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    Cost of Capital

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    khushi misha
    The cost of equity is: Rf + β(Rm - Rf) = 5% + 1.5(12% - 5%) = 5% + 1.5(7%) = 5% + 10.5% = 15.5% Therefore, the cost of equity is 15.5% Contd..... The CAPM model assumes that: 1. Investors are risk averse and maximize expected utility from wealth. 2. Investors choose from a very large number of risky securities and a single risk-free asset. 3. All investors have identical expectations about the distributions of returns and they agree on the parameters that describe these distributions.

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    Cost of Capital

    Uploaded by

    khushi misha
    20 views67 pages
    The cost of equity is: Rf + β(Rm - Rf) = 5% + 1.5(12% - 5%) = 5% + 1.5(7%) = 5% + 10.5% = 15.5% Therefore, the cost of equity is 15.5% Contd..... The CAPM model assumes that: 1. Investors are risk averse and maximize expected utility from wealth. 2. Investors choose from a very large number of risky securities and a single risk-free asset. 3. All investors have identical expectations about the distributions of returns and they agree on the parameters that describe these distributions.

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    The cost of equity is: Rf + β(Rm - Rf) = 5% + 1.5(12% - 5%) = 5% + 1.5(7%) = 5% + 10.5% = 15.5% Therefore, the cost of equity is 15.5% Contd..... The CAPM model assumes that: 1. Investors are risk averse and maximize expected utility from wealth. 2. Investors choose from a very large number of risky securities and a single risk-free asset. 3. All investors have identical expectations about the distributions of returns and they agree on the parameters that describe these distributions.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    20 views67 pages

    Cost of Capital

    Uploaded by

    khushi misha
    The cost of equity is: Rf + β(Rm - Rf) = 5% + 1.5(12% - 5%) = 5% + 1.5(7%) = 5% + 10.5% = 15.5% Therefore, the cost of equity is 15.5% Contd..... The CAPM model assumes that: 1. Investors are risk averse and maximize expected utility from wealth. 2. Investors choose from a very large number of risky securities and a single risk-free asset. 3. All investors have identical expectations about the distributions of returns and they agree on the parameters that describe these distributions.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 67

    Cost of Capital

    Understanding: Cost of Capital


    Definition of Cost of Capital
    According to Mittal and Agarwal “the cost of capital is the
    minimum rate of return which a company is expected to
    earn from a proposed project so as to make no reduction in
    the earning per share to equity shareholders and its
    market price”.
    Importance of Cost of Capital
    Cost of Debt
    A company may raise debt in variety of ways. It may borrow funds
    from financial institutions or public either in the form of public
    deposits or debentures (bonds) for a specified period of time at a
    certain rate of interest.

    A debenture or bond may be issued at par or at a discount or


    premium as compared to its face value.
    Debt Issued at Par
     
    Illustration
    A company has issued 8% debentures and the tax rate is
    50%, the after tax cost of debt will be?
    A. 6%
    B. 5%
    C. 4%
    D. 4.5%
    Debt Issued at Premium or at Discount

     
    Illustration
    A company issues 10% Debentures to Rs. 2,00,000 Rate of tax is
    55%. Calculate the cost of debt (after tax) if the debentures are
    issued

    (i) at par
    (ii) at a discount of 10% and
    (iii) at a premium of 10%.
    Solution
    (i) Issued at Par
    = Rs. 20,000/Rs. 2,00,000 (1 – .55)
    =1/10 x .45
    = 4.5%
    (ii) Issued at a Discount of 10%
    Rs. 20,000/Rs. 1,80,000 (1 – .55)
    = 1/9 x .45
    = 5 % 
    (iii) Issued at Premium of 10%
    Rs. 20,000/Rs. 2,20,000 (1 – .55)
    = 1/11 x .45
    = 4.1 %
    Formula for WACC
     
    Contd….
    In a general form, the formula for calculating WAC can be
    written as follows:

    where k1, k2, … are component costs and w1, w2, … weights of various
    types of capital, employed by the company.
    MCQ
    The weighted average cost of capital for a firm is the:
    a. Discount rate which the firm should apply to all of the projects it undertakes.
    b. Rate of return a firm must earn on its existing assets to maintain the current
    value of its stock.

    c. Coupon rate the firm should expect to pay on its next bond issue.
    d. Maximum rate which the firm should require on any projects it undertakes.
    B. Rate of return a firm must earn on its existing
    assets to maintain the current value of its stock.
    Illustration

    The following information is available from the balance sheet of the


    company:
    Equity share capital (2,00,000 shares) ₹ 40,00,000
    11.5% Preference share ₹ 10,00,000
    10% Debenture ₹ 30,00,000
    The equity share of the company sells for ₹ 20. It is expected that the
    company will pay next year a dividend of ₹ 2 per equity share, which is
    expected to grow at 5% p.a. forever. Assume a 35% corporate tax rate.
    Compute weighted average cost of capital (WACC) of the company
    based on the existing capital structure.
    Solution
    Contd……
    Contd…..
    Illustration
    Find the weighted average cost of capital from information given
    below
    Contd…..
    Suppose Lohia Chemicals LTD has 45,000,000 equity shares outstanding and the
    current market price per share is ₹ 20. Assume that the market values and the book
    values of debt and preference share capital are the same. If the component costs
    were the same as before, the market value weighted average cost of capital would
    be? Computation of WACC (Market value weights)?
    Why do managers prefer the book value weights for
    calculating WACC?
    1) Firms in practice set their target capital structure in terms of book values.
    2) The book value information can be easily derived from the published
    sources.
    3) The book value debt equity ratios are analyzed by investors to evaluate
    the risk of the firms in the practice.
    Contd…..
    Market value weights are theoretically superior to book value
    weights.
    They reflect economic values and are not influenced by accounting
    policies.
    They are also consistent with market determined component
    costs.
    Cost of Equity & The CAPM (Capital Asset Pricing
    Model)

     
    MCQ
    If the CAPM is used to estimate the cost of equity capital,
    the expected excess market return is equal to the:
    a. Return on the stock minus the risk-free rate.
    b. Difference between the return on the market and the risk-free rate.
    c. Beta times the market risk premium.
    d. Beta times the risk-free rate.
    b. Difference between the return on
    the market and the risk-free rate.
    Illustration

    The risk-free rate of return of the Purple Widget


    Company is 5%, the return on the Dow Jones
    Industrials is 12%, and the company’s beta is 1.5.
    The cost of equity is?

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