Why Cost of Capital? – Overall Cost of Capital of the Firm – Investment Proposal- Accept /Reject – Capital Structure – Yardstick to measure the worth of investment proposal – Discounting future cash flows – Overall Cost of Capital of the Firm – Investment Proposal- Accept /Reject – Capital Structure – Yardstick to measure the worth of investment proposal – Discounting future cash flows

Meaning Required rate of return on the various types of financing. Expected rate of return by investors Cut off rate Discount rate Opportunity cost of funds For eg. Opportunity cost of funds is 10%, the treasurer raised cost of fund is 8%. What is the real cost of fund.

Components Time value and risk premium. Time value is known as risk free rate. Risk premium is additional expected return Risk premium is of Business risk and financial risk. Business risk – change in EBIT due to change in sales Financial risk – change in EPS due to change in capital structure.

Practical consideration in calculation Tax consideration: after and before Book value or market value Specific cost of capital Overall cost of capital Why WACC, why not CAPM Beta estimation, applicability or not

Cost of debt Cost of Debt Cost of Debt is the required rate of return on investment of the lenders of a company Fixed interest rate Maturity year Tax K d = I/p(1-t)

Cost of Preferred Stock Cost of Preferred Stock Cost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company. k P = D P / P 0

Determination of the Cost of Preferred Stock Assume that XYZ has preferred stock outstanding with par value of Rs.100, dividend per share of Rs.6.30, and a current market value of Rs.70 per share. k P = 6.30 / 70 k P 9% k P = 9%

Cost of Equity Approaches Constant growth Model Constant growth Model Capital-Asset Pricing Model Capital-Asset Pricing Model

Constant Growth Model constant dividend growth assumption The constant dividend growth assumption reduces the model to: k e = ( D 1 / P 0 ) + g Assumes that dividends will grow at the constant rate “g” forever.

Determination of the Cost of Equity Capital Assume that XYZ has common stock outstanding with a current market value of per share, current dividend of 3 per share, and a dividend growth rate of 8% forever. k e = ( D 1 / P 0 ) + g k e = (3(1.08) / 64.80) +.08 k e.1313% k e = =.13 or 13%

Capital Asset Pricing Model The cost of equity capital, k e, is equated to the required rate of return in market equilibrium. The risk-return relationship is described by the Security Market Line (SML) k e = R f + (R m - R f )  j Risk free rate Market risk premium Beta

Determination of the Cost of Equity (CAPM) Assume that XYZ has a company beta of Research by Julie Miller suggests that the risk- free rate is 4% and the expected return on the market is 11.2% k e = R f + (R m - R f )  j = 4% + (11.2% - 4%)1.25 k e 13% k e = 4% + 9% = 13%

Difficulty in Determining the Expected Return Locate a proxy for the project (much easier if asset is traded). Plot the Characteristic Line relationship between the market portfolio and the proxy asset excess returns. Estimate beta and create the SML. Determining the SML:

Project Acceptance and/or Rejection SML X X X X X X X O O O O O O O SYSTEMATIC RISK (Beta) EXPECTED RATE OF RETURN RfRf Accept Reject

The Cost of Retained Earnings These funds are not free because they belong to the common shareholders (i.e., there is an opportunity cost) Therefore, the cost of retained earnings is exactly the same as the cost of new common equity, except that there are no flotation costs:

Weighted Average Cost of Capital (WACC) WACC weights the cost of equity and the cost of debt by the percentage of each used in a firm’s capital structure WACC=(E/ V) x R E + (D/ V) x R D x (1-T C ) – (E/V)= Equity % of total value – (D/V)=Debt % of total value – (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible