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Corporate Finance

Topic: Cost of Capital

Presented To: Rizwan Hamid Presented By: M.Hashaam Roll No. : AM552381 Class : MBA (B&F) 4th Semester

Acknowledgment
First of all thanks of Allah who is most beneficent and the most merciful whose blessings are abundant and favors are unlimited. It is my pleasure to acknowledge the guidance and support of my subject Teacher: Mr. Rizwan Hamid for his endless guidance.

An Abstract
Cost of Capital is the marginal cost of raising funds. This cost is important in our investment decision making because we ultimately want to compare the cost of funds with the benefits from investing these funds. Cost of Capital is the companys cost of using funds provided by creditors and shareholders.

Introduction to Cost of Capital


Cost of Capital is the required rate of return on the various types of financing. The overall cost of capital is a weighted average of the individual required rates of return (costs).

Cost of Capital =S kx(Wx)


x=1

Source of Capital
The Cost of Debt The Cost of Preferred Equity The Cost of Common Equity

Cost of Debt
Cost of Debt is the required rate of return on investment of the lenders of a company.

P0 = S
j =1

Ij + P j (1 + kd)j

ki = kd ( 1 - T )

Cost of Preferred Equity


Cost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company.

kP = DP / P0

Cost of Common Equity


The Cost of Common Equity, ke, is the required rate of return on common stock. Approaches are followings: Dividend Discount Model Capital-Asset Pricing Model Before-Tax Cost of Debt plus Risk Premium

Dividend Discount Model


The cost of equity capital, ke, is the discount rate that equates the present value of all expected future dividends with the current market price of the stock.
D1 D2 + P0 = 1 (1+ke) (1+ke)2 D +...+ (1+ke)

Capital Asset Pricing Model


The cost of equity capital, ke, is equated to the required rate of return in market equilibrium. The risk-return relationship is described by the Security Market Line (SML).

ke = Rj = Rf + (Rm - Rf)bj

Before-Tax Cost of Debt Plus Risk Premium


The cost of equity capital, ke, is the sum of the before-tax cost of debt and a risk premium in expected return for common stock over debt.

ke = kd + Risk Premium*
* Risk premium is not the same as CAPM risk premium

Conclusion
The cost of capital represents the

overall cost of future financing to the firm It is a weighted average of the costs of the various source of funds available It represents the minimum acceptable return from an investment

Recommendations
I will recommend, That firms should calculate betas relative to the world market. If investors throughout the world held the world portfolio, then they can demand the same return from an investment in any where in world.

Thank You