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CHAPTER 1

The Cost of Capital

qComponents Cost of Capital


Debt
Preferred
Common Equity
Retained Earning
qWACC
qMarginal Cost of Capital

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What sources of long-term
capital do firms use?

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What are the assumption of cost of
capital
Constant business risk:
The risk is defined as the potential variability of
returns on an investment or the risk to the firms being
unable to cover the operating cost. It assumes that the
firms acceptance of a given project does not affect its
ability to meet operating cost.
Constant financial risk:
It is the risk to the firms of being unable to cover the
required financial obligations such as lease payment,
interest and dividend etc. It assumes that the project
are financed in such a way that the firm’s ability to meet
required financing cost are unchanged.
Constant tax rate:
Cost of capital is measured in the after tax basis.
After tax cost are relevant cost for compensation of cost
of capital.

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Cost of Debt
Cost of debt to a firm is the rate of return
required by the firm’s creditors.
it is calculated as ,
Generally, calculated on the after tax basis.
Two common type of debt
vPerpetual Debt
After tax cost of debt on perpetual debt

vRedeemable Debt
Calculation of After tax cost of debt on perpetual debt
Approximate Cost of Debt

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Actual cost of Debt
Now,
After tax cost of Debt

Example,
A 15-year, 12% semiannual bond sells for
Rs.1,153.72 and tax rate is 35%.What’s
kdt?

0 1 2 30
i=? ...
-1,153.72 60 60 60 + 1,000

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Here,
Time to maturity (n)= 15 year = 30 semi year
Coupon Rate (C)= 12% p.a = 6% s.a
Face Value (M)= Rs. 1000
Current Price of Bond (V)= Rs. 1153.72
After tax cost of debt =?

We have,
Approx. Cost of Debt=

=0.04977= 0.05=5%

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Again,
Actual Cost of Debt=
=5+1
=6%
After Tax cost of Debt (kdt)= 6% (1-0.35)= 3.9%

Hence, the after tax cost of debt of the 15-year


12% semi -annually bond which sells at
Rs.1153.72 is 3.9%.

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Cost of Preferred Stock
Is the rate of return that investor require on
the firms preferred stock.
Two types of preferred stock
- Redeemable
- Irredeemable
Cost of preferred stock on redeemable stock

Cost of preferred stock on irredeemable stock

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Example, let ABC Company ltd. Plans to issue some
Rs.100 par preferred stock with 12% dividend. The
preferred stock is selling on the market for Rs.95 ,
and ABC must pay flotation cost of 5% of the
Here,
given, Par value of preferred stock (M)=Rs.100
Dividend per share (DPS) = 12%= Rs.12
Market price of PS (Vp)= Rs.95
Floatation Cost (F)=5%
Cost of preferred stock (Kps)=?
Now, Calculation of net proceed
Net proceed (NP)= Vp-Floatation cost =Rs.95- 5% of Rs.95 =Rs.95-
Rs.4.75
=Rs. 90.25
Again, Calculation of cost of Preferred stock,
we have,

=0.1330 = 13.30% 9
Cost of common Stock/ Cost of
equity
 is the shareholder’s requited rate of return, which equals the present
value of expected dividend with the market value of a share.
 There are two types cost of equity
- cost of internal equity/ cost of retained earning
- cost of external equity

Cost of internal equity (Ks): the firm may raise equity capital
internally by retaining the profit then it is called internal equity,
Ø it is the rate of return stockholder require on equity capital the firm
obtained by retaining the profit or earning, also known as the cost
of retained earning.
it is calculated as,

Cost of External equity (Ke): the firm raise equity capital by issuing
new common stocks then it is called the external equity. The cost of
external equity is determined by computing the cost of common
stock after considering both the amount of under pricing and the
floating cost associated with the new issue of common stock.
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 The cost of external equity (Ke) is calculated as,
-DCF approach

- CAPM approach

- Bond Yield- plus risk premium approach


Ke=Bond yield+ Risk Premium
Example: Pokhara Noodle’s stock is currently selling for Rs.60 a share.
The firm is expected to earn Rs.5.40 per share and to pay a year end
dividend of Rs.3.60.
a. If investors growth rate is 3 percent constant, what rate
of return must be expected for the firm?
b. If the firm reinvests retained earning in project whose
average return is equals to the stock’s expected rate of return, what
will be next year’s earning per share.

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Given,
Expected EPS =Rs. 5.40
Year end dividend (D1)=Rs. 3.60
Growth rate (g) = 3 %
Current Price of stock(P0)=Rs. 60
a. Calculation of Cost of equity
we know,
cost of equity

=o.o6+o.o3
=o.o9=9%
Hence the cost of equity is 9 percent
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b. Calculation of next year EPS
We know,
New growth rate=b(retention ratio)× r(reinvestment rate or
return)

=0.333

Growth rate (g)=b × r =0.333 × 0.09=0.02997 = 0.03= 3%


Next Year EPS= EPS(1+g) = Rs. 5.40 (1+0.03)= Rs. 5.562

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Weighted Average Cost of Capital

Is the weighted average of after tax


component; cost of debt, preferred stock and
common stock
Is worked out by weighting the cost of each
component of capital by its proportion in the
capital structure.

Or

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The Weighted Average
Calculation—Example

Capital Component Value Cost


Calculate the WACC for the Annapurna Company given the following information about its
capital
Debt structure. $60,000 9%
Preferred Stock 50,000 11
Common stock 90,000 14
$200,000

: First we need to calculate the capital structure weights based on the value given. For debt this
weight is $60,000  

Capital Component Value Weight Cost
Debt $60,000 30% 9% 2.70%
Preferred Stock 50,000 25% 11 2.75%
Common stock 90,000 45% 14 6.30%
$200,000 100% WACC 11.75
= %

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WACC

Example- Executive Fruit has issued


debt, preferred stock and common
stock. The market value of these
securities are $4mil, $2mil, and $6mil,
respectively. The required returns are
6%, 12%, and 18%, respectively.
Q: Determine the WACC for Executive
Fruit, Inc.
Marginal Cost of Capital
Definition: The cost of the last dollar of new
capital that the firm raises.
The Marginal Cost of Capital (MCC) is graph of the
WACC showing abrupt increases as larger amounts of
capital are raised in a planning period
Rises as more capital is raised.
 Since capital raised represents assets used on the
other side of the balance sheet, as more money is
used the company is a different company than it was
before financing.
 As more capital is raised, less is known about the
cash flow stream. Therefore, the risk premium should
be larger!
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Flotation costs—administrative fees and expenses
incurred in the process of issuing and selling securities
Lower the amount received when a security is issued,
increasing the cost of the capital raised
Thus, when a firm issues securities it will only net a portion
of the total amount issued, as the remainder must be paid as
issuance costs
A firm's component cost of capital will be higher than the
investor's return by the ratio of 1  (1 - flotation cost
percentage)

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Group ABC for CFD

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