Understanding the cost of capital
Download
1 / 19

Understanding the Cost of Capital - PowerPoint PPT Presentation


  • 376 Views
  • Uploaded on

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.

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Understanding the Cost of Capital' - assignment_maker


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Understanding the cost of capital l.jpg

Understanding the Cost of Capital

www.HelpWithAssignment.com


Cost of capital l.jpg
Cost of Capital

  • 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.

www.HelpWithAssignment.com


Cost of capital3 l.jpg
Cost of Capital

  • Financial managers must know the cost of capital in order to

  • Make capital budgeting decisions,

  • Help establish the optimal capital structure and

  • Make decisions concerning leasing, bond refunding and working capital management.

www.HelpWithAssignment.com


Cost of capital4 l.jpg
Cost of Capital

  • 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.

www.HelpWithAssignment.com


Weighted average cost of capital l.jpg
Weighted Average Cost of Capital

  • Each element of capital has a component cost that is identified by the following:

  • ki = before tax cost of debt

  • k­d = ki (1-t) = after tax cost of debt, where t = tax rate

  • kp = cost of preferred stock

www.HelpWithAssignment.com


Weighted average cost of capital6 l.jpg
Weighted Average Cost of Capital

  • ks = cost of retained earnings (or internal equity)

  • ke = cost of external equity, or cost of issuing new common stock

  • ko = company’s overall cost of capital , or a weighted average cost of capital

  • The after tax weighted average cost of capital (WACC) is given by the following formula:

  • WACC = ka = ke = (S/V) + kd (1-t) (D/V)

www.HelpWithAssignment.com


An example of cost of capital l.jpg
An Example of Cost of Capital

www.HelpWithAssignment.com


Formula for cost of capital l.jpg
Formula for Cost of Capital

www.HelpWithAssignment.com


An example of cost of capital9 l.jpg
An Example of Cost of Capital

  • Suppose this firm faces a corporate tax rate of 40%, has variable expenses equal to 30% of sales, and has fixed costs of $158.

  • 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.

www.HelpWithAssignment.com


An example of cost of capital10 l.jpg
An Example of Cost of Capital

  • Working backwards, we get:

  • Sales X

  • Variable Costs 0.3X

  • Fixed Costs 158

  • EBIT

  • Interest 42

  • Taxes (40%)

  • Net Income: 300

www.HelpWithAssignment.com


An example of cost of capital11 l.jpg
An Example of Cost of Capital

  • If sales = X, then VC = .3X and X - .3X – 158 = EBIT

  • (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:

www.HelpWithAssignment.com


An example of cost of capital12 l.jpg
An Example of Cost of Capital

  • Sales 1000

  • Variable costs 300

  • Fixed costs 158

  • EBIT 542

  • Interest 42

  • Taxes (40%) 200

  • Net Income: 300

www.HelpWithAssignment.com


An example of cost of capital13 l.jpg
An Example of Cost of Capital

  • 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!

  • Assuming earnings are a perpetuity, we have

www.HelpWithAssignment.com


An example of cost of capital14 l.jpg
An Example of Cost of Capital

  • P = EPS/Ke = ROE* BVPS/Ke

  • Firm ABC has:

  • Debt D of 8% annual coupon bonds with 10 years to maturity and book value of $1 m.

  • Preferred shares P with 10% annual dividend and book value of $1 m.

  • 100,000 Common shares originally issued at $15/share for a value of $1.5 m.

  • Retained earnings of $0.5

  • Total of $4 m.

www.HelpWithAssignment.com


An example of cost of capital15 l.jpg
An Example of Cost of Capital

  • Market values:

  • 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.

www.HelpWithAssignment.com


An example of cost of capital16 l.jpg
An Example of Cost of Capital

  • Similar risk preferred shares are providing yields of 8%, so the market value of the preferred shares is 100,000/.08 = $1,250,000.

  • The market value of the common shares is currently $25/share, so the total market value of the shares is $2,500,000.

www.HelpWithAssignment.com


An example of cost of capital17 l.jpg
An Example of Cost of Capital

  • 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.

www.HelpWithAssignment.com


Helpwithassignment com l.jpg
HelpWithAssignment.com

  • At HelpWithAssignment.com we provide best quality Assignment help, Homework help, Online Tutoring and Thesis and Dissertation help as well. For any of the above services you can contact us at

    • http://www.helpwithassignment.com/

    • http://www.helpwithassignment.com/finance-assignment-help

www.HelpWithAssignment.com


Helpwithassignment com19 l.jpg
HelpWithAssignment.com

  • You can visit our blogs at

    • http://www.helpwithassignment.blogspot.com

    • http://www.helpwithasignment.wordpress.com

      Thank You

www.HelpWithAssignment.com


ad