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# Understanding the cost of capital

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### Understanding the cost of capital

1. 1. Understanding the Cost of Capital<br />www.HelpWithAssignment.com<br />
2. 2. The Cost of Capital is defined as the rate of return that a company must offer on its securities in order to maintain its market value. <br />Cost of Capital<br />www.HelpWithAssignment.com<br />
3. 3. Financial managers must know the cost of capital in order to <br />Make capital budgeting decisions, <br />Help establish the optimal capital structure and <br />Make decisions concerning leasing, bond refunding and working capital management.<br />Cost of Capital<br />www.HelpWithAssignment.com<br />
4. 4. The cost of capital is computed as a weighted average of the various capital components, items on the right hand side of the balance sheet such as debt, preferred stock, common stock and retained earnings.<br />Cost of Capital<br />www.HelpWithAssignment.com<br />
5. 5. Each element of capital has a component cost that is identified by the following:<br />ki = before tax cost of debt<br />k­d = ki (1-t) = after tax cost of debt, where t = tax rate<br />kp = cost of preferred stock<br />Weighted Average Cost of Capital<br />www.HelpWithAssignment.com<br />
6. 6. ks = cost of retained earnings (or internal equity)<br />ke = cost of external equity, or cost of issuing new common stock<br />ko = company’s overall cost of capital , or a weighted average cost of capital<br />The after tax weighted average cost of capital (WACC) is given by the following formula:<br />WACC = ka = ke = (S/V) + kd (1-t) (D/V)<br />Weighted Average Cost of Capital<br />www.HelpWithAssignment.com<br />
7. 7. An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
8. 8. Formula for Cost of Capital<br />www.HelpWithAssignment.com<br />
9. 9. Suppose this firm faces a corporate tax rate of 40%, has variable expenses equal to 30% of sales, and has fixed costs of \$158. <br />Working back from these requirements we can forecast the level of sales the firm must earn in order to achieve these operating results…thereby setting a sales performance target for management. <br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
10. 10. Working backwards, we get:<br />Sales X<br />Variable Costs 0.3X<br />Fixed Costs 158<br />EBIT <br />Interest 42<br />Taxes (40%)<br />Net Income: 300<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
11. 11. If sales = X, then VC = .3X and X - .3X – 158 = EBIT<br />(EBIT – I)(1-T) = NI so (EBIT – 42)(1-.4) = 300 => EBIT = 542 which => X = 1000, and so VC = 300 and also Taxes = (542-42)(.4) = 200, so:<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
12. 12. Sales 1000<br />Variable costs 300<br />Fixed costs 158<br />EBIT 542<br />Interest 42<br />Taxes (40%) 200<br />Net Income: 300<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
13. 13. This working backwards process is the approach taken by regulators to set pricing for rate of return regulated industries, like utilities. So cost of capital drives utility rate increases!<br />Assuming earnings are a perpetuity, we have<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
14. 14. P = EPS/Ke = ROE* BVPS/Ke<br />Firm ABC has:<br />Debt D of 8% annual coupon bonds with 10 years to maturity and book value of \$1 m.<br />Preferred shares P with 10% annual dividend and book value of \$1 m.<br />100,000 Common shares originally issued at \$15/share for a value of \$1.5 m.<br />Retained earnings of \$0.5<br />Total of \$4 m.<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
15. 15. Market values:<br />The present market rate of similar risk 10 year bonds is 6% so the market value of the bonds is given by 80,000PVIFA(10 years, 6%) = [80000/.06](1-1/1.06^10) + 1,000,000/1.06^10 = \$1,147,202.<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
16. 16. Similar risk preferred shares are providing yields of 8%, so the market value of the preferred shares is 100,000/.08 = \$1,250,000.<br />The market value of the common shares is currently \$25/share, so the total market value of the shares is \$2,500,000.<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
17. 17. The market value of the firm’s balance sheet V = D + P + SE = \$1,147,202 + \$1,250,000 + \$2,500,000 = \$4,897,202 and D/V = .234, P/V = .255 and SE/V = .511.<br />An Example of Cost of Capital<br />www.HelpWithAssignment.com<br />
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