Beruflich Dokumente
Kultur Dokumente
Introduction
Cost of Capital is the required rate of return on the various types of financing. The overall cost of capital is the weighted average of the individual required rates of return (costs). It is the firms required rate of return that will satisfy all capital providers (common stockholders, preferred stockholders and debt holders). Three types of returns:
Cost of equity capital (common shares) Cost of debt Cost of preferred shares
1. Capital Providers
2. Invested capital
4. Weight 5. Weighted 6. Investor (proportion cost return of financing) (34) (amount) [25) 20% 1.0%
Bilal (Debt)
Rs. 2000
Cost of Equity
Cost of Equity can be calculated using:
CAPM model Dividend Discounted Model
RE = Rf + E x (RM Rf)
or Return on Equity = Risk free rate + (risk factor) x risk premium)
Advantages of CAPM: Evaluates risk, applicable to firms that dont pay dividends.
Disadvantages of CAPM: Need to estimate both Beta and risk premium (will usually base on past data, not future projections.)
Cost of Debt
Cost of Debt is the required rate of return on investment of the lenders of a company. The cost of debt is generally easier to calculate as it: Equals the current interest cost to borrow new funds. Current interest rates are determined from the going rate in the financial markets. Or It can be calculated using the applications of time value of money Three forms of Debts Non-Zero Coupen Bond Zero-Coupen Bond Perpetual Bond
Where MV is the Maturity Value For example, if the series of interest (I) is Rs. 100 and MV is Rs. 1000.
6-9
Here is the maturity value (MV) is the face value of the zero-coupen bond. If the MV = Rs. 1000; k = 12% and n = 10 years; then IV = ?
6-10
MV 1 k n
I IV k
Where, I = The series of Interest
WACC
WACC weights the cost of equity and the cost of debt by the percentage of each used in a firms capital structure WACC=(E/ V) x RE + (Ep/ V) x Rp + (D/ V) x RD x (1-TC)
(E/V) = Equity % of total value (common Shares) (Ep/ V) = Equity % of total value (Preferred Shares) (D/V) = Debt % of total value (1-Tc) = After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible
WACC
WACC should be based on market rates and valuation, not on book values of debt or equity. Book values may not reflect the current marketplace WACC will reflect what a firm needs to earn on a new investment. But the new investment should also reflect a risk level similar to the firms Beta used to calculate the firms RE.