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What sources of long-term
capital do firms use?
2
What are the assumption of cost of
capital
Constant business risk:
The risk is defined as the potential variability of
returns on an investment or the risk to the firms being
unable to cover the operating cost. It assumes that the
firms acceptance of a given project does not affect its
ability to meet operating cost.
Constant financial risk:
It is the risk to the firms of being unable to cover the
required financial obligations such as lease payment,
interest and dividend etc. It assumes that the project
are financed in such a way that the firm’s ability to meet
required financing cost are unchanged.
Constant tax rate:
Cost of capital is measured in the after tax basis.
After tax cost are relevant cost for compensation of cost
of capital.
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Cost of Debt
Cost of debt to a firm is the rate of return
required by the firm’s creditors.
it is calculated as ,
Generally, calculated on the after tax basis.
Two common type of debt
vPerpetual Debt
After tax cost of debt on perpetual debt
vRedeemable Debt
Calculation of After tax cost of debt on perpetual debt
Approximate Cost of Debt
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Actual cost of Debt
Now,
After tax cost of Debt
Example,
A 15-year, 12% semiannual bond sells for
Rs.1,153.72 and tax rate is 35%.What’s
kdt?
0 1 2 30
i=? ...
-1,153.72 60 60 60 + 1,000
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Here,
Time to maturity (n)= 15 year = 30 semi year
Coupon Rate (C)= 12% p.a = 6% s.a
Face Value (M)= Rs. 1000
Current Price of Bond (V)= Rs. 1153.72
After tax cost of debt =?
We have,
Approx. Cost of Debt=
=0.04977= 0.05=5%
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Again,
Actual Cost of Debt=
=5+1
=6%
After Tax cost of Debt (kdt)= 6% (1-0.35)= 3.9%
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Cost of Preferred Stock
Is the rate of return that investor require on
the firms preferred stock.
Two types of preferred stock
- Redeemable
- Irredeemable
Cost of preferred stock on redeemable stock
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Example, let ABC Company ltd. Plans to issue some
Rs.100 par preferred stock with 12% dividend. The
preferred stock is selling on the market for Rs.95 ,
and ABC must pay flotation cost of 5% of the
Here,
given, Par value of preferred stock (M)=Rs.100
Dividend per share (DPS) = 12%= Rs.12
Market price of PS (Vp)= Rs.95
Floatation Cost (F)=5%
Cost of preferred stock (Kps)=?
Now, Calculation of net proceed
Net proceed (NP)= Vp-Floatation cost =Rs.95- 5% of Rs.95 =Rs.95-
Rs.4.75
=Rs. 90.25
Again, Calculation of cost of Preferred stock,
we have,
=0.1330 = 13.30% 9
Cost of common Stock/ Cost of
equity
is the shareholder’s requited rate of return, which equals the present
value of expected dividend with the market value of a share.
There are two types cost of equity
- cost of internal equity/ cost of retained earning
- cost of external equity
Cost of internal equity (Ks): the firm may raise equity capital
internally by retaining the profit then it is called internal equity,
Ø it is the rate of return stockholder require on equity capital the firm
obtained by retaining the profit or earning, also known as the cost
of retained earning.
it is calculated as,
Cost of External equity (Ke): the firm raise equity capital by issuing
new common stocks then it is called the external equity. The cost of
external equity is determined by computing the cost of common
stock after considering both the amount of under pricing and the
floating cost associated with the new issue of common stock.
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The cost of external equity (Ke) is calculated as,
-DCF approach
- CAPM approach
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Given,
Expected EPS =Rs. 5.40
Year end dividend (D1)=Rs. 3.60
Growth rate (g) = 3 %
Current Price of stock(P0)=Rs. 60
a. Calculation of Cost of equity
we know,
cost of equity
=o.o6+o.o3
=o.o9=9%
Hence the cost of equity is 9 percent
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b. Calculation of next year EPS
We know,
New growth rate=b(retention ratio)× r(reinvestment rate or
return)
=0.333
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Weighted Average Cost of Capital
Or
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The Weighted Average
Calculation—Example
: First we need to calculate the capital structure weights based on the value given. For debt this
weight is $60,000
Capital Component Value Weight Cost
Debt $60,000 30% 9% 2.70%
Preferred Stock 50,000 25% 11 2.75%
Common stock 90,000 45% 14 6.30%
$200,000 100% WACC 11.75
= %
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WACC
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Group ABC for CFD
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