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cost of capital

Transcript: Introduction to Cost of Capital Significance of Cost of Capital Investment Decision-Making Capital Budgeting A company's capital budgeting process hinges on understanding its cost of capital, which informs decision-making on long-term investments. It affects cash flow projections and determines which projects are viable within financial constraints. The cost of capital serves as a vital benchmark for evaluating potential investments. Investors expect a return that aligns with this cost, guiding firms in selecting projects that promise adequate returns versus risks. Definition The cost of capital refers to the return investors expect for providing their capital to a business. This metric serves as a crucial benchmark for evaluating investment opportunities and overall business performance. Overview of Long-Term Debt Costs Cost of Debentures Components of Long-Term Debt Cost Definition of Long-Term Debt Irredeemable Debentures Formula for Cost of Irredeemable Debentures Calculation Example of Irredeemable Debentures The cost of long-term debt includes interest payments, issuance costs, and any premiums or discounts on repayment. These expenses can significantly affect a firm's profitability and cash flow management. Long-term debt refers to loans and financial obligations that are not due within a year. It includes bonds, loans, and debentures, providing necessary financing for company growth and operations. Irredeemable debentures do not have a maturity date, meaning interest is paid indefinitely. Their cost is primarily based on the annual interest payments versus market value. The cost of irredeemable debentures is calculated using the formula K_d = I / P, where K_d is the cost of debt, I is the annual interest payment, and P is the market price of the debenture. For a debenture issued at Rs. 100 with an annual interest of Rs. 10, the cost of debt is calculated as K_d = 10 / 100 = 10%. This highlights the expected return for investors. Redeemable Debentures Defined Formula for Cost of Redeemable Debentures Calculation Example of Redeemable Debentures Redeemable debentures are repayable after a specified period, providing investors with defined return timelines. They often feature a higher cost than irredeemable debentures due to redemption risk. The cost of redeemable debentures is expressed as K_d = (I + (RV - NP) / N) / ((RV + NP) / 2), where RV is the redemption value, NP is net proceeds, and N is the number of years to maturity. An example: A company issues debentures at Rs. 90, redeemable at Rs. 100 after 5 years, with an annual interest of Rs. 10. The computed cost is K_d = (10 + (100 - 90) / 5) / ((100 + 90) / 2) = 11.11%. Conclusion Conclusion THANK YOU Evaluating the cost of capital is crucial as it directly affects investment decisions, capital budgeting, and the overall financial strategy of the business. An accurate assessment ensures that firms can attract investors while optimizing their capital structure. Cost of Capital Understanding its Significance in Financial Management

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: Significance of Cost of Capital Overview of Preference Share Capital Definition of Cost of Capital Characteristics of Preference Shares The cost of capital is a critical measure for evaluating investment opportunities and guiding corporate finance decisions. A company with a lower cost of capital can undertake more projects, increasing its profitability and market value over time. Preference shares represent a hybrid equity instrument that combines features of both equity and debt. They typically pay dividends at a fixed rate and may have redeemable or irredeemable characteristics, influencing their risk and return profiles. Preference share capital represents a hybrid form of financing that provides a fixed dividend to shareholders before common shareholders receive any dividends. This type of capital can be categorized into irredeemable and redeemable preference shares, each with distinct characteristics and implications. Cost of capital refers to the minimum return that a company must earn on its investments to satisfy its investors. It includes the cost of equity, debt, and preference shares, providing a comprehensive overview of what the company needs to generate to maintain its value. Priority of Preference Shareholders Cost of Irredeemable Preference Shares Treatment of Dividends Formula for Irredeemable Preference Shares Preference shareholders have a superior claim on assets and dividends over ordinary equity shareholders. In the event of liquidation, they are paid before common shareholders, making them less risky but potential returns lower compared to ordinary shares. Dividends paid to preference shareholders are considered an appropriation of after-tax profits, not an expense. This treatment means these payments do not reduce the company’s tax liability, impacting overall financial strategy. The cost of irredeemable preference shares is akin to calculating perpetuity. It represents dividends paid to shareholders without a redemption feature, making it a key financial metric for investors seeking stable income. The formula for calculating the cost of irredeemable preference shares (Kp) is Kp = PD / Po, where PD stands for annual preference dividend and Po represents the net proceeds from the issue. Example Calculation - Irredeemable Example Calculation - Redeemable Formula for Redeemable Preference Shares Cost of Redeemable Preference Shares For redeemable preference shares with an annual dividend (PD) of $6, a redemption value (RV) of $100, net proceeds (NP) of $90, and remaining life (n) of 5 years, the cost is Kp = 6 + (100 - 90) / 5 / ((100 + 90) / 2) = 7.23%. If a company pays an annual preference dividend (PD) of $5 and the net proceeds from issuing the shares (Po) is $50, the cost of irredeemable preference shares would be Kp = 5 / 50 = 0.10 or 10%. Redeemable preference shares offer an expected return through dividends and a redemption value at maturity. Their cost is essential for assessing the overall expense of capital financing for companies. The cost of redeemable preference shares (Kp) is calculated with Kp = PD + (RV - NP) / n / ((RV + NP) / 2), where RV is redemption value, NP is net proceeds, and n is the remaining life of shares. Importance in Financial Decision Making Future Trends in Preference Capital Financing Summary of Key Points Preference shares are crucial in corporate financing, providing fixed dividends and priority over equity dividends. The cost of irredeemable and redeemable preference shares influences a company’s overall cost of capital and strategic financial planning. Understanding the cost of capital, particularly preference shares, enables firms to evaluate investment projects accurately. It impacts decision-making regarding financing strategies, capital structure, and overall financial health. The trend towards hybrid financing structures includes increasing reliance on preference shares. Advances in finance technology may streamline the issuance and management of these securities, responding to market demands for flexibility and lower costs. Understanding Cost of Capital A Comprehensive Analysis of Preference Shares

