The document discusses the concept of cost of capital. It defines cost of capital as the minimum rate of return a firm must earn on its investments to maintain the market value of its equity shares. It notes that cost of capital includes the return on risk-free investments plus premiums for business risk and financial risk. The document also outlines different types of costs of capital such as explicit vs implicit cost and average vs marginal cost. Finally, it provides examples of calculating the costs of different sources of capital such as debt, preference shares, and equity.
The document discusses the cost of capital, which is the rate of return a firm requires to increase its market value. It has three components: return at zero risk, business risk premium, and financial risk premium. Cost of capital is classified as historical vs future, specific vs composite, average vs marginal, and explicit vs implicit. Specific costs include cost of debt, preference shares, equity shares, and retained earnings. Composite cost is the weighted average cost of different sources. Cost of capital is computed using book value weights or market value weights to determine the weighted average cost of capital (WACC).
The study analyzed the impact of working capital management on the profitability of 58 small manufacturing firms in Mauritius over the period of 1998-2003. The results showed that return on total assets, a measure of profitability, was positively correlated with measures of working capital management efficiency like accounts receivable days and cash conversion cycle. However, it was negatively correlated with accounts payable days. The paper concluded that synchronizing current assets and liabilities is important for small firm profitability and the paper industry showed best practices in working capital management.
This document discusses capital structure and the factors considered when determining a firm's optimal capital structure. It discusses several approaches to determining the optimal capital structure, including:
1. The net income approach, which argues that changing capital structure affects overall cost of capital and firm value.
2. The net operating income/Modigliani-Miller approach, which argues that changing capital structure does not affect overall cost of capital or firm value.
3. The traditional/intermediate approach, which argues that increasing debt initially decreases overall cost of capital up to an optimal point, after which further increasing debt increases overall cost of capital.
The document analyzes the assumptions and implications of each approach. It also lists factors
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices
The document discusses capital structure, which refers to the mix of debt and equity used by a company to finance its long-term operations. It examines several factors that influence a company's capital structure choices as well as different theories about optimal capital structure. The Net Income Theory proposes that firms can maximize value and minimize cost of capital by using as much debt as possible. The Net Operating Income Theory argues capital structure is irrelevant to firm value and cost of capital. The Traditional Theory suggests an optimal debt-equity mix exists. Finally, the Modigliani-Miller Theory states that under certain assumptions, capital structure does not impact firm value or cost of capital, though when taxes are considered, more debt can increase value.
,
cost of capital
,
bond
,
preferred stock
,
factors influencing cost of capital determination
,
cost of new common stock
,
cost of debt components
,
cost of preferred stock
,
components of cost of capital
The document discusses the cost of capital, which is the rate of return a firm requires to increase its market value. It has three components: return at zero risk, business risk premium, and financial risk premium. Cost of capital is classified as historical vs future, specific vs composite, average vs marginal, and explicit vs implicit. Specific costs include cost of debt, preference shares, equity shares, and retained earnings. Composite cost is the weighted average cost of different sources. Cost of capital is computed using book value weights or market value weights to determine the weighted average cost of capital (WACC).
The study analyzed the impact of working capital management on the profitability of 58 small manufacturing firms in Mauritius over the period of 1998-2003. The results showed that return on total assets, a measure of profitability, was positively correlated with measures of working capital management efficiency like accounts receivable days and cash conversion cycle. However, it was negatively correlated with accounts payable days. The paper concluded that synchronizing current assets and liabilities is important for small firm profitability and the paper industry showed best practices in working capital management.
This document discusses capital structure and the factors considered when determining a firm's optimal capital structure. It discusses several approaches to determining the optimal capital structure, including:
1. The net income approach, which argues that changing capital structure affects overall cost of capital and firm value.
2. The net operating income/Modigliani-Miller approach, which argues that changing capital structure does not affect overall cost of capital or firm value.
3. The traditional/intermediate approach, which argues that increasing debt initially decreases overall cost of capital up to an optimal point, after which further increasing debt increases overall cost of capital.
The document analyzes the assumptions and implications of each approach. It also lists factors
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices
The document discusses capital structure, which refers to the mix of debt and equity used by a company to finance its long-term operations. It examines several factors that influence a company's capital structure choices as well as different theories about optimal capital structure. The Net Income Theory proposes that firms can maximize value and minimize cost of capital by using as much debt as possible. The Net Operating Income Theory argues capital structure is irrelevant to firm value and cost of capital. The Traditional Theory suggests an optimal debt-equity mix exists. Finally, the Modigliani-Miller Theory states that under certain assumptions, capital structure does not impact firm value or cost of capital, though when taxes are considered, more debt can increase value.
,
cost of capital
,
bond
,
preferred stock
,
factors influencing cost of capital determination
,
cost of new common stock
,
cost of debt components
,
cost of preferred stock
,
components of cost of capital
This presentation is an overview of Capital Structure Theories.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata
The document discusses various aspects of capital structure including definitions, key terms, theories, and principles. It defines capital structure as the mix of debt and equity used by a company to finance its overall operations and long-term needs. Several theories of capital structure are described, including the net income approach, net operating income approach, and Modigliani & Miller approach. Factors that determine an optimal capital structure are discussed, including costs, risks, flexibility, and control. Formulas for calculating financial break-even point, point of indifference, and capital gearing ratio are provided. Examples are given to illustrate how to apply the concepts.
The document discusses the cost of capital, including its meaning, significance, and methods for determining it. The cost of capital is the minimum expected rate of return required by a firm's investors. It is used to evaluate investment projects and determine the optimal capital structure. There are different types of costs - historical vs future, specific vs composite, explicit vs implicit, and average vs marginal. Determining the accurate cost of capital can be challenging due to conceptual issues around capital structure and difficulties calculating costs like equity and retained earnings.
This document discusses dividend policy and the various theories around it. It defines dividends and discusses Walter's model and Gordon's model, which propose that dividend policy affects firm value. It also covers the irrelevance theories of Modigliani-Miller and the traditional approach, which argue that dividend policy does not impact value. The document provides formulas for the different models and discusses their assumptions and criticisms.
