Investment Analysis and Portfolio Management-C1

A lecture
on
Module5: Equity valuation
“Cost of capital –WACC-growth estimation- cash flow estimation –DCF models”
by
Dr. Biswabhusan Bhuyan
Assistant Professor, VITBS,
Vellore Institute of Technology (Chennai Campus),
Feb, 2023
DCF models
Introduction
Cost of capital-WACC-growth estimation
Introduction
In our discussions of the investment decisions so far, we have assumed that the
discount rate is known. In this chapter, we focus on the concept of the opportunity
cost of capital as a discount rate and the procedure of its measurement

The opportunity cost of capital (or simply, the cost of capital) for a project is the
discount rate for discounting its cash flows.

The project’s cost of capital is the minimum required rate of return on funds
committed to the project, which depends on the riskiness of its cash flows

The firm represents the aggregate of investment projects undertaken by it.

Therefore, the firm’s cost of capital will be the overall, or average, required rate of
return on the aggregate of investment projects.
SIGNIFICANCE OF THE COST OF CAPITAL
 It used for evaluating investment decisions, designing a firm’s debt policy and, appraising the financial performance of top management

 Investment Evaluation;
 The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects.
 In the NPV method, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting its cash flows by
the cost of capital. In this sense, the cost of capital is the discount rate used for evaluating the desirability of an investment project.
 In the IRR method, the investment project is accepted if it has an internal rate of return greater than the cost of capital. In this context, the cost of
capital is the minimum required rate of return on an investment project. It is also known as the cut-off rate or the hurdle rate.
 An investment project that provides a positive NPV when its cash flows are discounted by the cost of capital makes a net contribution to the
wealth of shareholders.
 If the project has zero NPV, it means that its cash flows have yielded a return just equal to the cost of capital, and the acceptance or rejection of
the project will not affect the wealth of shareholders.
 The cost of capital is the minimum required rate of return on the investment project that keeps the present wealth of shareholders unchanged.
 It may be, thus, noted that the cost of capital represents a financial standard for allocating the firm’s funds, supplied by owners and creditors, to
the various investment projects in the most efficient manner.

 Designing Debt Policy

 Therefore, an additional statement is needed to show the changes in assets, liabilities and owners’ equity between dates of two balance sheets. Such a
statement is referred to as the statement of changes in financial position.

 The most commonly used forms of the statement of changes in financial position are called the funds flow statement and the cash flow statement.
Designing Debt Policy
 In practice, the debt policy of a firm is significantly influenced by the cost consideration.
 In designing the financing policy, that is, the proportion of debt and equity in the capital structure,
the firm aims at maximizing the firm value by minimizing the overall cost of capital.
 The cost of capital can also be useful in deciding about the methods of financing at a point of time.
For example, cost may be compared in choosing between leasing and borrowing.

Performance Appraisal
 The cost of capital framework can be used to evaluate the financial performance of top
management.
 Such an evaluation will involve a comparison of actual profitability of the investment projects
undertaken by the firm with the projected overall cost of capital, and the appraisal of the actual
costs incurred by management in raising the required funds.
Measurement of Cost of Capital
Weighted average cost of capital (WACC)

 A company’s cost of capital is the weighted average cost of various sources of finance used by it,
i.e., equity, preference, and debt.

Example: Suppose that a company uses equity, preference, and debt in the following proportions; 50,
10, and 40. If the component costs of equity, preference, and debt are 16 %, 12 %, and 8 %,
respectively, what is the weighted average cost of capita?

 WACC=(Proportion of equity)(Cost of equity)+(Proportions of preference)(Cost of

preference)+(Proportion of debt)(Cost of debt)

 WACC=(0.5)(16)+(0.10)(12)+(0.4)(8)=12.4 %
Contd…
 If a firms rate of return on its investment exceeds its cost of capital, equity share holder will be
benefited. To explain this point considered a firm which employs equity and debt in equal
proportions and whose cost of equity and debt are 14 % and 6 %, respectively, The cost of capital,
which is weighted average cost of capital, works out to 10 % (0.5*14+0.5*6). Now, if the firms
invests Rs.100 million on a project which earns a rate of return of 12 %, the return on equity funds
employed in the project will be:

Total return on the project - Interest on debt 100(0.12)  50(0.06)

  18%
Equity funds 50

 Since 18 % exceeds the cost of equity (14 %), equity shareholders benefit.
Cash Flow Analysis