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Cost of Capital

# Cost of Capital

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01/28/2011

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Presentation Plan
• Introduction • Significance of cost of capital • Different types of costs • Components of cost of capital • Calculation of WACC • Calculation of Beta (β ) • Capital Asset Pricing Model

Introduction
• Cost of Capital – The opportunity cost of capital or simply the cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskness of its cash flows. • The firm’s cost of capital is different from that of the project’s. The project’s cost of capital is defined by the risk involved in the respective project, whereas, the firm’s cost of capital is the required rate of return on the aggregate of investment projects.

SIGNIFICANCE OF COST OF CAPITAL
• Evaluating investment decision • Designing a firm’s debt policy • Appraising the financial performance of top management

Different types of costs
• Opportunity cost • Future cost • Marginal cost • Historical Cost

• Cost of debt
Kd = I (1-T) P

Components of cost of capital
Kd = I(1-T) + (RV – NIP/ no. of years) (RV + NIP/2)

• Cost of equity
Ke = Expected Dividend + Growth Price Ke = D0(1+g) x g P

• Cost of retained earnings or surplus Kr = Ke when MP or FV is taken but is different in case where, FP is taken because in retained earnings, there is no floatation cost involved

COMPONENTS CONTD.
• Cost of Preference Capital
Kp = Preference Dividend + Corporate Dividend Tax Price Kp = PD + CDT P Kp = PD + CDT + (RV – NIP/ no. of years) (RV + NIP/2)

CALCULATION OF WACC
• Weighted average cost of capital is the calculation of a firm's cost of capital in which each category of capital is proportionately weighted. WACC = Σ WX Total Investment

RISK & RETURN
RISK (σ )
RETURN
Ex – post Ex – ante
Anticipation

Systematic (β ) Unsystematic (ρ
Macro economic firm factors Can’t be eliminated eliminated

im)

Historical data based based

Unique to

Quantitative Objective

Qualitative Subjective

Can be

First short listing knowledge of macroeconomic factors

CALCULATION OF BETA (β )
Beta = Cov (i, m) σ ^2 m

=

Σ (Ri – R1’)(Rm – Rm’)/ n-1 R Σ (Rm – Rm’)^2/ i = return on security n -1

Rm = Return on market n = Number of samples

CAPITAL ASSET PRICING MODEL
Expected Return (Ri)

• High Return
& underpriced

• Low return
& Overpriced

Ri = Rf + β (Rm - Rf)

Risk (β )