uMAF 203

The cost of capital

The cost of capital

uLearning objectives

uTo understand the concept of the cost of capital.

uTo estimate the cost of each source of capital

ucost of debt finance

ucost of equity finance

uTo be able to calculate and interpret the weighted average cost of capital (WACC)

uTo understand the impact of corporate tax on the company cost of capital

uTo appreciate other relevant issues related to cost of Capital

uUnit Overview

uWhat do we mean by Capital and Cost of Capital?

uBy “capital” we mean money for running the business.

uCapital is the money provided by shareholders and lenders/debtholders for running the business.

uCapital could also be internally generated

uCan you think of an example?

uCapital is represented in balance sheet on the right-hand side as the financial assets of the firm

uWhat do we mean by Capital and Cost of Capital?

qCapital can be viewed as one of the inputs or factors of production of the firm’s operations in the same way as salaries and wages, raw materials, rent, fuel and power

qJust like other inputs capital has a cost and must be paid for.

u“Cost of capital” means return that the company has to pay to the providers of capital

uCost of capital is the rate of return that the shareholders and lenders require in order to be compensated for the risk of investing in a company.

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uShould We Care about the Firm’s Cost of Capital?

Yes!!!
uBecause it affects the value of the firm.

uHow?

代写uMAF 203qCost of funds used to finance the activities of the firm.

qCompensation for providers of capital.

qOpportunity cost foregone by providers of capital for investing funds in the real assets of the firm.

qTherefore, the cost rate is the rate of return the firm must generate from investment in real assets to compensate suppliers of capital.

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uShould We Care about the Firm’s Cost of Capital?

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uWhat are the Different Sources from Which the Firm Can Raise Capital?

uExternal source

uDebt : The firm promise to make fixed payments in the future (interest payments and repaying the principal)

ubank loans, corporate bonds

uEquity: The firm get whatever cash flows are left over after it has made debt payments (residual cash flow)

uissuing shares in the stock market

uInternal Source

uRetained earnings

uHowever, our focus here is to calculate cost of capital for funds sourced externally (debt and equity).

uAs a company draws finance (capital) from several sources, the firm’s cost of capital is the sum of the weighted average cost of each source of capital, i.e. the WACC.

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uWhat is the meaning of Cost of Debt?

uCost of Debt: It is the market interest rate that the firm has to pay on its long term borrowing, net of tax benefit.

uWhen the company takes a loan from a bank (to invest in a project) then the interest rate on the loan is the rate of return the company should expect from the project in order to return the money to the bank.

uNet of tax benefit is the final amount after accounting for the tax savings.

uCost of Capital Components:

Calculate Cost of Debt:

Calculate Cost of Debt:

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uCost of Capital Components:

Calculate Cost of Debt with Tax

Calculate Cost of Debt with Tax

uTaxes are an important consideration in the company cost of capital. Because, interest payments can be deducted from income before tax is calculated.

uThe after-tax cost of interest payments equals the pretax cost times 1 minus the tax rate:

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uWhat is the meaning of Cost of Equity?

uThe cost of equity is the expected rate of return (E(R)) or required rate of return (RRR) by a company’s shareholders, given its riskiness.

uShareholders can be ordinary shareholders or preference shareholders

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uCost of Capital Components:

Calculate Cost of Equity

Calculate Cost of Equity

uOrdinary shares

uThere are TWO methods for estimating the cost of ordinary shares.

uCAPM

uConstant Dividend growth Model (OR Multistage/variable growth dividend Model)

uCost of Capital Components:

Calculate Cost of Equity: Ordinary Shares:CAPM

Calculate Cost of Equity: Ordinary Shares:CAPM

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uCost of Capital Components:

Calculate Cost of Equity: Ordinary Shares: CAPM

Calculate Cost of Equity: Ordinary Shares: CAPM

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uCost of equity

Which Method should We Use?
uCAPM is used as the benchmark. Most people use this to estimate the cost of equity/the discount rate for evaluating a project.

uIn contrast to other methods, this method gives a comparison of required return for equity shares which have the same level of systematic risk.

uLimitation: this method could be flawed if the shares are currently mispriced (not in equilibrium) .

uWACC: General Model

uIf finance managers can estimate the cost of each type of financing, they can calculate the cost of capital for the company by using the following equation (13.2 on pg 453):

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kcompany is the company’s cost of capital.xi = fraction or weight of the total market value of the financing by type i.

ki = cost of financing by type i.

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uPre Tax WACC: Debt and Equity

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uPre-tax WACC with Debt and Equity

ExampleDebt-holders have contributed $8 million to ABC company at an interest rate of 10% p.a. Equity holders have contributed $2 million and require a rate of return of 15% on their investment. What is the company’s cost of capital?

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uAfter Tax WACC with Debt and Equity

uInterest payments gain a tax benefit to the company. Hence, the interest cost (cost of debt) need to be adjusted to reflect the tax benefit.

uIf there is debt and ordinary shares, the standard WACC formula is:

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uNote the tax adjustment: A company can deduct interest from revenues in arriving at it’s taxable income

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uPre-tax WACC with Debt and Equity

Example代写uMAF 203Debt-holders have contributed $8 million to ABC company at an interest rate of 10% p.a. Equity holders have contributed $2 million and require a rate of return of 15% on their investment. The company tax rate is 30%. What is the company’s cost of capital?

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uAfter Tax WACC with Debt and Equity (Including Preference Shares

uIf there are Preference shares also, it must be included in the formula. (Preference share dividend does not give a tax benefit to the company. Because, it is considered as part of equity by Tax Department)

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kcompany is the weighted average cost of capitalke is the cost of equity

kd is the cost of debt

kP is the cost of preferred shares

D is the valued of debt

E is the value of equity

P is the value of preferred shares

T is the corporate tax rate

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uHow do Company use WACC?

uThis cost of capital (WACC) is used as the discount rate (hurdle rate) for evaluating investments in new assets of similar risk.

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u(Formula 10.1, p. 343)

uIn the above formula which variable do you think is the WACC?

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u A Comprehensive Problem

uCost of Debt

uSolution to Comprehensive Problem:

Cost of Debt, Equity and Preference Shares

Cost of Debt, Equity and Preference Shares

uSolution to Comprehensive Problem: Calculate Weights of Capital Components

uSolution to Comprehensive Problem

uUsing the WACC in Practice

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uUsing the WACC in practice

uWhen a single rate (WACC) is used to discount cash flows for different projects with varying levels of risk, the WACC-based discount rate may be too low or too high.

uWith too high discount rate, company may reject a true positive-NPV project.

uWith too low discount rate, company may accept a negative-NPV project. (The estimated NPV will be positive even though the true NPV is negative.)

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uFigure 13.3

Potential Errors When Using the WACC

Potential Errors When Using the WACC

uUsing the WACC in Practice

uTherefore, the estimated NPV may be negative even though the true NPV is positive, and vice versa.

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uThe key point is that it is only correct to use a company’s WACC to discount the cash flows (i.e., as the hurdle rate) for a project only if some conditions do hold.

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uUsing the WACC in Practice: Conditions:

1.The level of (systematic) risk for a project is the same as that for the portfolio of projects the company is already having (the risk profile of the project same as the risk profile of the company as a whole) (Condition 1).

代写uMAF 203