Cost of Capital,Meaning,Computation of Specific Costs,Cost of Debt,Cost of Preference Shares,Cost of Equity Capital,Cost of Retained Earnings ,Weighted Average Cost of Capital
The document discusses capital structure and its theories. It defines capital structure as the proportion of long-term debt and equity used to finance a company's assets. A company's capital structure determines its risk and cost of capital. There are several theories on capital structure including the net income, net operating income, traditional, and Modigliani-Miller approaches. The optimal capital structure balances minimum costs and risks. Factors like tax rates, control, flexibility, and legal requirements influence a company's choice of capital structure.
This document discusses factors that affect a company's capital structure. It defines capital structure as how a firm finances its operations through various sources of funds such as debt, equity, short-term debt, and other financing options. It then lists 14 factors that influence a company's capital structure decisions, including control interests of shareholders, risks, tax considerations, cost of capital, flexibility, investors' attitudes, legal provisions, growth rate, market conditions, profitability, floatation costs, cost of debt, cost of equity capital, and government policies. Maintaining an optimal capital structure is important for balancing business risks and maximizing shareholder value.
The document discusses Modigliani and Miller's approach to capital structure. It states that under their approach, in the absence of taxes, a firm's market value is not affected by its capital structure. It also discusses how when taxes are incorporated, the value of the firm increases and cost of capital decreases with the use of debt due to the deductibility of interest payments. The document provides an example comparing two companies, one with equal proportions of debt and equity and one with more equity than debt, to illustrate this point. It also presents the formulas used in Modigliani and Miller's approach.
The document defines the cost of capital as the minimum required rate of return on invested funds. It discusses how the cost of capital is helpful for capital budgeting and structure decisions. It then outlines the different components of cost of capital - cost of debt, preferred shares, equity shares, and retained earnings. Various formulas are provided for calculating the costs of redeemable and irredeemable debt, preferred shares, and equity shares. The cost of retained earnings is said to equal the cost of equity shares.
Working capital refers to a company's short-term assets and liabilities. There are two main concepts of working capital - gross working capital, which is the total investment in current assets, and net working capital, which is the difference between current assets and current liabilities. A company's working capital requirements are determined by factors like its nature of business, production cycle, and seasonal needs. There are different approaches to financing working capital, including the hedging approach of matching debt maturities to needs, the conservative approach of financing all current assets with long-term debt, and the aggressive approach of relying more on short-term debt.
The document discusses capital structure, which refers to the proportion of debt, preferred stock, and common equity used to finance a company's assets. Capital structure includes long-term debt and stockholder equity. Capitalization refers to the total amount of securities issued, while capital structure refers to the types and proportions of securities. Financial structure includes all financial resources, both short- and long-term. An optimal capital structure maximizes share price and minimizes cost of capital. Factors that determine a company's capital structure include financial leverage, growth and stability of sales, cost of capital, cash flow ability, nature and size of the firm, control, flexibility, requirements of investors, and capital market conditions.
Working capital refers to the capital required for financing short-term assets such as cash, inventory, and accounts receivable. It is also known as revolving or circulating capital. There are different types of working capital like gross working capital, net working capital, permanent working capital, and temporary working capital. Management of working capital involves maintaining optimal levels of current assets and current liabilities to ensure sufficient liquidity and an efficient balance between risk and profitability.
The document discusses the cost of capital. It defines cost of capital as the minimum return expected by investors for providing capital to a company. It includes the costs of debt, equity, preference shares, and retained earnings. The weighted average cost of capital takes the costs of different sources of capital weighted by their proportions. Calculating cost of capital is important for capital budgeting and evaluating new projects and investments.
There are several types of dividend policies a company can adopt:
1. A regular dividend policy pays dividends at a usual rate and is preferred by retired investors who need steady income. It requires long-standing, stable earnings.
2. A stable dividend policy aims to consistently pay dividends, through methods like a constant dividend per share, constant payout ratio, or stable low dividend plus extra in high-profit years.
3. An irregular dividend policy is used when earnings are uncertain or the company lacks liquid resources. A no dividend policy may be adopted if working capital is unfavorable or funds are needed for future growth.
This analysis is an important tool used to optimize the capital structure for highest earnings for shareholders
It helps in understanding the sensitivity of EPS at given level of Earning before Interest & Tax under different sources of financing
It helps in analyzing how capital structure decision is important to raise the value of firm
An optimal financing structure minimizes the cost of capital and maximizes the earnings
Earning Per Share under different Capital structure plans
Plan 1 ( Only Equity Shares )
EPS = (EBIT (1−Tax rate))/(No. of Outstanding Shares)
Plan 2 ( Equity Shares & Debt )
EPS = ((EBIT −Interest) (1−Tax rate))/(No. of Outstanding Shares)
Plan 3 (Equity, Debt & Preference Shares)
EPS = ((EBIT −Interest) (1−Tax rate)−Pref. Dividend)/(No. of Outstanding Shares)
Plan 4 (Equity shares & Preference Shares)
EPS = (EBIT (1−Tax rate)−Pref. Dividend)/(No. of Outstanding Shares)
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1. Capitalization refers to the total amount of long-term funds available to a company including share capital, reserves, debentures, and long-term loans.
2. There are two main theories of capitalization - the cost theory which is based on the cost of assets, and the earnings theory which is based on expected earnings and rate of return.
3. Overcapitalization occurs when a company's capital exceeds what is needed based on its earning capacity, resulting in a lower return on capital. Undercapitalization is the opposite, where the capital is too low relative to earning capacity. Maintaining fair capitalization is ideal for a company.
This document provides an overview of capital budgeting. It defines capital budgeting as the planning process used to determine long-term investments worth funding through a firm's capital structure. The document outlines the importance, process, techniques and acceptance criteria for capital budgeting. It describes techniques like payback period, accounting rate of return, net present value and profitability index. The overview emphasizes that capital budgeting decisions require consideration of factors like profitability, risk and cash flows over long time horizons.
The document discusses capital budgeting, which is the process companies use to evaluate long-term investments. It involves identifying potential capital projects, analyzing their expected cash flows, prioritizing projects based on available resources and strategy, and monitoring approved projects. The goals are to increase company value and returns. Key aspects covered include the capital budgeting process, principles, types of projects, and importance of making sound capital budgeting decisions given the large investments, long-term implications, risks, and difficulty of accurately forecasting future cash flows.
