2. CONTENT
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1. Introduction to cost of capital
2. Significance of cost of capital
3. Cost of debt
4. Cost of equity
5. DGM and CAPM model
6. WACC
7. Example and uses of WACC
8. WACE
9. Cost of equity versus cost of debt
10. conclusion
3. INTRODUCTION
• The cost of capital is the cost of using funds of
creditors and owners.
• The cost of capital is the rate of return that the
suppliers of capital-bondholders and owners-
requires as a compensation of their contributions of
capital.
• Two ways in which company can raise capital:
1.Equity
2.Debt
4. Significance Of Cost Of Capital
1. Making Investment Decision
2. Designing Capital structure
3. Evaluating The Performance
4. Formulating Dividend Policy
5. COST OF DEBT
• Cost of debt is one part of a company's capital
structure, which also includes the cost of equity.
The measure can also give investors an idea of
the riskiness of the company compared to others,
because riskier companies generally have a
higher cost of debt.
• Cost of debt refers to the effective rate a company
pays on its current debt. In most cases, this
phrase refers to after-tax cost of debt, but it also
refers to a company's cost of debt before taking
taxes into account.
6. COST OF EQUITY
• The cost of equity is the return a company requires to
decide if an investment meets capital return requirements;
it is often used as capital budgeting threshold for required
rate of return.
• A firm's cost of equity represents the compensation the
market demands in exchange for owning the asset and
bearing the risk of ownership. The traditional formulas for
cost of equity(COE) are the dividend capitalization model
and the capital asset pricing model.
cost of equity=dividend per share(for next year)/current
value of stock +growth rate of dividend
7. Cost of Equity Models and Theory
• The dividend growth model is also known as the Dividend
discount model, the Dividend valuation model or the Gordon
growth model.
• The model is named in the 1960s after Professor Myron J.
Gordon.
• The dividend growth model is used to calculate the cost of
equity, but it requires that a company pays dividends. The
calculation is based on future dividends.
• This method is used for calculating the intrinsic value of a
stock, exclusive of current market conditions. The model
equates this value to the present value of a stock's future
dividends.
8. The DGM is commonly expressed as a formula
in two different forms:
• Ke = (D1 / P0) + g
or (rearranging the formula)
• P0 = D1 / (Ke - g)
Where:
• P0 = current market value of equity per period.
• D1 = expected future dividend at Time 1 period later.
• Ke = cost of equity per period.
• g = constant periodic rate of growth in dividend from
Time 1 to infinity.
9. Example : Cost of equity
• D1 = expected future dividend at Time 1 = $10m.
• P0 = current market value of equity per period = $125m.
• g = constant periodic rate of growth in dividend from Time 1
to infinity = 2%.
Ke = (D1 / P0) + g
= (10 / 125) + 2%
= 8% + 2%
= 10%.
10. FORMS OF GORDON GROWTH MODEL
• Stable Model
Value of stock = D1/ (k - g)
• Multistage Growth Model
When dividends are not expected to grow at a
constant rate, the investor must evaluate each year's
dividends separately, incorporating each year's
expected dividend growth rate. However, the
multistage growth model does assume that dividend
growth eventually becomes constant. See the example
below.
11. CAPM Formula
• The capital asset pricing model (CAPM) is used to calculate
the required rate of return for any risky asset.
• As an analyst, you could use CAPM to decide what price you
should pay for a particular stock. If Stock A is riskier than
Stock B, the price of Stock A should be lower to compensate
investors for taking on the increased risk.
The CAPM formula is:
Cost of Equity = Risk-Free Rate of Return + Beta * (Market
Rate of Return - Risk-Free Rate of Return).
12. Cont.
• Risk-free Rate of Return – This is the return of a security that
has no default risk, no volatility, and beta of zero. Ten-year
government bond is typically taken as risk-free rate
• Beta- is a statistical measure percentage of the variability of a
company’s stock price in relation to the stock market overall.
So if the company has high beta, that means the company has
more risk and thus, the company needs to pay more to attract
investors. Simply put, that means more cost of equity.
• Risk Premium (Market Rate of Return – Risk Free Rate) – It
measure of the return that equity investors demand over a
risk-free rate in order to compensate them for the
volatility/risk of an investment which matches the volatility of
the entire market. Risk premium estimates vary from 4.0% to
7.0%
13. Example
• Assume the following for Asset XYZ:
• rrf = 3%
rm = 10%
Ba = 0.75
• By using CAPM, we calculate that you should
demand the following rate of return to invest in
Asset XYZ: ra = 0.03 + [0.75 * (0.10 - 0.03)] =
0.0825 = 8.25%
14. WEIGHTED AVERAGE COST OF CAPITAL
WACC is the average after-tax cost of a company’s various
capital sources, including common stock, preferred stock,
bonds, and any other long-term debt.
WACC is calculated by multiplying the cost of each capital
source (debt and equity) by its relevant weight, and then
adding the products together to determine the WACC value:
15. Example
• Equity = $8,000
• Debt = $2,000
• Re = 12.5%
• Rd = 6%
• Tax rate = 30%
• To find WACC, enter the values into the equation and solve:
• WACC =[( * 0.125)] + [( * 0.06 * (1 - 0.3)]
• WACC = 0.1 + .0084 = 0.1084 or 10.84%; the WACC for this firm
then is 10.84%.
16. USES OF WACC
• assessing the value of investments.
• an indicator of whether or not an investment is
worth pursuing.
• can serve as a useful reality check for investors.
17. WEIGHTED AVERAGE COST OF EQUITY
• WACE is a way to calculate the cost of a company's equity that gives
different weight to different aspects of the equities. Instead of lumping
retained earnings, common stock and preferred stock together, WACE
provides a more accurate idea of a company's total cost of equity.
example of how to calculate WACE:
• First, calculate the cost of new common stock, the cost of preferred stock
and the cost of retained earnings. Let's assume we have already done this
and the cost of common stock, preferred stock and retained earnings are
24%, 10% and 20% respectively.
Now, calculate the portion of total equity that is occupied by each form of
equity. Again, let's assume this is 50%, 25% and 25%, for common stock,
preferred stock and retained earnings, respectively.
Finally, multiply the cost of each form of equity by its respective portion of
total equity, and sum of the values to get WACE. Our example results in a
WACE of 19.5%.
WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5%
18. Limitations of Cost of Equity
• In the case of Gordon growth model
the growth rate can not always be estimated by the
investor. The investor only can estimate what the
dividend appreciation was in the previous year (if
any) and then can assume that the growth would be
similar in the next year.
• In the case of CAPM
1. Risk free rate
2. Return on equity
19. Cost of Equity versus Cost of Debt
• Meaning- Cost of Equity is the rate of return expected by
shareholders for their investment. Cost of Debt is the rate
of return expected by bondholders for their investment.
• Tax- Cost of Equity does not pay interest, thus it is not
tax deductible. Tax saving is available on Cost of Debt
due to interest payments.
• Calculation- Cost of Equity is calculated as rf + βa (rm–
rf). Cost of Debt is calculated r (D)*(1 – t).
20. CONCLUSION
• Capital can be raised through equity and debt.
• A firm's cost of equity represents the compensation
the market demands in exchange for owning the
asset and bearing the risk of ownership.
• CAPM model, Weighted average cost of equity and
dividend growth model is useful for calculating cost
of equity.
