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Cost of Capital

FINANCIAL MANAGEMENT. Cost of Capital. 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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Cost of Capital

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  1. FINANCIAL MANAGEMENT Cost of Capital

  2. 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

  3. TOPICS COVERED • Cost of Capital • Cost of Debt • Cost of Common Stock • Cost of Preferred Stock • Weighted average Cost of Capital

  4. SOME BASIC DEFINITIONS • 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 firm’s cost of capital will be determined by its capital structure. COST OF CAPITAL :

  5. CAPITAL STRUCTURE : • The mix ( or proportion) of a firm’s permanent long term financing represented by debt, preferred stock and common stock equity.

  6. 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.

  7. 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.

  8. NOTE We will rely on return (yield) calculations to determine cost figures because “cost” & “return are essentially two sides of the same coin.

  9. The cost of capital-what is it really? It is the firm’s 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?

  10. Solution: Capital Invested Investor Proportion Weighted Investor Providers Capital return of Total Cost Return %age financing

  11. 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.

  12. Capital Invested Investor Proportion Weighted Investor Providers Capital return of Total Cost Return %age financing

  13. 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

  14. OR

  15. Example: If a company’s 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%

  16. 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?

  17. 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.

  18. 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.

  19. 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.

  20. 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%

  21. 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%

  22. 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

  23. 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.

  24. 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

  25. 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.

  26. Solution : Formula : ke = (D1 /Po) + g =$2.95 /$42 +0.066 =13.6% This rate would be used as an estimate of the firm’s required return on common stock capital.

  27. 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 ?

  28. Solution : formula : ke = (D1 /Po) + g = ($2/$27) + 0.08 = 15.4% Assume that the firm has a constant growth rate.

  29. 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.

  30. 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.

  31. 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.

  32. 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.

  33. 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.

  34. WACC Weighted Average Cost of Capital • The expected rate of return on a portfolio of all the firm’s 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.

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

  36. WACC Weighted -average cost of capital=

  37. 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

  38. 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.

  39. To continue with our illustration ,suppose that the firm computed the following after-tax costs for the component sources of financing:

  40. The weighted average costs of capital for this example problem is determined as follows:

  41. 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?

  42. 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?

  43. 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.

  44. Example - continuedStep 1 Firm Value = 4 + 2 + 6 = $12 milStep 2 Required returns are givenStep 3

  45. 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 firm’s securities

  46. Thaank you

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