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Cost of Capital
Cost of Capital
Cost of Capital
Online video
https://epgp.inflibnet.ac.in/Home/ViewSubjec
t?catid=6
(The same has been referred for this ppt)
Cost of Capital
Cost of capital refers to the cost of a firm's funds (debt,
preference and equity capital).Optimal capital structure refers
to the best debt-equity ratio for a company that enhances its
value and decreases the company’s cost of capital.
Factors affecting Cost of Capital
Following are the elements influencing cost of capital:
a) Risk free rate
b) Business risk premium
c) Financial risk premium
d) Other factors like liquidity, profitability, tax rate
Continued
Significance of Cost of capital:
a) Evaluating investment proposals/ Capital budgeting
decisions
b) Designing the debt policy or the firm’s capital structure
c) Performance appraisal of top management
d) Other like dividend decisions, working capital policy etc.
Explicit and Implicit cost of capital:
Explicit cost of capital to a company involves an explicit payment
made by the business to the suppliers of funds such as interest
payments to debenture holders and dividend payments to
preference and equity shareholders. On the contrary, implicit
costs of capital do not require any cash outflow to the providers
of funds. This is related with retained earnings.
Continued
Marginal cost of capital:
Marginal cost of capital is the average cost of new or incremental
funds raised by the firm. It tends to increase proportionately as the
amount of debt increases. The overall marginal cost of additional
funds is calculated on the basis of market value weights because the
new funds are to be raised at the market values.
Cost of Debt:
The cost of debt refers to the cost associated with using fixed
interest bearing securities like debentures, long term loans and
bonds in the firm’s capital structure. In other words, it is the rate of
return demanded by the lenders who loan money to the company .
Continued
In the case of debt, the return paid to the debt holders is not the same as the
cost to the firm. This is due to the tax-deductibility of interest paid on debt.
Thus, the actual cost of debt is less than the yield to maturity.
Net Proceed = Par Value – (discount on issue & floatation cost) + Premium on
issue
Example:
Par Value = 100, Int = 5% * 100 = 5, NP = 100 – (20%*100) = 80, Tax = 50%
Before Tax Kd = 5 / 80 = .0625 or 6.25%
After Tax Kd = 6.25 * (1- .50) = 3.125%
Continued
Assumptions of CAPM:
• All investors are Rational and Risk averse.
• They have homogeneous expectations regarding the expected
returns, variances and correlation of returns among all securities;
• All information about securities is available to all the investors
• There are no restrictions on investments;
• There are no taxes;
• There are no transaction costs; and
• No single investor can affect the market price significantly. They
are only price takers.
• There is no restriction on lending and borrowing at risk
Continued
Ke = Rf + β (Rm – Rf )
Where,
Ke = Cost of Equity; Rf = Risk Free Rate; Rm= Rate of return on Market
portfolio or average return on all the assets; Rm - Rf = Market risk
premium; β = Beta coefficient (Systematic risk)
Source: epgpathshala
Continued
WACC is 13.572 as per Book value method and 13.782% as per market value method
Source: https://xplaind.com/965210/cost-of-capital
Continued
Estimating Cost of Equity
Cost of Equity = RF+ (Beta × Market Risk Premium)
= 4% + 1.2 × 8% = 13.6%
Estimating Cost of Debt
After-tax Cd= 10.61% × (1 − 30%) = 7.427%
Calculating WACC
Source Market value After tax Cost (x) Weights (w) wx
Equity 1,000,000 × $30 = 13.6 % .3871 5.2646 %
30,000,000
Debt 50,000 × $950 = 7.427 % .6129 4.5520 %
47,500,000
77,500,000 1.000 9.8166 %