This ppt is all about the long term finance for the business. From which sources a business firm used to get their long term finance to run the business. So i hope it will help you to give your presentation . Thanks for the download. And if you find any mistake, please feel free to comment and inform.
or send me a mail in tatinpisa@outlook.com
This document provides an introduction to financial management. It defines financial management as the activity of acquiring funds at minimum cost and utilizing them optimally to generate returns. It discusses the meaning, functions, nature, scope and objectives of financial management. The key objectives of financial management discussed are profit maximization and wealth maximization. The document also outlines arguments for and against each objective.
The document discusses the cost of capital, which is the rate of return a firm requires to increase its market value. It has 3 components: return at zero risk, business risk premium, and financial risk premium. Cost of capital is calculated as the weighted average of the costs of the different sources of financing like equity, debt, preference shares, and retained earnings. Specific costs include the cost of debt, preference shares, equity shares, and retained earnings. The composite cost of capital is the combined cost of all sources. Formulas to calculate the costs of different sources are provided.
This presentation is an overview of Capital Structure Theories.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata
The document discusses various aspects of capital structure including definitions, key terms, theories, and principles. It defines capital structure as the mix of debt and equity used by a company to finance its overall operations and long-term needs. Several theories of capital structure are described, including the net income approach, net operating income approach, and Modigliani & Miller approach. Factors that determine an optimal capital structure are discussed, including costs, risks, flexibility, and control. Formulas for calculating financial break-even point, point of indifference, and capital gearing ratio are provided. Examples are given to illustrate how to apply the concepts.
The document discusses the cost of capital, including its meaning, significance, and methods for determining it. The cost of capital is the minimum expected rate of return required by a firm's investors. It is used to evaluate investment projects and determine the optimal capital structure. There are different types of costs - historical vs future, specific vs composite, explicit vs implicit, and average vs marginal. Determining the accurate cost of capital can be challenging due to conceptual issues around capital structure and difficulties calculating costs like equity and retained earnings.
This document discusses dividend policy and the various theories around it. It defines dividends and discusses Walter's model and Gordon's model, which propose that dividend policy affects firm value. It also covers the irrelevance theories of Modigliani-Miller and the traditional approach, which argue that dividend policy does not impact value. The document provides formulas for the different models and discusses their assumptions and criticisms.
Cost of Capital,Meaning,Computation of Specific Costs,Cost of Debt,Cost of Preference Shares,Cost of Equity Capital,Cost of Retained Earnings ,Weighted Average Cost of Capital
The document discusses capital structure and its theories. It defines capital structure as the proportion of long-term debt and equity used to finance a company's assets. A company's capital structure determines its risk and cost of capital. There are several theories on capital structure including the net income, net operating income, traditional, and Modigliani-Miller approaches. The optimal capital structure balances minimum costs and risks. Factors like tax rates, control, flexibility, and legal requirements influence a company's choice of capital structure.
This document discusses factors that affect a company's capital structure. It defines capital structure as how a firm finances its operations through various sources of funds such as debt, equity, short-term debt, and other financing options. It then lists 14 factors that influence a company's capital structure decisions, including control interests of shareholders, risks, tax considerations, cost of capital, flexibility, investors' attitudes, legal provisions, growth rate, market conditions, profitability, floatation costs, cost of debt, cost of equity capital, and government policies. Maintaining an optimal capital structure is important for balancing business risks and maximizing shareholder value.
The document discusses Modigliani and Miller's approach to capital structure. It states that under their approach, in the absence of taxes, a firm's market value is not affected by its capital structure. It also discusses how when taxes are incorporated, the value of the firm increases and cost of capital decreases with the use of debt due to the deductibility of interest payments. The document provides an example comparing two companies, one with equal proportions of debt and equity and one with more equity than debt, to illustrate this point. It also presents the formulas used in Modigliani and Miller's approach.
The document defines the cost of capital as the minimum required rate of return on invested funds. It discusses how the cost of capital is helpful for capital budgeting and structure decisions. It then outlines the different components of cost of capital - cost of debt, preferred shares, equity shares, and retained earnings. Various formulas are provided for calculating the costs of redeemable and irredeemable debt, preferred shares, and equity shares. The cost of retained earnings is said to equal the cost of equity shares.
Working capital refers to a company's short-term assets and liabilities. There are two main concepts of working capital - gross working capital, which is the total investment in current assets, and net working capital, which is the difference between current assets and current liabilities. A company's working capital requirements are determined by factors like its nature of business, production cycle, and seasonal needs. There are different approaches to financing working capital, including the hedging approach of matching debt maturities to needs, the conservative approach of financing all current assets with long-term debt, and the aggressive approach of relying more on short-term debt.
The document discusses capital structure, which refers to the proportion of debt, preferred stock, and common equity used to finance a company's assets. Capital structure includes long-term debt and stockholder equity. Capitalization refers to the total amount of securities issued, while capital structure refers to the types and proportions of securities. Financial structure includes all financial resources, both short- and long-term. An optimal capital structure maximizes share price and minimizes cost of capital. Factors that determine a company's capital structure include financial leverage, growth and stability of sales, cost of capital, cash flow ability, nature and size of the firm, control, flexibility, requirements of investors, and capital market conditions.
Working capital refers to the capital required for financing short-term assets such as cash, inventory, and accounts receivable. It is also known as revolving or circulating capital. There are different types of working capital like gross working capital, net working capital, permanent working capital, and temporary working capital. Management of working capital involves maintaining optimal levels of current assets and current liabilities to ensure sufficient liquidity and an efficient balance between risk and profitability.
The document discusses the cost of capital. It defines cost of capital as the minimum return expected by investors for providing capital to a company. It includes the costs of debt, equity, preference shares, and retained earnings. The weighted average cost of capital takes the costs of different sources of capital weighted by their proportions. Calculating cost of capital is important for capital budgeting and evaluating new projects and investments.
There are several types of dividend policies a company can adopt:
1. A regular dividend policy pays dividends at a usual rate and is preferred by retired investors who need steady income. It requires long-standing, stable earnings.
