This document introduces topics related to business finance, including cost of equity, cost of debt, and weighted average cost of capital (WACC). It discusses how to calculate cost of equity using the dividend valuation model and capital asset pricing model. It also explains how to determine cost of debt and provides an example. Finally, it defines WACC as the average rate a company pays on its capital, provides the formula, and works through an example to calculate WACC.

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.