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CoC
Also referred to as cut-off rate, target
Importance of CoC
Capital Budgeting Decisions
Designing the Corporate Financial Structure
Deciding about the method of financing in
Measuring CoC
A realistic measure of CoC should have the following
qualities of capital expenditure decisions:
1. It must account for the general uncertainty of
expected future returns from investment proposals.
2. It must allow for the various degrees of uncertainty
of expected future returns associated with different
uses of funds.
3. It must allow for the effects of uncertainty
associated with an incremental investment and the
uncertainty of returns from the entire asset
portfolio of the firm.
4. It must account for a variety of financing means
available to a firm.
5. It must allow for the differential effects of financing
combination on the amount and quality of residual
net benefits accruing to shareholders.
6. It must reflect the changes in the capital market.
Cost of Equity
Most difficult and controversial cost to work out.
Conceptually, the cost of equity ke may be
defined as the minimum rate of return that a
firm must earn on the equity financed portion
of an investment project in order to leave
unchanged the market price of the shares.
The cost of equity capital is higher than that of
preference and debt because of greater
uncertainty of receiving dividends and
repayment of principal at the end.
2 approaches to measure
Ke
1. Dividend approach dividend valuation
Formula
N
= D1(1+g)n-1/(1+ke)n
n=1
Po(1-f) = D1/(keg) or
Ke = (D1/Po) + g; where
D1 = expected dividend per share
Po = net proceeds per share/current market price
g = growth in expected dividends
D1(1+g1) (1+g2)/(1+ke)3 .+
Note 2: if we limit the dividend payment upto
N years, then,
Po(1-f)or Po=D1/(1+ke) + D1(1+g)/(1+ke)2 ++
Ke=15/200(1-0.10)+[25/200(1-0.10)](115/25)=15/180+(25/180)(0.40)=.1388=13.9%
Under new tax laws:
Po=D1/(Ke-g) OR Ke=D1/P0+g
But 10% tax is paid by company out of profits.
Thus, retained earnings or g alone is affected.
Thus, revised formula for g is:
g=EPS/P0[1-DPS(1+dt)/EPS] or g=[EPSDPS(1+dt)]/P0
where, dt is dividend tax
For existing issue, Ke=D1/P0+[EPSDPS(1+dt)]/P0
Ke=15/200+[25-15(1+0.1)]/200=15/200+[2516.5]/200=15/200+8.5/200=.1175=11.75%
= 2*1.10(1.1)n-1/(1+ke)n +
n=1
10
D6(1.08)n-1/(1+ke)n +
n=6
D6(1.06)n-1/(1+ke)n +
n=11
Systematic/Non-diversifiable risk: is
Market Portfolio
Systematic risk can be measured in
Formula
ke = rf + (km rf);
Where,
ke = cost of equity capital;
rf = the rate of return required on a risk free
asset/security/investment
km = required rate of return on the market
portfolio of assets that can be viewed as
the average rate of return on all assets
= the beta coefficient.
for market portfolios is 1, while it is 0 for
risk-free investments.
ke
rm
rf
1
reflected in beta.
CAPM model suffers from the problem of
collection of data.
Beta measures only systematic risk.
Example: =1.4, rf=8%, km=12%
ke=8%+1.4(12%-8%)
=8%+1.4*4%=13.6%
Cost of Preference
Capital
They are a hybrid security between debt and
A. Irredeemable (perpetual)
kp=dp/P0(1-f); where,
dp=constant annual dividend,
P0=expected sales price of preference share
f= floatation costs
Example: a 12% irredeemable preference share of
face value of Rs.100, f=5%. What is kp if
preference share issued at i. par, ii.10% premium,
iii. 10% discount
i. At par, kp=12/100(1-0.05)=12/95=12.63%
ii. At 10% premium, kp=12/110(1-0.05)=11.48%
iii. At 10% discount, kp=12/90(1-0.05)=14.03%
Cost of Debt
Debt is the cheapest form of long-term
Cost of Debt
It is the interest rate which equates the
Cost of Debt
Cost of debt is the after-tax cost of long-
Steps in Calculation of
WACC (Ko)
Assigning weights to specific costs.
Multiplying the cost of each sources by the
appropriate weights.
Dividing the total weighted cost by the total
weights.
+40%*14%
=2.4%+3.9%+5.6%=11.9%
Note: ko calculated on the basis of market value is
likely to be greater than the one calculated on the
basis of book value since market values of equity
and preference shares is usually higher than book
value and hence their weight is more with respect
to debt. For example, in the above example,
market values are:
Advantages of BV
weights
1. The capital structure targets are usually