Basics of IBF with example

1. INTRODUCTIO
N
TO
BUSINESS
FINANCE
BY: HADIQA MURTAZA

2. Topics to be cover:
COST OF EQUITY
COST OF DEBT
WACC (Weighted Average Cost of Capital)

3. COST OF EQUITY:
 Cost of equity refers to a shareholder's
required rate of return on an equity investment.
 It is the rate of return that could have been earned by
putting the same money into a different investment
with equal risk.

4. TWO WAYS:
In general, there are two ways to determine cost of equity.
1. Dividend Valuation Model.
2. Capital Asset Pricing Model (CAPM).

5. DIVIDEND VALUATION MODEL:
First is the dividend valuation model:
 Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) +
Dividend Growth Rate.
Where:
• Ke= cost of equity.
• D1= dividend expected one year hence.
where, D1= Do(1+g)
• Do= last paid dividend.
• Po= price of common stock.
• g= growth rate.

6. Example:
 FOR HADI’S COMPANY
Current market price, Po= $10
Expected Dividend, D1= $0.5 per share
Dividend growth rate, g = 5% per year
Compute cost of equity, Ke=
SOLUTION:
 Ke=(D1/P0 +g)*100
 Ke= (0.5/10 +0.05)*100
Answer: Ke=10%

7. CAPITAL ASSET PRICING MODEL
(CAPM).
 Second is the Capital Asset Pricing Model (CAPM):
Where:
• Rf = Risk free interest rate.
• Be = Equity beta.
• Rm = the market's overall expected rate of return.
• Ke = cost of equity.

8. Example:
 FOR ZUBI’S COMPANY:
 Let's assume the following for Company:
Risk free interest rate, Rf= 3%
Equity Beta, Be=$1.0
Average Market rate of return, Rm= 12%
SOLUTION:
Ke = Rf + Be (Rm-Rf)
Ke = 3% + 1.0*(12% - 3%)
Answer : Ke = 12%

9. COST OF DEBT:
 Cost of debt is the interest a company pays on its
borrowings. It is expressed as a percentage rate.
 cost of debt can be calculated as a before-tax rate or an
after-tax rate.
 Because interest is deductible for income taxes, the cost of
debt is usually expressed as an after-tax rate.

10. EXAMPLE: COST OF DEBT AFTER
TAX
 FOR ZAC’S COMPANY:
CURRENT MARKET VALUE= $95
INTEREST RATE = 12%
PAR VALUE OF BOND,Redemption = $100
MATURITY= 8 YRS

11. Example: COST OF DEBT AFTER
TAX
FOR ZAC’S COMPANY:
Items Cashflow Years D.F@10% Dcf Df@7% Dcf
Current market value ($95) 0 1 ($95) 1 ($95)
Interest $12 1-8 5.332 44.78 5.967 50.1
Redemption $100 8 0.466 46.6 0.5282 52.8
-3.6 +7.92

12. COST OF DEBT AFTER TAX:
Where a=7% ,b=10%, A= 7.92 and B= 3.6
SOLUTION:
 Kd(1-t)=[a+A/A+B (b-a)]
Kd(1-t)=[7+7.92/7.92+3.6 (10-7)]
Kd(1-t)=[7+7.92/11.52 (3)]
Answer: Kd(1-t)= 9.06%

13. WACC (Weighted Average Cost Of Capital)
 “The weighted average cost of capital (WACC) is the rate
that a company is expected to pay on average to all its
security holders to finance its assets”.
 The WACC represents the minimum return that a company
must earn on an existing asset base to satisfy its creditors,
owners, and other providers of capital, or they will invest
elsewhere.

14. TWO COMPONENTS:
 There are two major components :
 Debt.
 Equity.

15. FORMULA:
 Where,
 D = market value of Debt
 E = market value of Equity
 Kd = cost of debt
 Ke = cost of equity
 t = corporate tax rate

16. EXAMPLE: WACC
FOR SHAN’S COMPANY:
Kd(1+t)= 6.90%
D= 1650
E= 9600
Ke=18.4%
WACC=?
SOLUTION:
WACC= Kd(1-t)* D/E+D + Ke* E/E+D
WACC= 6.90 * 1650/9600+1650 +18.4* 9600/9600+1650
ANSWER: WACC= 16.7%

17. WHY COMPANY CONSIDER WACC?
Companies can use WACC to see if the
investment projects available to them are
worthwhile to undertake.