2. A stable dividend policy aims to consistently pay dividends, through methods like a constant dividend per share, constant payout ratio, or stable low dividend plus extra in high-profit years.
3. An irregular dividend policy is used when earnings are uncertain or the company lacks liquid resources. A no dividend policy may be adopted if working capital is unfavorable or funds are needed for future growth.
This analysis is an important tool used to optimize the capital structure for highest earnings for shareholders
It helps in understanding the sensitivity of EPS at given level of Earning before Interest & Tax under different sources of financing
It helps in analyzing how capital structure decision is important to raise the value of firm
An optimal financing structure minimizes the cost of capital and maximizes the earnings
Earning Per Share under different Capital structure plans
Plan 1 ( Only Equity Shares )
EPS = (EBIT (1−Tax rate))/(No. of Outstanding Shares)
Plan 2 ( Equity Shares & Debt )
EPS = ((EBIT −Interest) (1−Tax rate))/(No. of Outstanding Shares)
Plan 3 (Equity, Debt & Preference Shares)
EPS = ((EBIT −Interest) (1−Tax rate)−Pref. Dividend)/(No. of Outstanding Shares)
Plan 4 (Equity shares & Preference Shares)
EPS = (EBIT (1−Tax rate)−Pref. Dividend)/(No. of Outstanding Shares)
Thank You For Waching
Subscribe to DevTech Finance
1. Capitalization refers to the total amount of long-term funds available to a company including share capital, reserves, debentures, and long-term loans.
2. There are two main theories of capitalization - the cost theory which is based on the cost of assets, and the earnings theory which is based on expected earnings and rate of return.
3. Overcapitalization occurs when a company's capital exceeds what is needed based on its earning capacity, resulting in a lower return on capital. Undercapitalization is the opposite, where the capital is too low relative to earning capacity. Maintaining fair capitalization is ideal for a company.
This document provides an overview of capital budgeting. It defines capital budgeting as the planning process used to determine long-term investments worth funding through a firm's capital structure. The document outlines the importance, process, techniques and acceptance criteria for capital budgeting. It describes techniques like payback period, accounting rate of return, net present value and profitability index. The overview emphasizes that capital budgeting decisions require consideration of factors like profitability, risk and cash flows over long time horizons.
The document discusses capital budgeting, which is the process companies use to evaluate long-term investments. It involves identifying potential capital projects, analyzing their expected cash flows, prioritizing projects based on available resources and strategy, and monitoring approved projects. The goals are to increase company value and returns. Key aspects covered include the capital budgeting process, principles, types of projects, and importance of making sound capital budgeting decisions given the large investments, long-term implications, risks, and difficulty of accurately forecasting future cash flows.
This ppt is all about the long term finance for the business. From which sources a business firm used to get their long term finance to run the business. So i hope it will help you to give your presentation . Thanks for the download. And if you find any mistake, please feel free to comment and inform.
or send me a mail in tatinpisa@outlook.com
This document provides an introduction to financial management. It defines financial management as the activity of acquiring funds at minimum cost and utilizing them optimally to generate returns. It discusses the meaning, functions, nature, scope and objectives of financial management. The key objectives of financial management discussed are profit maximization and wealth maximization. The document also outlines arguments for and against each objective.
The document discusses the cost of capital, which is the rate of return a firm requires to increase its market value. It has 3 components: return at zero risk, business risk premium, and financial risk premium. Cost of capital is calculated as the weighted average of the costs of the different sources of financing like equity, debt, preference shares, and retained earnings. Specific costs include the cost of debt, preference shares, equity shares, and retained earnings. The composite cost of capital is the combined cost of all sources. Formulas to calculate the costs of different sources are provided.
- Cost of capital is the minimum rate of return that a company must earn on its investments to maintain its value and attract funds. It includes the costs of different sources of financing like equity, debt, and retained earnings.
- Cost of capital is classified as historical vs future, specific vs composite, average vs marginal, and explicit vs implicit. Composite cost is the weighted average cost across all sources.
- Specific costs include cost of debt (interest rate), cost of preference shares (dividend rate), and cost of equity (dividend yield method, CAPM, etc.). Cost of debt and preference shares are explicit while cost of equity can be implicit.
- Calculating cost of equity involves dividend yield
The document discusses the cost of capital and how to calculate it. It defines cost of capital as the rate of return a firm requires to increase its market value. It then discusses:
1) The sources of capital for a firm including debt, equity, preference shares, and retained earnings.
2) How to calculate the weighted average cost of capital (WACC) by determining the costs of each source and weighting them based on proportion of total capital.
3) Methods to calculate the costs of different sources like debt, preference shares, equity, and retained earnings. This includes considering factors like tax rates, issue premiums/discounts, and growth rates.
The document discusses the concept of cost of capital. It provides definitions of cost of capital from various experts that establish it as the minimum rate of return a firm must earn on its investments to maintain its market value. The cost of capital comprises three components: return at zero risk, business risk premium, and financial risk premium. It explains the importance of cost of capital for capital budgeting decisions, capital structure decisions, and evaluating firm performance. It also covers classification of cost of capital, problems in determining it, and methods for computing the cost of debt, cost of preference shares, and weighted average cost of capital.
Cost of Capital and its different types of cost of capitalVadivelM9
The document discusses methods for calculating the cost of capital for a company. It covers calculating the costs of different sources of capital, including debt, preferred stock, and common equity. For common equity, it presents three methods: the dividend growth model, capital asset pricing model (CAPM), and risk premium approach. An example is provided for each method to illustrate how to calculate the cost of internal common equity. The weighted average cost of capital (WACC) formula is also introduced.
The document discusses methods for calculating the weighted average cost of capital (WACC) for a firm. It explains how to calculate the cost of each source of capital, including debt, preferred stock, and common equity. For common equity, it outlines three approaches: the dividend growth model, capital asset pricing model (CAPM), and risk premium model. An example calculation is provided for each capital source. The weighted average cost of capital is the average of the costs of each source weighted by its proportion of the firm's total capital structure.
