May. 29, 2023•0 likes•4 views

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Business

Financial management course

- 1. 11/17/2022 Cost of Capital Financial management and control systems (Lecture 2) Dr. Mahmoud Otaify Assistant Professor of Finance 2 LO1 Understand the basic concept of cost of capital LO2 Determine a firm’s cost of equity capital. LO3 Determine the cost of long-term debt LO4 Calculate the weighted average cost of capital (WACC) Dr. Mahmoud Otaify - FMCS: Cost of Capital 1 2
- 2. 11/17/2022 3 Weight Amount $ Source E/V=600,000/1000,000=0.6 600,000 Common Stocks (E) P/V=150,000/1000,000=0.15 150,000 Preferred Stock (P) D/V=250,000/1000,000=0.25 250,000 Bonds (D) 1 1,000,000 Total value of capital structure (V=E+P+D) How Much? % Symbol Cost of Capital SML RE Cost of Equity DDM RP Cost of Preferred YTM RD Pre-tax cost of Debt Dr. Mahmoud Otaify - FMCS: Cost of Capital Owners + Creditors Require rate of return Company Use funds to receive more than cost of funds Dr. Mahmoud Otaify - FMCS: Cost of Capital 4 3 4
- 3. 11/17/2022 Debt Financing • If you want to finance project from banks and bank requires 10% as interest (return), the cost of debt capital is 10% • Firm must earn at least 10% to pay the interest payment. Equity Financing • If you want to finance project from capital market and investors require 8% return, the cost of equity capital is 8%. • Firm must earn at least 8% to compensate investors for the use of the capital needed to finance the project. Cost of Debt Capital • The return that lenders require on the firm's debt. Cost of Equity Capital • The return that equity investors require on their investment in the firm. 5 Dr. Mahmoud Otaify - FMCS: Cost of Capital 5 6
- 4. 11/17/2022 Expected return on the market – risk-free rate of return Dr. Mahmoud Otaify - FMCS: Cost of Capital 7 E(RM) = 17% RF=12% Beta = 1.2 RE=? RE = 12%+ (17% - 12%) = 17% RE = 12%+ 1.2*(17% - 12%) = 18% E(RM) – RF = 17 – 12 = 5% CAPM Dr. Mahmoud Otaify - FMCS: Cost of Capital 8 7 8
- 5. 11/17/2022 Cost of Common Stock (SML) 9 Compute cost of equity using the SML Risk-free rate, Rf Market risk premium, E(RM) – Rf Systematic risk of asset, ) ) ( ( f M E f E R R E R R Example: Company’s equity beta = 1.2 Current risk-free rate = 7% Expected market risk premium = 6% What is the cost of equity capital? % 2 . 14 ) 6 ( 2 . 1 7 RE Dr. Mahmoud Otaify - FMCS: Cost of Capital 9 10
- 6. 11/17/2022 Cost of Preferred Stocks (Rp) 11 Reminders Preference shares generally pay a constant dividend every period. Dividends are expected to be paid every period forever. Preference share valuation is an annuity, so we take the annuity formula, rearrange and solve for RP. RP = D/P0 Example Your company has preference shares that have an annual dividend of $3. If the current price is $25, what is the cost of a preference share? RP = 3 / 25 = 12% Dr. Mahmoud Otaify - FMCS: Cost of Capital 11 12
- 7. 11/17/2022 Risk- free rate Credit Risk Premiu m Required Return by Bondholders A bond’s rating is used to indicate its relative probability of default Yield on Treasury Securities Dr. Mahmoud Otaify - FMCS: Cost of Capital 13 Dr. Mahmoud Otaify - FMCS: Cost of Capital 14 The cost of debt = the required return on a company’s debt. Compute the yield to maturity on existing Bond 𝒀𝑻𝑴 = 𝑪𝒐𝒖𝒑𝒐𝒏 + 𝑭𝑽 − 𝑩𝑽 𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝑭𝑽 + 𝑩𝑽 𝟐 13 14
- 8. 11/17/2022 Cost of Debt (Example) Dr. Mahmoud Otaify - FMCS: Cost of Capital 15 Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt? Tax rate = 40% Coupon = 1000*0.09 = 90 Semiannual coupon = 90/2 = 45 𝒀𝑻𝑴 = 𝟏𝟎𝟎 𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐 𝟐𝟓 𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐 𝟐 = 10% Annual pretax cost = 5*2 = 10% After-tax cost of Debt = RD (1- TC) = 10 x (1 – 0.4 ) = 6% 15 16
- 9. 11/17/2022 Source Amount Weight Cost Equity (E) 600,000 60% 14.2% Preferred (P) 150,000 15% 12% Debt (D) 250,000 25% 10% Capital (V) 1,000,000 Tax Rate 40% WACC WACC= E/V*RE + P/V*RP + D/V*RD(- TC) =0.6*14.2 + 0.15*12 + 0.25*10(1-0.4) = 17 17