risk
• Often difficult to find pure play companies
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Subjective Approach
• Consider the project’s risk relative to the firm
overall.
• If the project is riskier than the firm, use a
discount rate greater than the WACC.
• If the project is less risky than the firm, use a
discount rate less than the WACC.
• One may still accept projects that one
shouldn’t and reject projects one should
accept, but one’s error rate should be lower
than not considering differential risk at all.
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Divisional and Project Costs of Capital
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Floatation Costs--
• Floatation or issue costs consist of items
like underwriting costs, brokerage
expenses, fees of merchant bankers etc.
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--Floatation Costs
WACC
Revised WACC =
1 – Floatation costs
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