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COST OF CAPITAL

Transcript: WACC BETA BETA OF A PROJECT COUNTRY RISK COST OF CAPITAL TARGET CAPITAL STRUCTURE ESTIMATION FORMULA TAX EFFECTS COST OF PREFERRED STOCKS Working Average Capital Cost MCC COST OF DEBT COST OF COMMON EQUITY COST OF CAPITAL WHAT DO CFOs DO? MARGINAL COST OF CAPITAL SCHEDULE

cost of capital

Transcript: the rate of return that a firm must earn on the project in which it invest to maintain its market value at real fund the firm capital structure the definition of capital what is capital? money used to start or run a business wi = % of dept wp = % of perference ws = % of common equity WACC= wiri + wprp + wsrs Why do we need to calculate WACC? so now lets define the cost of capital 1- Debt 2- Equity 3- Preference share WACC financial tool for both investors and the companies is well accepted among the financial analysts. It is important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks weighted average cost of capital (WACC) Example Calculation of important metrics like net present values and economic value added requires WACC. It is equally important for investors for arriving at valuations of companies. cost of capital

COST OF CAPITAL

Transcript: FORMULA RETAINED EARNING Cost of Debt Cost of Equity Shares Cost of Preference Shares Cost of Retained Earning Cost of debt capital is associated with the amount of interest that is paid on currently outstanding debts. it is denoted by Kd. COST OF CAPITAL (MEANING) The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). EXAMPLE Cost of preference share capital is that part of cost of capital in which we calculate the amount which is payable to preference shareholders in the form of dividend with fixed rate. It is denoted by Kp. Cost of Equity Share is the annual rate of return that an investor expects to earn when investing in the shares of the company. It is denoted by Ke FORMULA GROWTH APPROACH Ke = D/P + g where, Ke - cost of equity share D - Dividend P - Current market price of Equity Share g - Growth Rate Of Dividend DIVIDEND CAPITALISATION APPROACH Ke = D/P ratio approach EARNING CAPITALISATION APPROACH Ke = E/P ratio approach where, D- Dividend E- Earning Per Share P- Net Proceed or Market price of an equity share IRREDEEMABLE PREFERENCE SHARE Kp = D/P where, D - Dividend (including dividend tax if any) P- Proceed from issue Now issue of irredeemable preference share is not permissable as per Companies Act 1956 THANKYOU COST OF EQUITY SHARE when an investor purchases stock in a company, he/she expects to see a return on that investment. Since the individual expects to get back more than his/her initial investment, the cost of capital is equal to this return that the investor receives, or the money that the company misses out on by selling its stock. According to Solomom Ezra " The cost of capital is the minimum required rate of earning or the cut-off rate of capital expenditure." IRREDEMABLE DEBT Kd = I/NP (Before Tax) Kd = I(1-t)/ NP (After Tax) Where, Kd - Cost of debt t - Tax Rate I - Interest NP - Net Price COST OF CAPITAL PRESENTED BY:- HARSHITA PARIHAR AYUSHI VIJAYVARGIYA POORWA TIWARI APARNA PATHAK A firm's overall cost of capital is the weighted average of the cost of various sources of finance used by it. The weighted assigned to various sources of fund may be book value or market value. Formula: Ko= TotalWeighted Cost/ Total Capital x 100 FORMULA REDEEMABLE PREFERENCE SHARE Cost of Retained Earning is normally used equal to te cost of equity share capital. But sometimes it remains less than cost of equity because it does not require any floatation cost. DEFINITION COST OF PREFERENCE SHARE REDEEMABLE DEBT when tax benefit on issue cost is not considered Kd = [I(1-t)+(R-P)/n]/ (R+P)/2 when tax benefit on issue cost is also considered Kd = [I(1-t)+(R-P)(1-t)/n]/(R+P)/2 where, I- Interest t- Tax rate R- Redemption price P- Net proceed from debt Redeemable preference shares (Tax benefit on cost of issue considered) Kp = [D+(R-P)/n x (1-t)]/(R+P)/2 where, D- Dividend (including dividend tax ,if any) R- Redemption price P- Proceeds from issue t- Tax rate n- Number of years COMPONENTS/TYPES OF COST OF CAPITAL COST OF DEBT OVERALL COST OF CAPITAL

