Cost of Capital

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FINANCIAL MANAGEMENT
Cost of Capital
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GROUP MEMBERS

• SYED SAAD ALI 04-0216
• SYED YASIR HUSSAIN 04-0224
• AHMED SABIH 04-0017
• WAQAS QURESHI 04-0097
• ATIF SATTAR MAHAR 04-0186
• PAWAN KUMAR 04-0211

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TOPICS COVERED

• Cost of Capital
• Cost of Debt
• Cost of Common Stock
• Cost of Preferred Stock
• Weighted average Cost of Capital

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SOME BASIC DEFINITIONS

• COST OF CAPITAL

• The required rate of return on the various types
  of financing. The overall cost of capital is the
  weighted average of the individual required rates
  of return.
• A firms cost of capital will be determined by
  its capital structure.

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• CAPITAL STRUCTURE

• The mix ( or proportion) of a firms permanent
  long term financing represented by debt,
  preferred stock and common stock equity.

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COST OF DEBT (CAPITAL)

• The required rate of return on investment of the
  lenders of a company.
• COST OF Common Stock (CAPITAL)
• The required rate of return on investment of the
  common shareholders of the company.

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COST OF PREFERRED STOCK

• The required rate of return on investment of the
  preferred share holders of the company.
• WEIGHTED AVERAGE COST OF CAPITAL (WACC)
• After the computation of the costs of individual
  components , we will compute a weighted average
  of the components costs of financing to obtain an
  overall costs of Capital to the firm.

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NOTE

• We will rely on return (yield) calculations to
  determine cost figures because cost return
  are essentially two sides of the same coin.

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The cost of capital-what is it really?

• It is the firms required rate of return that
  will satisfy all capital providers.
• EXAMPLE
• Assume that Sunny borrow some money from two
  friends Amir Abbas and Humair Abbas (Abbas
  Brothers) at two different costs, add some of his
  own money with the expectation of at least a
  certain minimum return ,and seek out an
  investment. What is the minimum return Sunny can
  earn that will satisfy the return expectations of
  all capital providers?

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Solution

• Capital Invested Investor
  Proportion Weighted Investor
• Providers Capital return
  of Total Cost Return
• age
  financing

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Assume that Sunny,s firm earns a yearly 11.5
return (WACC) on the 10,000 of invested capital.
The 1,150 of will satisfy the return
requirements of all the capital providers. Now
replace Amir ,Humair and Sunny with Debt,
Preferred stock and Common stock. With this new
terms in place you should begin understand the
direction that we will be taking in finding the
firm's required rate of return the cost of
capital-that will satisfy all the capital
providers.
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• Capital Invested Investor
  Proportion Weighted Investor
• Providers Capital return
  of Total Cost Return
• age
  financing

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COST OF DEBT

• The required rate of return on investment of
  the lenders of a company.
• FORMULA
• kj kd (1- t)
• where,
• kj after tax cost of debt
• kd discount rate
• t tax rate

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OR
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Example

• If a companys kd,discount rate was found to be
  11 and the tax rate was 40 ,the cost of debt
  would be
• kj 0.11(1-.40)
• 6.60

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Example

• Suppose that a firm issues, at face value ,10
  million of bonds with a coupon rate of 9.4.In
  return for obtaining 10 million now ,the firm is
  committed to paying 940,000 every year for a
  fixed time period after which it will redeem the
  bonds for 10 million ,if the Tax rate is 48
  then what would be its cost of debt financing?

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Solution

• kj kd (1- t)
• .094(1 - .48)
• 4.89
• Assumptions
• 1) The firm incurs no floatation costs.
• 2) Bonds are issued at face value.

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COST OF PREFERRED STOCK

• The cost preferred stock is a function of its
  stated dividend.
• Preferred stocks are perpetual stocks, i.e. the
  firm is under no obligation to retire them,
  irrespective of the preferred stock which have
  callable feature.
• The yield on preferred stock serves as our
  estimate of the cost of preferred stock.

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The cost of preferred stock, kp , or the return
to investor on this perpetual investment can be
given by

• Formula
• Kp Dp /Po
• Where,
• Dp is the stated annual dividend.
• Po is the current market price of the preferred
  stock.

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Example

• Suppose that Pixie corporation issues 3million
  of 100 par preferred stock with a dividend rate
  of 11.Determine the cost of preferred stock ?
• Solution
• Kp Dp /Po
• 11 /100
• 11

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Example

• If a company is able to sell a 10 preferred
  stock issue(50 par value at a current market
  price of 49 a share ,then determine the cost of
  preferred stock?
• Solution
• Kp Dp /Po
• 5 /49
• 10.20

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WHAT IS COMMON STOCK?

