FORMULAS COVERED IN IBF TO BE USED IN

COST OF CAPITAL

The cost of equity funds (ks ):

Cost of Equity Funds = kj =kRF+(kM-kRF)Bj OR

Required return for Stockj=kRF+(RPM)Bj

If you do not have a financial calculator, you
must use a trial-and-error approach to solve
for kd, which is the yield to maturity, in
Equation 5—2. You would substitute values
for k, until you find a rate that “works” so
that the present value of the interest
payments combined with the present value of
the repayment of the maturity value equals
the current price of the bond. But what would
be a good interest rate to use as a starting point?
First, you know that the bond is selling at a premium
over its par value ($l,l64.88 versus $ 1,000), so the
bond’s yield to maturity must be below its 10
percent coupon rate. Therefore, you might start by
trying rates below 10 percent. It could take you a
while to “zero in” on the appropriate rate. It
probably would be better to get an estimate of
the rate by computing the approximate yield
to maturity, which can be found with the
following equation on the next page:
If the firm has no publicly traded debt, then
the cost of debt can be measured as the yield
to maturity on similar debt that is traded.
AFTER-TAX COST OF DEBT
After-tax cost of debt = Before tax cost (1- tax rate)
If tax rate is 30% & before tax cost of debt is 8%, then
After-tax cost of debt = 8% x (1- 0.3) = 5.6%

After tax cost of debt is explained on the next page

Time Value of Money formulas on next page:
 COST OF CAPITAL
It is the firms required rate of return that
will just satisfy all capital providers. To get
some feel for what this cost of capital figure really means,
let’s look at a simple, personal example. Assume that you
borrow some money from two friends (at two different
costs), add some of your own money with the expectation
of at least a certain minimum return, and seek out an
investment. What is the minimum return you can earn that
will just satisfy the return expectations of all capital
providers (as listed in column number 2 of the table
below)?
LEVERED FIRMS EXPLAINED ON NEXT PAGE …
Effect of leverage on return on equity:
By using borrowed funds you can increase the rate of return on equity funds
provided the return on total investment is greater than the interest rate on
borrowed funds.