Cost of Capital

Transcript: COST OF CAPTAL PREPARED BY: NUR AFINA BINTI MUHAMMAD ARIFF SHAH (2017635926) Concept of Cost of Capital Cost of Capital is the cost of a firm's debt and equity funds or the required rate of return on a portfolio of the company's existing securities. CAPITAL What is CAPITAL? A large sum of money which you use to start a business, or which you invest in order to make more money. COST To require expenditure or payment What is COST? It is used to evaluate and decide new projects, as well as the minimum return investors expect from the invested capital Why it is used? It is computed using debt, equity and weighted average formulas. Useful in making capital budget decisions. A proposal is not accepted if its rate of return is less than the cost of capital. Firms typically use debt or equity resources to expand the firm Computation of Cost of Captal COST OF DEBT Interest paid on the amount borrowed. It is the interest rate on a risk-free bond whose duration is the same as the term structure of the firm's debt plus the default premium. risk increase as the debt increases. Debt Options for debt financing Business credit card A business credit card is a credit card intended for use by a business rather than for an individual’s personal use. Just like with personal credit cards, a business credit card is convenient, offers rewards and incentives, can be a tool to build credit, and can provide a company with a much-needed financial cushion when the business is short on cash. Term loan (Borrowing a full amount of capital upfront and we are repaying that load in fix) A loan from a bank for a specific amount that has a specified repayment schedule and either a fixed or floating interest rate. A term loan is often appropriate for an established small business with sound financial statements. Bond A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental) Pros & Cons Interest rates could be very high The money from debt financing has to be paid back / The need for regular income Adverse impact on credit ratings Potential bankruptcy Qualification requirements Retain full ownership of your business Predictable payment at known interest rate It provides immediate cash without reporting responsibilities Once the debt is paid, there is no longer an obligation Tax-deductible interest payments Discounted of tax rate DISCOUNTED TAX RATE For profitable firms, debt is discounted by the tax rate. Since interest expense is tax deductible, the after-tax cost of debt is calculated as: Yield to maturity = Debt x (1 - T) Where: T = The company's marginal tax rate Debt x = Risk free rate COST OF EQUITY Equity The return a company requires to decide if an investment meets capital return requirements. The cost of equity is approximated by comparing the particular investment to other investments having similar risk profiles. Capital Asset Pricing Model (CAPM) is used to approximate the cost of equity. CAPM Typically using common stock returns over time, CAPM associates the risk-return trade-offs of individual assets to market returns, and operates only in a market of equilibrium. Stock prices and market indexes are readily available and efficiently priced. The CAPM represents, "a linear relationship between individual stock return and stock market return over time." CAPM Using the Least Squares Regression formula: Kj = α + βKm + e Where: Kj = Common stock return α = "Alpha," the intercept on the y-axis (expected risk- free rate of return) β = "Beta," the co-efficient (sensitivity to market movement) Km = Stock market return (typically S&P 500 Index) e = Error term Formula Simpler Version of CAPM Perhaps a simpler version of the CAPM may also be expressed as: Es = Rf + βs (Rm – Rf) Where: Es = Expected return on a security Rf = Expected risk-free rate of return in the relevant market βs = Sensitivity to market risk for the particular security Rm = Historic return of the equity market (Rm – Rf) = Risk premium of market assets over risk-free assets. Pros & Cons CAN GET MONEY WITHOUT OPERATING HISTORY OR PROFITABILITY INVESTOR ONLY GET THE BENEFITS IF BUSINESS IS SUCCESSFUL NO PERSONAL LIABILITIES PROVIDES LEVERAGE CAPACITY GIVE UP SOME OWNERSHIP OF YOUR COMPANY INVESTOR MAY CONTROL OVER SOME DECISIONS EXTENSIVE EVALUATION PROCESS DIFFICULTY IN FINDING INVESTOR NO BENEFIT OF LEVERAGE Angel Investors An angel investor is a high-net-worth individual who provides financial backing for small startups or entrepreneurs, typically in exchange for ownership equity in the company. Venture Capitalists A venture capitalist (VC) is a private equity investor that provides capital to companies exhibiting high growth potential in exchange for an equity stake. Initial Public Offering An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public Debt