Cost of capital is the minimum rate of return that a company must earn on its investments to maintain its market value and attract funds. It is used to evaluate investment projects and determine the company's capital structure. Cost of capital can be calculated for specific sources like equity, debt, preference shares, and retained earnings using various methods. The overall cost of capital is the weighted average of the costs of each source based on their proportion in the company's capital structure. It is an important concept in financial management for capital budgeting, valuation, and performance evaluation.
This document discusses the cost of capital, which is the rate of return a firm must earn on investments to maintain its market value and attract funds. It is affected by business risk, financial risk, and after-tax costs. There are four basic sources of long-term capital: long-term debt, preferred stock, common stock, and retained earnings. The cost of each is calculated differently based on factors like interest rates, dividends, and valuation models. The weighted average cost of capital combines the costs of each source based on their relative weights and represents the overall expected cost of funds for a firm.
The document discusses the cost of capital and how to calculate the weighted average cost of capital (WACC) for a firm. It explains the different sources of capital including debt, preferred stock, and common equity. It also discusses how to estimate the costs of each type of capital and calculate WACC, as well as how to adjust the WACC for project-specific risks that differ from the average risk of the firm.
- The cost of capital is the minimum required rate of return for a project given its riskiness, while the firm's cost of capital is the weighted average required return across all projects.
- The cost of capital is used for investment decisions, debt policy design, and evaluating management performance.
- It represents the expected return forgone by investing in a project rather than the next best alternative of similar risk. Various capital sources have different costs depending on their risk.
- The weighted average cost of capital (WACC) is calculated by weighting the costs of different capital sources by their proportion of the total capital structure.
This document discusses the concept of cost of capital, which refers to the rate of return that a company must provide to its investors and lenders. It explains that cost of capital is important for evaluating investment projects and determining a company's optimal capital structure. The document then outlines various methods to measure the cost of different sources of capital, including debt, preferred stock, common equity, and retained earnings. It concludes by defining composite cost of capital as the weighted average of the costs of each source of funds based on their proportion in the capital structure.
This document discusses the calculation of a company's weighted average cost of capital (WACC). It defines WACC as the product of the costs of various sources of finance (debt, equity, preference shares) and their proportions in the capital structure. The document provides examples of calculating WACC using both book values and market values for a company's capital sources. It also outlines different methods for determining the costs of equity, debt, and preference shares. Finally, it lists factors that can affect a company's WACC, including interest rates, market risk premium, tax rates, and internal policies around investment, capital structure, and dividends.
FM CH 4.pptx best presentation for financial managementKalkaye
This chapter discusses the cost of capital, which is the minimum rate of return a firm must earn on its invested capital to maintain its market value. The cost of each source of capital (debt, preferred stock, common stock, retained earnings) is calculated separately as the component or specific cost of capital. The overall cost of capital is the weighted average cost of capital (WACC), which is calculated using either book values or market values of each capital source. The chapter provides examples of calculating the specific cost for each component and the WACC using both book value and market value methods. It also discusses calculating the weighted marginal cost of capital when additional capital is raised from multiple sources.
This document discusses the cost of capital and how to calculate it. It defines cost of capital as the rate of return a firm must earn on its investments to maintain its market value and attract funds. It then discusses how to calculate the costs of different sources of capital including long-term debt, preferred stock, common stock, and retained earnings. It explains how to calculate the weighted average cost of capital (WACC) and discusses weighting schemes. Finally, it discusses how to determine break points and calculate the weighted marginal cost of capital (WMCC), which can be used with the investment opportunities schedule to make financing decisions.
Bba 2204 fin mgt week 9 cost of capitalStephen Ong
This document provides an overview and learning objectives for a lesson on cost of capital. It discusses the different sources of capital available to firms, including long-term debt, preferred stock, and common stock. It provides formulas for calculating the costs of these different sources. Specifically, it covers how to calculate the after-tax cost of debt, the cost of preferred stock, and the cost of common stock using either a constant growth valuation model or the capital asset pricing model (CAPM). It also discusses how to calculate the weighted average cost of capital (WACC), which weights the costs of each source of capital by the firm's target capital structure.
The document discusses the cost of capital and how it is calculated for different sources of financing. It defines cost of capital as the minimum rate of return a firm requires to undertake an investment. It then provides formulas to calculate the cost of various sources including debt, preferred shares, common equity, and retained earnings. It also discusses weighted average cost of capital (WACC), which is a weighted average of the costs of each source of financing used by a company. An example is provided to demonstrate how to calculate WACC.
The document discusses the cost of capital, which is the rate of return a firm must earn on its investments to maintain its market value and attract funds. It defines the key components that make up the cost of capital, including the cost of long-term debt, preferred stock, common stock equity, and retained earnings. It also discusses how to calculate the weighted average cost of capital (WACC) by weighting the cost of each capital component by its proportion in the firm's target capital structure. The document provides examples to demonstrate how to calculate the various costs and the WACC.
Cost of debt (i.e, debentures and long term debt) is defined in terms of the required rate of return that the debt, investment must yield to protect the shareholders interest. Hence, Cost of debt is contractual interest rate, adjusted further for the tax liability of the firm.
Cost of DebtDebentures are issued at par, at a premium and discount. Cost of Redeemable Debt
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2. 4.1 CONCEPT OF COST OF CAPITAL
Cost of capital refers to the minimum rate of return a
firm must earn on its investment, so that the market
value of the company's equity shares does not fall.
“The rate of return, the firm requires from investment
in order to increase the value of the firm in the market
place”. – Hampton,
John. J.
It is not a cost as such. It is really the rate of return that
a firm requires to earn from its project.
3. 4.2 COMPONENTS OF COST OF CAPITAL
Return to zero risk level: This refers to the
expected rate of return when a project involves no
risk.
Premium for business risk: Business risk refers
to the variability in operating profit due to changes
in sales.
Premium for financial risk: Financial risk refers
to the risk on account of higher debt content in
capital structure.
4. 4.3 SIGNIFICANCE OF COST OF CAPITAL
1. Capital Budgeting Decision
Cost of capital is used as the measuring rod for
selecting an investment proposal, out of various
proposals pending before management.
