1.

Calculate the individual costs of components

2. Consider future costs
3. Consider average costs, not marginal costs
4. Weight should always be based on market value, don’t use the value in Balance sheet
5. Weight should be based on the value structure of the company. Theoretically it should be
based on optimal capital structure, but actually we calculate it on the basis of the current
capital structure.

Beta=LINEST(%change_in_stock_data, %change_in_market_data)

Rm=Avg(LastCol)

Rf=Risk free rate

2nd Method

Variance of market

Covariance of market with stock data

Beta=Covariance/Variance

38%, -52%, 34%, 17%, 18%, 25%, 26%,

Deciding period:

Whenver you see unusual increase or decrease or increase in the market return, exclude that period
or increase the period span

Calculate Beta for five years and then cost of equity for 5 years. (B,Rm,Ke) and then for overall

Thus, we’ll have 6B, 6Rm, 6Ke

Types of Beta:
1. Historical Beta
2. Accounting Beta
Price data is replaced by earnings (since we only get quarterly returns, data points are relatively
low). We normally don’t use it since it is based on accrual company
3. Non-listed/New Company
Bottom-up betas
Identify similar listed companies (D/E, Revenue, Business Risk)
Suppose you get 5 similar companies, assign them weights based on the market capitalization
and then calculate weighted beta
Beta levered=Bl, Beta unlevered=Bu
Bl=Bu*[1 + (1-t)*D/E]

Bl -> Cost with Debt

After that find Bu for the 5 companies

Use this Bu to find the Bl for the unlisted company

Factors governing capital structure policy:

1. Risk

Leverage

Degree of operating leverage = %change in EBIT / %change in sales -------a

Degree of financial leverage = %change in EBT or PBT / % change in EBIT-------b

Degree of combined leverage = a*b

2. Income

Indifference level of EBIT -> EPS remains the same irrespective of the leverage

Indifference Level of EBIT = Capitalization * Debt %, 100000 in the above example

On introduction of leverage,
On the Indifference level of EBIT, EPS remains the same irrespective of the leverage
Above the Indifference level of EBIT, EPS increases on introducing new leverage
Below the Indifference level of EBIT, EPS decreases on introducing new leverage

3. Control: Some companies (ex. Partnerships) may prefer debt over equity as they may not
like to share the control of the company. But for sole proprietorship, the owner may prefer
equity over debt, as his personal assets are on the line. Thus, he’d prefer risk over control.
4. Future Financing
 Debt Limit: Company shouldn’t operate too close to its debt limit (Should ideally keep 30-
35% buffer)
 Timing to raise money: Theoretically debt should be raised when market is in recession and
money through equity should be raised when the market is booming

External factors:

1. Characteristics of the Economy: GDP growth, policy rates, mood of capital and money
markets
2. Characteristics of the Industry: If the industry is in the initial stage, a new policy may have a
huge impact on the industry. If the industry is uncertain, the company shouldn’t raise capital
3. Characteristics of the company: Small companies should keep the leverage low

Value of Firm = Free cash flow / WACC