• It is a type of stock that represent the ultimate
  ownership (and risk) position in a corporation
• Common stocks entitles the investor to share
  earning to the company one the claims of all
  other groups have been paid

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COST OF COMMON STOCK

• The cost of common stock can be calculated by
  using two methods.
• 1 ) Dividend Discount Model Approach.
• 2) Capital Asset pricing Model.

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Dividend Discount Model

• The cost of Common stock under dividend discount
  model can be calculated by using the following
  formula
• Formula
• ke (D1 /Po) g
• where,
• ke is the cost of common stock
• D1 is the dividend paid in the 1st year
• Po is the market price of a share
• g expected growth rate of dividends in future

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Example

• Suppose that Javitt Corporation,s current price
  of common stock is 42 per share.It is expected
  to pay 2.95 in dividends at the end of the year
  , and its dividends are expected to grow at an
  annual compounded rate of 6.6.Determine its cost.

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Solution

• Formula
• ke (D1 /Po) g
• 2.95 /42 0.066
• 13.6
• This rate would be used as an estimate of the
  firms required return on common stock capital.

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Example

• If the dividends are expected to grow at an 8
  annual rate into the foreseeable future , and
  expected dividend in the 1st year were 2 and
  the present market price were 27, what would be
  the cost of common stock ?

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Solution

• formula
• ke (D1 /Po) g
• (2/27) 0.08
• 15.4
• Assume that the firm has a constant growth rate.

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Capital Asset Pricing Model

• Rather than estimating the future dividend stream
  of the firm and then solving for the cost of
  common stock, we may approach the problem
  directly by estimating the required rate of
  return on the company's common stock.

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• CAPM implies the following required rate of
  return Rj, for a share of common stock
• Rj Rf (Rm Rf)Bj
• where ,
• Rf is the risk-free rate
• Rm is the expected return for the market
  portfolio
• Bj is the beta coefficient for stock j.

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Beta It is a index of systematic risk and
measures the sensitivity of stock returns to
changes in returns on market portfolio. The beta
of a portfolio is simply a weighted average of
the individual stock betas in the portfolio.
Greater the beta greater will be the risk and
greater will be the required return. One can use
past return to compute beta for the stock.

• Risk free rate Market return These are the
  estimates of the future depending on the past
  experiences.
• Most agree that a Treasury security, is the
  proper instrument to use in making a risk free
  return estimate.

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Example

• Suppose that Beta for Memon Paint Company was
  found to be 1.20,based on monthly excess return
  data over the last five years. Furthermore assume
  that a rate of return of about 13 on stocks in
  general is expected to prevail and that a
  risk-free rate of 8 is expected. Determine the
  cost of Common stock capital.

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Solution

• Formula
• Rj Rf (Rm Rf)Bj
• 0.08 (0.13-0.08)1.20
• 14
• This is the required rate of return that will
  satisfy the return requirement of Common stock
  holders.

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WACC

• Weighted Average Cost of Capital
• The expected rate of return on a portfolio
• of all the firms securities.
• The WACC is the rate of return that the firm must
  expect to earn on its average-risk investments if
  it is to fairly compensate all its security
  holders
• Company cost of capital Weighted average of
  debt and equity returns.

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WACC

• Three Steps to Calculating Cost of Capital
• 1. Calculate the value of each security as a
  proportion of the firms market value.
• 2. Determine the required rate of return on each
  security.
• 3. Calculate a weighted average of these required
  returns.

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WACC

• Weighted -average cost of capital

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where,

• V is the total value of the firm
• D market value of debt
• Cs is the market value of common stock
• Ps is the market price of preferred stock

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ILLUSTRATION OF WACC

• To illustrate the calculations involved, suppose
  that a firm had the following financing at the
  latest balance sheet, where the amounts shown in
  the table below represent market values.

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To continue with our illustration ,suppose that
the firm computed the following after-tax costs
for the component sources of financing
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The weighted average costs of capital for this
example problem is determined as follows
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• Example - Geothermal Inc. has the following
  structure. Given that geothermal pays 8 for
  debt and 14 for equity, what is the Company Cost
  of Capital?

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Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8 for
debt and 14 for equity, what is the Company Cost
of Capital?
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WACC

• Example - Executive Fruit has issued debt,
  preferred stock and common stock. The market
  value of these securities are 4mil, 2mil, and
  6mil, respectively. The required returns are
  6, 12, and 18, respectively.
• Q Determine the WACC for Executive Fruit, Inc.

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Example -
continuedStep 1 Firm Value 4 2 6 12
milStep 2 Required returns are givenStep 3
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WACC

• In estimating WACC, do not use the Book Value of
  securities.
• In estimating WACC, use the Market Value of the
  securities.
• Book Values often do not represent the true
  market value of a firms securities

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Thaank you