Cost of capital

Transcript: Cost of preference shares Remember when we did basic valuations we considered the risk intrinsic to the investment when deciding on a discount factor. The same must be done when using WACC to value projects or companies. Wacc is a function of the investment being valued not of the investor. As such it must reflect the risks specific to the investment being valued. Where the risks of a project is different to the risk profile of a company (which is embodied in the WACC), the WACC must be adjusted. Step 4: Calculate WACC THE FORMULA Formula: Ks= (D1 / P0) + g WACC = {Kd x (D/V)} + {Ke (E/V)} + {Kp (P/V)} 3. What are the principles that apply? The following order of preference: Target capital structure Market values of current financing Book values What is the market value of the debentures? R100 per debenture. Why? What is the interest payment per debenture? R10 What is the proceeds per debenture? R100 x 98% = R98 Effective cost of debenture R10/98 = 10.24% Formula: Dp / Vp (1 - F) Where Dp: Expected dividend payable Vp: Market value of preference share F: Flotation costs the market value of ordinary shares is representative of: Ordinary share capital, share premium, reserves and retained income on the statement of financial position. Cost of equity: Ks = (D1 / P0) + g = (2.02/ R20) + 0.12 = 22.08% COST OF CAPITAL An example of flotation costs: Company A is in the process of issuing a 1 000 R100 non-redeemable debentures. The coupon rate is the same as the market rate at 10%. Flotation costs (cost of issue) is estimated to be 2% of face value. Cost of equity COMPREHENSIVE EXAMPLE WACC (Pty) Ltd has the following capital structure, based on market values, as at 31 December 2011: R (millions) Ordinary Shareholders’ Equity 45 Preference Shareholders’ Equity 15 Debt (Debentures R15m and Loan R25m) 40 Total 100 The dividend rate on the current preference shares in the balance sheet is 10%. The interest rate paid to the lender on the current loan in the balance sheet is 11%. WACC (Pty) Ltd would like to target the following capital structure in the future: % Ordinary Shareholders’ Equity 50% Preference Shareholders’ Equity 10% Debt 40% Total 100% The 2011 year earnings after tax are R5m. The current share price is R20, dividend per share is R1.80. The company expects a sustainable growth rate of 12%. New share issues will cost the company 50c per share. Preference shares can be issued at 9% which represents the current market rate. The shares will be non-redeemable and will be issued at a price of R5. Flotation costs will amount to R0.25 per share. A R2m loan can be raised at a before-tax cost of 12%. A further R1m loan can be raised at 13% (before tax). Thereafter, further loan finance will attract a before-tax cost of 16%. Debentures were issued a year ago at a rate of 8.5%. New debentures can be issued at 11% and flotation costs are neligible. A company tax rate of 28% applies. Formula: Kd = I (1 - t) Use marginal cost Consider the effect of corporate tax Use nominal rate Cost of new debt The company has projects that it wishes to undertake next year with the following internal rates of return and investment amounts: IRR Project amount Project A 9% R3 m Project B 10.5% R2 m Project C 14% R1.5 m Project D 11% R2.5 m The above projects are indivisible. Remember that we are looking at components which are considered to be costs to the company. As such we must consider whether the costs are also tax deductible. If the costs are tax deductible then it will decrease taxible income and the tax expense. This in effect lowers the real cost to the company. SARS is subsidising some of the financing. Furthermore, we are also using after-tax cash flows, and it is appropriate to then use an after-tax discount rate. Where D1: Expected dividend payable P0: Market value of preference share g: growth Cost of equity Marginal cost is the cost of future financing (the next issue) In order to calculate marginal cost one would consider market values of the instrument, as these represent what instruments can be issued at in the future. Flotation costs must be consider as this in affect increases cost compared to proceeds Ordinary equity Preference shares Debentures Loan Cost of new share issue Formula: Kr = (D1 / P0(1-F)) + g DIVIDEND GROWTH MODEL Return: What is this? Lenders: Interest on amount lent to company Preference shareholders: Dividends as per terms of agreement Ordinary shareholders: Dividends and growth Other: Cost as per terms of agreement Remember that a return to these investors represents a cost to the company 2. What are the principles to remember? 4. What are the principles that apply? Pooling of funds approach. What is this? This was given in the question Ordinary Shareholders’ Equity 50% Preference Shareholders’ Equity 10% Debt (debentures 15%, loan 25%) 40% Remember that creating value for shareholders is the financial manager's primary objective Cost of debt: Debentures: Kd = I ( 1 - t) = 11 (1 - 0.28) = 7.92%

