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LEARNING OBJECTIVES
Explain the general concept of the opportunity cost of capital Distinguish between the project cost of capital and the firms cost of capital Learn about the methods of calculating component cost of capital and the weighted average cost of capital Recognize the need for calculating cost of capital for divisions Understand the methodology of determining the divisional beta and divisional cost of capital Illustrate the cost of capital calculation for a real company
INTRODUCTION
The projects cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firms cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects
THE CONCEPT OF THE OPPORTUNITY COST OF CAPITAL The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.
Cost of Capital
Viewed from all investors point of view, the firms cost of capital is the rate of return required by them for supplying capital for financing the firms investment projects by purchasing various securities. The rate of return required by all investors will be an overall rate of return a weighted rate of return.
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COST OF DEBT
Debt Issued at Par
INT kd i B0
INTt
t 1 (1 k d ) t
Bn (1 k d ) n
Tax adjustment
After tax cost of debt k d (1 T)
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EXAMPLE
Now,
PDIVt
t 1 (1 k p ) t
Pn (1 k p ) n
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Example
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DIV1 EPS 1 P0 P0
(since g 0)
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Example
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Example: EPS
A firm is currently earning Rs 100,000 and its share is selling at a market price of Rs 80. The firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to remain stable, and it has a payout ratio of 100 per cent. What is the cost of equity? We can use expected earnings-price ratio to compute the cost of equity. Thus:
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Equation requires the following three parameters to estimate a firms cost of equity:
The risk-free rate (Rf) The market risk premium (Rm Rf) The beta of the firms share ()
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Example
Suppose in the year 2002 the risk-free rate is 6 per cent, the market risk premium is 9 per cent and beta of L&Ts share is 1.54. The cost of equity for L&T is:
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Example
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Companies in practice may develop policy guidelines for incorporating the project risk differences. One approach is to divide projects into broad risk classes, and use different discount rates based on the decision makers experience.
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