Professional Documents
Culture Documents
R36 Cost of Capital
R36 Cost of Capital
Cost of Capital
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1. Introduction
A company grows by investing in projects that are profitable and survives by its
revenue streams.
All investments have associated costs and the most critical is the cost of capital.
The cost of capital is an important ingredient in both investment decision making
by companys management and also its valuation by investors
Cost of capital estimation is a complex undertaking which requires many
assumptions and, factors that need to be taken into account.
Investments that alter a companys capital structure require project specific cost of
capital adjustments
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2. Cost of Capital
Lenders/Bondholders
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Example
IFT has the following capital structure: 30 percent debt, 10 percent preferred stock
and 60 percent equity. The before tax cost of debt is 8 percent, cost of preferred stock
is 10 percent and cost of equity is 15 percent. If the marginal tax rate is 40%, what is
the WACC?.
Example
Machiavelli Co. has an after tax cost of debt capital of 4%, a cost of preferred stock of
8%, a cost of equity capital of 10% and a weighted average cost of capital of 7%. MC
intends to maintain its current capital structure as it raises additional capital. In
making its capital budgeting decisions for the average risk project the relevant cost of
capital is
A. 4%
B. 7%
C. 8%
Answer: B
The WACC using weights derived from the current capital structure, is the best estimate of the cost of capital
for the average risk project of a company.
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Revenue
Operating Expenses
Interest
EBT
Tax Expense (40%)
Net Income
Revenue
Operating Expenses
EBT
Tax Expense (40%)
Interest expense
Net Income
100
50
10
40
16
24
100
50
50
20
10
20
Example 2
In the absence of explicit information about a firms target capital structure, use:
Current capital structure based on market values
Trend in the firms capital structure
Average of comparable companies
Example 3
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Example
You gather the following information about the capital structure and before-tax
component costs for a company. The companys marginal tax rate is 40 percent.
What is the cost of capital?
Capital component
Component cost
Debt
$100
$90
8%
Preferred stock
$20
$20
10%
Common stock
$100
$300
14%
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Example 4
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Examples 5 and 6
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Example
You have gathered the following information about a company and the market
Current share price = 30
Most recent dividend paid = 2
Expected dividend payout rate = 40%
Expected ROE = 15%
Equity beta = 1.5
Expected return on market = 15%
Risk free rate = 8%
Using the DCF approach, what is the cost of
retained earnings?
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A companys interest rate on long term debt is 8%. The risk premium is estimated to
be 5%. What is the cost of equity?
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3. Get the equity (levered) beta for the project = asset {1+[(1-t) D/E]}
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Examples 9, 10 and 11
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Sovereign yield spread = developing country government bond yield (denominated in the
developed market currency) developed country bond yield
Example 12
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Cost of debt
(after tax)
Cost of
equity
4.0
14%
9.0
20%
> 4.0
16%
> 9.0
22%
WACC(%)
Capital
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Rd
Equity
re
4.0
14%
9.0
20%
> 4.0
16%
> 9.0
22%
Capital
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re = D1 / (P0 F) + g
A higher discount rate reduces the
present value of future cash flows; is this
appropriate?
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Summary
WACC concept and calculation
Cost of debt
Cost of preferred shares
Cost of equity
Other topics: pure-play, CRP, MCC schedule, flotation costs
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Conclusion
Read summary
Review learning objectives
Examples are good
Practice problems: good but not enough
Practice questions from other sources
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