cost of capital

Transcript: Background Common stock (Brigham and Houston, 2009) Debt Common stock 1. Market Interest Rate 2. What is the cost of debt? Interest expense is tax deductible = (1 – 0.4)*10% = 6.00% (after tax costs) Cost of Capital Formula for WACC Introduction Firms cannot control Interest rates in the economy The general level of stock prices Tax rates Firm can control Capital structure Dividend payout ratio Capital budgeting decision rules “Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.” You are an assistant to the VP of Finance at Coleman Technologies. In order to assess the company’s expansion strategy your task is to estimate Coleman’s cost of capital: Alfred Fraser, Douglas Ebanks where: D =preferred dividend P =dividend by the current price of the preferred stock Overall WACC Flotation s What goes into WACC calculations? P/S 9% > 6% Debt If the tax rate = 40% Then, Where: T = the firm’s marginal tax rate rd = interest rate on the firm’s new debt ( = before-tax component cost of debt ) rp = component cost of preferred stock rs = component cost of common equity raised by retaining earnings wd, wp, wc = target weights of three types of capital Debt Preferred stock Retained earnings Common stock Thank you Preferred issue is a perpetual Preferred dividends are not tax deductible, so no adjustment is needed Use nominal rates to be consistent Consistent approach for all calculations (NPV, DCF) p 4. Implied cost of equity capital Cash flows and rate of return calculations should be done on a after-tax basis. Cost of debt (interest expense) is tax deductible, therefore multiplied with (1 – tax rate). Only current, marginal costs are used for WACC calculations, not historical costs. 10% x (1-40%) = 6.00% Outline Preferred stock Definition of Flotation costs Investment bankers’ fees Not an issue, BUT substantial Approaches Factors that affect the WACC If the following conditions are met: The project can match the average risk/return profile The previous projects are sufficiently large 2 r = Bond yield + Risk premium = 10.0% + 4.0%=14.0% However, the coincidence is extremely small. Preferred stock s 2. Bond-Yield-plus-Risk-Premium approach Background Components of the WACC WACC = APPROPRIATE DISCOUNT RATE Background 3. Overall WACC Group 11 After tax adjustment Common stock Retained earnings Can WACC be used as a hurdle rate? Adjust the cost of capital Components Our 10% pre-tax estimate is the nominal cost of debt, EAR = 1.05 – 1.0 = 0.1025 = 10.25% Debt Capital Asset Pricing Model (CAPM) Bond-Yield-plus-Risk-Premium approach Discounted cash flow (DCF) approach Implied cost of equity capital Background Flotation Costs (Source: investopedia.com) Conclusion WACC could be used as a hurdle rate Reference For a closely held company(CAPM not applicable); this method is somewhat subjective “get us in the right ballpark” https://www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/valuing-different-costs-88/the-cost-of-new-common-stock-379-3902/ http://www.information-management.com/issues/2007_58/master_data_management_mdm_quality-10015358-1.html http://2012books.lardbucket.org/books/finance-for-managers/s12-04-cost-of-common-stock.html http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital http://www.stockresearching.com/2013/11/23/google-inc-fundamental-analysis-wacc-cost-of-debt-and-cost-of-equity-goog/ http://www.valuebasedmanagement.net/methods_wacc.html Wang, P. (2013): Estimating Firm-Specific Implied Risk Premium Brigham, E. and Houston, J.(2010) Fundamentals of Financial Management (Custom Edition). South Western Cengage Learning. ISBN 9781408039137. Please note that this book is only available in the University bookshop. Approaches N = 30 (15x2, because we have semiannual payments) PMT = 60 (12% Coupon x 1000.00 FV, divided by 2 = 60) PV = - 1153.72 FV = 1000.00 YTM = 5.00002% x 2 (because of semiannual values) ≈ 10% p.a. p Overall WACC Common stock Common stock Debt The risk premium (r - long term bond yield) is typically between 3% and 5% Component cost of common equity 1. CAPM approach Any question? Definition of WACC Overall WACC Add flotation costs to a project’s cost P/S 9.00% < 10% Debt Flotation Flotation

