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    Cost of Capital

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    Tanjim Hossain

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    © All Rights Reserved
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    Cost of Capital

    Uploaded by

    Tanjim Hossain
    1 views15 pages

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    © © All Rights Reserved

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    Copyright:

    © All Rights Reserved
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    Download as ppt, pdf, or txt
    1 views15 pages

    Cost of Capital

    Uploaded by

    Tanjim Hossain

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 15

    Required

    Required Returns
    Returns
    and
    and the
    the Cost
    Cost of
    of
    Capital
    Capital
    15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    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).

    15.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Cost of Debt

    Cost of Debt is the required rate


    of return on investment of the
    lenders of a company.
    n I j + Pj
    P0 =  (1 + k ) j
    j=1 d

    ki = kd ( 1 – T )
    15.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Determination of
    Cost of Debt
    Assume that Basket Wonders (BW) has
    Tk.1,000 par value zero-coupon bonds
    outstanding. BW bonds are currently
    trading at Tk.385.54 with 10 years to
    maturity. BW tax bracket is 40%.
    0 + 1,000
    385.54 =
    (1 + kd)10

    15.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Determination of
    the Cost of Debt
    (1 + kd)10 = 1,000 / 385.54
    = 2.5938
    (1 + kd) = (2.5938) (1/10)
    = 1.1
    kd = 0.1 or 10%
    Ki= Kd*(1-t)
    ki = 10% ( 1 – .40 )

    15.5
    ki = 6%
    Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Cost of Preferred Stock

    Cost of Preferred Stock is the


    required rate of return on
    investment of the preferred
    shareholders of the company.

    kP = D P / P 0

    15.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Determination of the
    Cost of Preferred Stock
    Assume that Basket Wonders (BW)
    has preferred stock outstanding with
    par value of Tk.100, dividend per
    share of Tk.6.30, and a current market
    value of Tk.70 per share.

    kP = 6.30 / 70
    kP = 9%
    15.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Cost of Equity
    Approaches

    • Dividend Discount Model


    • Capital-Asset Pricing Model

    15.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Dividend
    Dividend Discount
    Discount Model
    Model

    The cost of equity capital,


    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 D
    P0 = + +...+
    (1 + ke)1 (1 + ke)2 (1 + ke)

    15.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Constant
    Constant Growth
    Growth Model
    Model

    The constant dividend growth


    assumption reduces the model to:

    ke = ( D 1 / P 0 ) + g

    Assumes that dividends will grow


    at the constant rate “g” forever.
    15.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Determination of the
    Cost of Equity Capital
    Assume that Basket Wonders (BW) has
    common stock outstanding with a current
    market value of Tk.64.80 per share, current
    dividend of Tk.3 per share, and a dividend
    growth rate of 8% forever.
    ke = ( D 1 / P0 ) + g
    ke = (3(1.08) / 64.80) + 0.08

    15.11
    ke = 0.05 + 0.08 = 0.13 or 13%
    Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Capital
    Capital Asset
    Asset
    Pricing
    Pricing Model
    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)j
    15.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Determination of the
    Cost of Equity (CAPM)
    Assume that Basket Wonders (BW) has a
    company beta of 1.25. Research by Julie
    Miller suggests that the risk-free rate is
    4% and the expected return on the market
    is 11.4%
    ke = Rf + (Rm – Rf)j
    = 4% + (11.4% – 4%)1.25
    ke = 4% + 9.25% = 13.25%
    15.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Market Value of
    Long-Term Financing
    Type of Financing Mkt Val Weight
    Long-Term Debt Tk. 35M 35%
    Preferred Stock Tk. 15M 15%
    Common Stock Equity Tk. 50M 50%
    Tk. 100M 100%

    15.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
    Weighted Average
    Cost of Capital (WACC)
    n
    Cost of Capital = 
    kx(Wx)
    x=1

    WACC = 0.35(6%) + 0.15(9%) +


    0.50(13%)
    WACC = 0.021 + 0.0135 + 0.065
    = 0.0995 or 9.95%
    15.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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