According to discounted cash flow methods of capital
budgeting, if the present value of expected return from
investment is greater than or equal to the cost of
investment, the project may be accepted; otherwise the
project may be rejected. Hence, the concept of cost of
capital is very useful in capital budgeting decision.
5. 2. Designing the Capital Structure
While designing an optimal capital structure, a proper
mix of debt and equity capital, the management has to
keep in mind the objective of maximizing the value of
the firm and minimizing the cost of capital.
3. Decision about the Method of Financing
An efficient financial executive must analyze the rate
of interest on loans and normal dividend rates in the
market form time to time. Then, he may have a better
choice of the source of finance which bears the
minimum cost of capital, whenever the company
requires additional finance.
6. 4. Evaluation of Performance of Top Management
The actual profitability of the project is compared
with projected overall cost of capital and actual cost
of capital of funds raised to finance the project. If the
actual profitability of the project is higher than the
projected, the performance is satisfactory.
5. Other Areas of Decision Making
It is also used in making other financial decisions such
as dividend decisions, working capital management
policies, capital expenditure control, capitalization of
profits and making the right issues.
7. 4.4 DIFFERENT TYPES OF COSTS
1. Explicit Cost and Implicit Cost
The explicit cost is the discount rate that equates the
present value of the cash inflows with that of cash
outflow. In other words, it is the internal rate of return.
The implicit cost is also known as opportunity cost or
cost of retained earnings. It is the rate of return
associated with the best investment opportunity of its
shareholders, that will be foregone if the project
presently under consideration by the firm were
accepted.
8. 2. Specific Cost and Composite Cost
Specific cost refers to the cost of a specific source of capital.
Example: Interest is the specific cost of Bond and Dividend
is the specific cost of Preferred Capital. Composite cost is
the combined cost of various sources of capital. (i.e., the
total of equity shares, preference shares, bonds, loans
etc.,) It is also called overall cost of capital.
3. Historical cost and Future cost
Historical cost is the cost which is calculated on the basis
of existing capital structure.
9. Future cost refers to expected cost of funds to finance
the expected project.
4. Average cost and Marginal cost
Average cost is the weighted average cost of the
various sources of finance.
Marginal cost refers to average cost of capital which
has to be incurred to obtain additional funds required
by a firm.
10. 4.5 DETERMINANT OF COMPONENTS COST OF
CAPITAL
1. Cost of Debt
According to Weston and Brigham, the cost of debt is defined
as “the rate of return that must be earned on debt-finance
investment in order to keep unchanged the earnings available to
equity share holders”. Thus it is required rate of return that the
debt investment yield to protect the shareholders interest.
Computing Cost of Debt:
i) Debt issued at Par: Cost of debt is the rate of interest payable
on debt.
Kdb = I / P
Where, Kdb – Cost of debt before tax; P – Par value of
debentures; I – Interest;
11. ii) Debt issued at Premium or Discount: If the bonds are
issued at premium or discount, the cost debt will not be
equal to the coupon rate of interest as adjusted by the
company’s rate of tax. Hence it should be calculated on
the basis of net proceeds realized on account of such
issues.
Kdb = I / NP
Where, Kdb – Cost of debt before tax; NP – Net proceeds
of debentures; I – Interest;
Kda = Kdb(1-T) = (I / NP) * (1-T)
Where, Kda – Cost of debt after tax; Kdb – Cost of debt
before tax; NP – Net proceeds of debentures; I – Interest;
12. iii) Cost of Debt Redeemable at Par: If the bonds are redeemable after
the expiry of fixed period the effective cost of debt after tax can be
calculated.
Kda = {[I + (P-NP)/n] / [(P+NP)/2]}*(1-T)
Where, Kda – Cost of debt after tax; NP – Net proceeds; P = Par value
of debentures; I – Interest; T – Tax; n = Number of years to maturity;
iv) Cost of Debt Redeemable at Premium: If the bonds are
redeemable at premium after the expiry of fixed period the effective
cost of debt after tax can be calculated.
Kda = [I + (RV-NP)/n] / [(RV+NP)/2]
Where, Kda – Cost of debt after tax; NP – Net proceeds; RV -
Redeemable value of debentures; I – Interest; n = Number of years to
maturity;
13. Example:1
A company issues 10% irredeemable debentures of
Br 100,000. The company is in the 55% tax bracket.
Calculate the cost of debt before tax if the debentures
are issued at i) par ii) 10% discount iii) 10%
premium.
Solution:
i) Issued at Par
Kdb = I / NP = 10,000 / 100,000 = 0.1 or 10%
I = 100,000 * 10% = 10,000
ii) Issued at discount (10%)
I = 100,000 * 10% = 10,000
NP = 100,000 – (100,000*10%) = 90,000
Kdb = I / NP = 10,000 / 90,000 = 0.111 or 11.1%
14. iii) Issued at premium (10%)
I = 100,000 * 10% = 10,000
NP = 100,000 + (100,000*10%) = 110,000
Kdb = I / NP = 10,000 / 110,000 = 0.0909 or 9.09%
Example:2
A ltd. Issues Br 50,000 8% debentures. The tax rate
applicable to the company is 50%. Compute the cost of
debt capital if the debentures are issued at i) par ii) 5%
discount iii) 10% premium.
Solution:
i) Issued at Par
NP = 50,000; I = 50,000* 8% = 4000; Tax = 50% or .50;
Kda = (I / NP) * (1-T) = (4000 / 50000) * (1-0.50) = 0.04 or 4%
15. ii) Issued at discount (5%)
NP = 50,000 – (50,000*5%) = 47,500;
I = 50,000* 8% = 4000; Tax = 50% or .50;
Kda = (I / NP) * (1-T) = (4000 / 47,500) * (1-0.50)
= 0.0421 or 4.21%
iii) Issued at premium (10%)
NP = 50,000 + (50,000*10%) = 55,000;
I = 50,000* 8% = 4000; Tax = 50% or .50;
Kda = (4000 / 55,000) * (1-0.50) = 0.0363 or 3.63%
16. Example:3
D Ltd. Issues Br 100,000 9% debentures at a
premium of 10%. The costs of floatation are 2%. The
tax rate applicable is 60%. Compute cost of debt
capital.