COST OF CAPITAL

Transcript: SUBTITLE GOES HERE COST OF CAPITAL WHAT IS COST CAPITAL? "RATE OF RETURN" RETURN AT ZERO RISK LEVEL - RATE OF RETURN WHEN A PROJECT INVOLVES NO FINANCIAL OR BUSINESS RISK BUSINESS RISK PREMIUM - IF THE FIRM SELECTS A PROJECT WHICH HAS MORE THAN THE NORMAL RISK HIGHER RATE OF RETURN COST OF CAPITAL INCREASES - HIGHER DEBT CONTENT OF A FIRM IN ITS CAPITAL STRUCTURE, MORE RISK FINANCIAL RISK PREMIUM FOUR CLASSIFICATIONS OF CAPITAL COST CLASSIFICATION OF COST CAPITAL Costs which are incurred in the procurement of funds based upon the existing capital structure of the firm HISTORICAL AND FUTURE COST HISTORICAL COST FUTURE COST - Cost which is relate to estimated for the future -Cost to be incurred for raising new funds - Cost which is associated with the particular sources of income Specific Cost SPECIFIC COST AND COMPOSITE COST Composite Cost - Combined cost of different sources of capital taken together. - Combined cost of various sources of capital such as equity shares, debentures and preference shares. Average Cost AVERAGE COST AND MARGINAL COST Marginal Cost - Average cost of capital which has to be incurred due to new funds raised by the company for their financial requirements - Cut off rate or internal rate of return Explicit Cost EXPLICIT COST AND IMPLICIT COST Implicit Cost - Cut off rate or internal rate of return I. Computation of Specific Cost COMPUTATION OF COST CAPITAL II. Computation of Composite Cost Cost of Debt Cost of Preference Shares Cost of Equity Shares Cost of Retained Earnings Weighted Average Cost of Capital COST OF DEBT SPECIFIC COST - rate of return which is expected by the lenders - refers to the debt which is redeemable or repayable after expiry of a fixed period of time COST OF REDEEMABLE DEBT (before tax) SPECIFIC COST COST OF REDEEMABLE DEBT (after tax) - refers to the debt which is redeemable or repayable after expiry of a fixed period of time COST OF PREFERENCE SHARE CAPITAL SPECIFIC COST Topic 4 Topic 4

cost of capital

Transcript: Nominal Dividend Rate: 10% Dividends per year: 4 Par Value: $100 Price: $111.10 Tax Rate: 40% Coupon Rate: 12% Coupons per year: 2 Years to Maturity: 15 Price: $1,153.72 Face Value: $1000 Input data In financial management, the cost of capital is used primarily to make decisions which involve raising new capital. Thus, the relevant component costs are today’s marginal costs rather than historical costs. Price: $50 Current Dividend: $4.19 Constant Growth Rate: 5% ß: 1.2 Krf: 7% Km-Krf: 6% “Bond Yield+RP” premium: 4% Floatation Cost: 15% Retained Earnings: $300,000 Common stock informartion Stock holders are concerned primarily with those corporate cash flows that are available for their use, namely, those cash flows available to pay dividends for reinvestment. Since dividends are paid from and reinvestment is made with after-tax dollars, all cash flow and rate of return calculation should be done on an after-tax basis. 2. Should the component costs be figured on a before-tax or an after-tax basis? cost of capital case analysis The WACC is used primarily for making long-term capital investment decisions, i.e., for capital budgeting. Thus, the WACC should include the types of capital used to pay for long-term assets, and this is typically long-term debt, preferred stock (if used), and common stock. Short-term sources of capital consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accruals and (2) short-term interest-bearing debt, such as notes payable. If the firm uses short-term interest-bearing debt to acquire fixed assets rather than just to finance working capital needs, then the WACC should include a short-term debt component. Noninterest-bearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs, that is, net rather than gross working capital is included in capital expenditures. 3. Should the cost be historical (embedded) costs or new (marginal) costs? Preferred stock information a. 1. What sources of capital should be included when you estimate Coleman’s weighted average cost of capital (WACC)?

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