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Cost of Capital

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

3. Investment return (%) 5%

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

Cost of Equity (Using DDM)


The Cost of Equity may be derived from the dividend growth model as follows: P (IV) = D / K g Where the price of a security equals its dividend (D) divided by its return on equity (K) less its rate of growth (g). We can invert the variables to find K or Ras follows; Where RE is Return of equity K or RE= D / P + g Limitations of the Model: But this model has drawbacks when considering that some firms concentrate on growth and do not pay dividends at all, or only irregularly. Growth rates may also be hard to estimate. Also this model doesnt adjust for market risk.

Cost of Equity (Using DDM)


Example:........... For example, Company Y has common stock outstanding with a current market value of Rs. 64 per share, current dividend of Rs. 3 per share, and a dividend growth rate of 8% forever. RE = ( D1 / P0 ) + g RE = [{(D0 (1+ g)}/ P0 )] + g RE = (3(1.08) / 64) + 0.08 RE = 0.048 + 0.08 = 0.128 or 12.8%

Cost of Equity (using CAPM)


The CAPM can be used for estimating the cost of equity:

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

Cost of Debt (Non-Zero Coupen Bond)


Non-Zero Coupon Bonds having finite maturity: In such bonds, the investor receives interest (I) in the form of annuity and terminal value (MV)
I I I I MV IV 2 3 n 1 k 1 k 1 k 1 k 1 k n

Where MV is the Maturity Value For example, if the series of interest (I) is Rs. 100 and MV is Rs. 1000.
6-9

Cost of Debt (Zero-Coupen Bond)


Zero-Coupen Bond: A bond that pays no interest but sells at a discount from its face value. The discount is the return for investors. No interest is paid on such bonds.
IV

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

Cost of Debt (Zero-Coupen Bond)


Example: Assume, the Company Y has Rs. 1,000 par value zero-coupon bonds outstanding. Company Y bonds are currently trading at Rs. 300 with 10 years to maturity.
300 =
1,000 (1 + k)10

Cost of Debt (Zero-Coupen Bond)


(1 + k)10
(1 + k) (1 + k) k

= 1,000 / 300 = 3.33 = (3.33) (1/10) = 1.127 = 0.127 or 12.7%

Cost of Debt (Perpetuity Bond)


Perpetual Bonds: The bonds with infinite maturity.

I IV k
Where, I = The series of Interest

Cost of preferred shares


These share receive (usually) a fixed amount of dividend. As shares have infinite time period. So, the intrinsic value of the preferred shares are also calculating like perpetual bonds. D IV k Where, D = The series of Dividend; So the K will be: Where D K IV or P

Cost of preferred shares


For Example, Company Y has preferred stock outstanding with par value of Rs. 100, dividend per share of Rs. 6, and a current market value of Rs. 70 per share. k = 6 / 70 K = 0.0857 k = 8.57%

Weighted Average Cost of Capital (WACC)


A firms overall cost of capital must reflect the required return on the firms assets as a whole If a firm uses both debt and equity financing, the cost of capital must include the cost of each, weighted to proportion of each (debt and equity) in the firms capital structure This is called the Weighted Average Cost of Capital (WACC)

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.