Solution:
NP = 100,000 + (100,000*10%) = 110,000;
NP with cost floatation = 110,000 – (110,000 * 2%)
= 107,800
Tax = 0.60; I = 100,000 * 9% = 9000
Kda = (I / NP) * (1-T) = (9000 / 107,800) * (1-0.60)
= 0.0334 or 3.34%
17. Example:4
A company issues Br 1,000,000, 10% redeemable
debentures at a discount of 5%. The costs of
floatation amount to Br. 30,000. The debentures are
redeemable after 5 years. Calculate before-tax and
after-tax cost of debt assuming a tax rate of 50%.
Solution:
Kdb = [I + (P-NP)/n] / [(P+NP)/2]
I = 1,000,000 * 10% = 100,000; P= 1,000,000;
NP = 1,000,000 – (1,000,000 *5%) – 30,000 = 920,000;
Kdb= [100,000 + (1,000,000 – 920,000)/5]
(1,000,000+920,000)/2
= 116,000 / 960,000 = 0.1208 or 12.08%
Kda = Kdb(1-T) = 12.08(1-0.50) = 6.04%
18. 2. Cost of Preference Capital
A fixed rate of dividend is payable on preference
shares. The rate of dividend is fixed at the time of
issue. The cost of preference capital is a function of
dividend expected by its investors.
i) Cost of preference capital issued at par
Kp = Dp/ P
Where, Kp – Cost of preference capital;
P – Par value of preference capital;
Dp – Annual preference dividend;
19. ii) Cost of preference capital issued at premium or discount
Kp = Dp / NP
Where, Kp – Cost of preference capital; NP – Net proceeds of
preference capital; Dp – Annual preference dividend;
iii) Cost of redeemable preference shares
Kpr = [Dp + (MV-NP)/n] / [(MV+NP)/2]
Where, Kpr – Cost of redeemable preference shares;
NP – Net proceeds; MV - Maturity value of preference shares;
Dp – Annual preference dividend;
n = Number of years in which preference shares to be
redeemed;
20. Example:5
A company raises the capital of Br 100,000 by issuing
10000 preference share of Br 10 each. The dividend rate
on the preference share is 10%. Calculate the cost of
preference share when 1. Preference share are issued at
par 2. Preference shares are issued at 10% premium 3.
Preference share are issued at 10% discount.
Solution:
i) Issued at par
Dp= 100,000 * 10% = 10,000;P = 100,000
Kp = Dp/ P = 10,000 / 100,000 = 0.1 or 10%
ii) Issued at 10% premium
NP = 100,000 + (100,000*10%) = 110,000;
Dp= 100,000 * 10% = 10,000
Kp = Dp/ NP = 10,000 / 110,000 = 0.09 or 9%
21. ii) Issued at 10% discount
NP = 100,000 - (100,000*10%) = 90,000;
Dp= 100,000 * 10% = 10,000
Kp = Dp/ NP = 10,000 / 90,000 = 0.111 or 11.1%
Example:6
A firm has issued preference share of Br 100 each
generating a proceed of Br 100,000. The dividend rate is
14%.The Preference shares will be redeemed after 10
years. Floatation cost is about 5%.Determine the cost of
preference share.
Solution:
Dp= 100,000 * 14% = 14,000; MV = 100,000;
NP = 100,000 – (100,000 *5%) = 95,000; n= 10
Kpr = [Dp+ (MV-NP)/n] / [(MV+NP)/2]
Kpr= [14,000 + (100,000 – 95,000)/10] = 0.1487 or 14.87%
22. 3. Cost of Equity Capital
1. It is not the out of pocket cost of using equity
capital, as the equity shareholders are not paid
dividend at a fixed rate every year.
2. Moreover payment of dividend is not a legally
binding on the part of the company.
3. The equity shareholders invest their funds in
shares with the expectation of getting dividend from
the company.
4. Therefore equity shares carry a cost which is
highest among all the sources of funds as they
involve highest degree of risk.
23. i) Dividend Yield or Dividend Price Approach: The cost of equity share is
calculated on the basis of required rate of return in terms of future
dividends to be paid on equity shares for maintaining their present market
price.
Ke = D/ NP (or) D / MP
Where, Ke – Cost of equity capital; NP – Net proceeds per share;
D – Expected dividend per share; MP – Market price per share;
ii) Dividend Yield plus Growth in Dividend Approach: The cost of equity
share capital is calculated on the basis of expected dividend rate plus rate
of growth in dividend.
Ke = (D/ NP) + g (or) (D / MP) + g
Where, Ke – Cost of equity capital; NP – Net proceeds per share;
D – Expected dividend per share; MP – Market price per share;
g – Expected rate of growth in dividend;
24. iii) Earning Price Approach: The cost of equity share capital is
equal to the rate which must be earned on incremental issue of
equity shares so as to maintain the present value of investment
intact.
Ke = EPS/ NP (or) EPS / MP
EPS = Total earnings / Number of shares outstanding
Where, Ke – Cost of equity capital; NP – Net proceeds per share;
EPS – Earnings per share; MP – Market price per share;
iv) Realized Yield Approach: The cost of equity share capital is
calculated on the basis of past records of dividends actually
realised by the equity shareholders which is discounted at the
present value factor and then compare with the value of
investment.
25. Example:7
A company offers for public subscription the shares of Br 10 at a
premium of 10%.The commission cost for the company is 5%. The
dividend rate is 20%. Calculate the cost of equity.
Solution:
D= 10*20% = 2; NP = 10 + 10*10% = 10+1 =11
NP = 11- (5% of 11) = 10.45
Ke = D/ NP = 2 / 10.45 = 0.1914 or 19.14%
Example:8
A company s share of face value Br 10,has a market value of Br
15. The expected dividend to be paid is 20% of the face value.
Calculate the cost of equity.
Solution:
D= 10*20% = 2; MP = 15
Ke = D/ MP = 2 / 15 = 0.1333 or 13.33%
26. Example:9
A company's share has a market price of Br 20.
The company pays a dividend of Br 1 per share.
The shareholders expect a growth rate of 5%
per year. Calculate the cost of equity.
Solution:
D= 1; MP = 20; g =5%
Ke = (D/ MP ) +g = (1 / 20) + 0.05 = 0.10 or 10%
27. 4. Cost of Retained earnings
Retained earnings are the accumulated amount of
undistributed profits belonging to the equity shareholders. It
provides a major source of financing expansion and
diversification projects.
If these were distributed to the shareholders, they would have
reinvested them in the same company by purchasing its equity
and earn on these additional shares the same rate of return as
they are earning on their existing shares. Thus the cost of
retained earnings is the same as the cost of equity capital.
28. Cost of Retained earnings
Kr = Ke (1-T) (1-B)
Where, Kr – Required rate of return on retained earnings;
Ke- Shareholders required rate of return;
T - Shareholders marginal tax rate;
B – Brokerage cost;
Example:10
Calculate the cost of retained earnings. Current market price of a
share Birr 140. Cost of floatation/brokerage per share 3% on
market price. Growth in expected dividends 5%. Expected
dividend per share on new shares Birr 14. Shareholders
marginal/personal tax rate 30%.
Solution:
D= 14; MP = 140; g =5%
Ke = (D/ MP ) +g = (14 / 140) + 0.05 = 0.15 or 15%
Kr = Ke (1-T) (1-B) = 15% (1-0.30) (1-0.03) =10.19%
29. 5. Weighted average cost of capital
Weighted average is an average of the costs of specific source
of capital employed in a business, properly weighted by the
proportion, they hold in the firms capital structure.
As against the simple average, weighted average is useful due
to the fact that the proportion of various sources of funds in the
capital structure of a firm is different.
A) Advantages of Weighted Average Cost of Capital
In financial decision making the weighted average cost of
capital is more relevant.
The average cost of capital provides one single figure which
may be used as discount factor in computing the discounted
cash inflows of the future stream of earnings.
30. B) Disadvantages of Weighted Average Cost of Capital
The cost raising funds are independent to the value funds
raised.
It is presumed that the present cost of the various sources of
funds would remain the same in future also. Which is not
true in actual practical life.
The specific costs are based upon the existing capital
structure and these will change when additional funds have
been raised.
If the growth of the company are being changed, there will
be a change in the weighted average cost of capital.
Where there is a change in capital structure involving a
change in debt-equity mix. There will be a change in the
weighted average cost of capital.
31. Example:11
A firm’s after tax cost of capital of the specific sources is
as follows: Cost of debt – 4.77%; Cost of preference
shares – 10.53%; Cost of Equity capital – 14.59%; Cost
of retained earnings – 14.00%.
The following is the capital structure: Debt Br 300,000;
Preference capital Br 200,000; Equity capital Br
400,000; Retained earnings Br 100,000; Total Br
1,000,000.
Calculate the weighted average cost of capital using
book value weights (Proportion method).
32. Solution:
Computation of weighted average of cost of capital
(Book Value Weights)
Weighted average cost of capital = 0.1077 *100 =
10.77%
Sources of
funds
Amount Proportion Specific
after
tax cost
Weighte
d cost
Debt
Preference Capital
Equity capital
Retained earnings
300,000
200,000
400,000
100,000
(300,000/1,000,000)*100 = 30%
(200,000/1,000,000)*100 = 20%
(400,000/1,000,000)*100 = 40%
(100,000/1,000,000)*100 = 10%
0.30
0.20
0.40
0.10
0.0477
0.1053
0.1459
0.1400
0.0143
0.0210
0.0584
0.0140
Total 1,000,000 0.1077
33. Example:12
From the following information capital structure of a
company, calculate the overall cost of capital (Total cost
method) using a) book value weights and b) market
value weights
The after tax cost of different sources of finance is as
follows: Equity share capital – 14%; Retained earnings –
13%; Preference share capital – 10%; Debentures – 5%.
Sources Book Value Market value
Equity share capital (Br 10 shares) Br 45,000 Br 90,000
Retained earnings 15,000
Preference capital 10,000 10,000
Debentures 30,000 30,000
34. Solution:
Computation of weighted average of cost of capital
(Book Value Weights)
Weighted average cost of capital
=(10,750/100,000)*100
= 10.75%
Sources of funds Amount Specifi
c after
tax
cost
Total after tax
cost
Equity capital
Retained earnings
Preference Capital
Debentures
45,000
15,000
10,000
30,000
14%
13%
10%
5%
45,000*14%=
6300
15,000*13%=1950
10,000*10%=1000
30,000*5% = 1500
Total 100,000 10,750
35. Computation of weighted average of cost of capital
(Market Value Weights)
Weighted average cost of capital
=(15,100/130,000)*100
= 11.62%
Sources of funds Amount Specific
after tax
cost
Total after tax
cost
Equity capital
Preference Capital
Debentures
90,000
10,000
30,000
14%
10%
5%
90,000*14%= 12600
10,000*10%=1000
30,000*5% = 1500
Total 130,000 15,100
36. 4.6 MARGINAL COST OF CAPITAL
Cost of capital plays important roles in financial
analysis and asset valuation. A chief use of the marginal
cost of capital estimate is in capital-budgeting decision
making.
A way of determining the cost of obtaining just one
more dollar of capital.
The marginal cost will vary according to the type of
capital used. For example, raising funds through the use
of unsecured or subordinated debt, or
through debt that requires higher interest
rates to offset risk, will be more expensive than debt
that is backed by collateral, such as a secured bond.
37. A company's marginal cost of capital (MCC) may
increase as additional capital is raised, whereas
returns to a company's investment opportunities are
generally believed to decrease as the company
makes additional investments, as represented by the
investment opportunity schedule (IOS).
For an average-risk project, the opportunity cost of
capital is the company's WACC.
38. The following graph demonstrate the relationship
between cost of capital and investment returns.
39. The WACC or MCC corresponding to the average risk of
the company, adjusted appropriately for the risk of a given
project.
It plays a role in capital budgeting decision making based
on the net present value (NPV) of that project.
It is the difference between the present value of the cash
inflows, discounted at the opportunity cost of capital
applicable to the specific project, and the present value of
the cash outflows, discounted using that same opportunity
cost of capital.
NPV =Present value of inflows - Present value of outflows
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