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

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Cost of Capital

Transcript: Capital structure and Cost of Capital Out-of-pocket Costs The cost of capital is the cost of a company's funds (both debt and equity), or from an investor point of view It is the minimum return that investors expect for providing capital to the company Capital Structure Explicit cost The term ‘capital’ refers to any financial resources or assets owned by a business that are useful in further development and generating income. Implicit cost Implicit cost Interest on owner's capital, Salary to owner, rent of owner's building, etc The costs in which there is no cash outlay, is known as Implicit Cost Estimation of Cost Implied Objective Equity share Preference share Retained earning Borrowed capital Components of COC Capital structure consist of to words Capital and structure Mix-up of various sources of funds in desired proportion Company can raise their capital through owned or borrowed capital or both Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Cost of Debt The costs which involve outflow of cash due to the use of factors of production is known as Explicit Cost. Components of capital structure Cost of Pref. Share capital (Kp) = amount of preference dividend/ Preference share capital Kp = D/P Cost of debt generally refers to the effective paid by a company on its debts. 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 will affect on capability to receive funds from this source. External Factors Market condition Cost of capital Government regulation Taxation Competition Types of COC An explicit cost is a direct payment made to others in the course of running a business, such as wage, rent and materials Kd = i(1-t)/P0 Kd = cost of debt (required rate of return) i = annual interest paid P0 = ex interest market value of debt t = corporation tax rate Cost Risk Control Flexibility Timing INTRODUCTION Subjective Aarti Ganesh Rashmi NIhal Aishwarya Nikita Priyanka Usama Arunkumar Factors influencing capital structure Meaning BASIS FOR COMPARISON Imputed Costs Principles of capital structure Example Types of COC Member Actual Occurrence Cost Of Preference Share Cost of Equity Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return) Internal Factors Requirement of capital Size and nature of business Growth of business firms Trading on equity Future plan Weighted Average Cost of Capital (WACC) An implicit cost is any cost that has already occurred but is not necessarily shown or reported as a separate expense. It represents an opportunity cost Cost of Equity Cost of Debt Cost Preference share capital Cost of Retained earning Alternatively Salaries, rent, advertisement, wages, etc Explicit cost Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted Cost of Capital

Cost of Capital

Transcript: DEFINITION Cost of capital is... ~is a rate of return that must be achieved COST OF CAPITAL is defined as the rate of return that an enterprise must offer on its securities in order to maintain its market value 1. Make capital budgeting decisions 2. Help to establish the optimal capital structure 3. Make decisions concerning leasing , bond refunding and working management Each element of capital has a component cost that is identified by the following ~computed as a weighted average of the various capital components, items on the right hand side of the statement of financial position , such as debt, preference share capital , ordinary share capital, and retained earnings Monday, February 22, 2015 Quotation 1 Cost of Capital Financial managers must know the cost of capital in order to: COMPUTING INDIVIDUAL COSTS OF CAPITAL Vol XCIII, No. 311

Cost of Capital

Transcript: OBJECTIVE: Weighted Average Cost of Capital (WACC) Important Factors to Consider: The current amount of the company's current debt obligations The company's ability to borrow additional funds or issue additional bonds The sensitivity of stockholders regarding the current risk of the company due to existing debt The past and expected future profitability of the company Definition Common Benefits Company is using the money of others, allowing the business to keeps more funds available The risk is lower (legal obligation) Cost of capital is lower than other funding sources as a result of lower risk for lenders interest payments on debts are tax deductible Optimal Capital Structure Some debt can be beneficial but too much can cause problems While the cost of debt is lower than the cost of equity, debt increases risk (missed payments and bankruptcy) Optimal Capital Structure is an attempt to have an appropriate balance between the amount of debt and equity Financial combination of a low cost of capital and maximum market value One of the most important managerial decisions is how much debt and equity to use Cost of Debt Conclusion Definition: the required return of the owners in a company this percentage is the rate that lenders expect to receive when allowing someone to use their money Ex: 8% bond issued means the cost of debt is 8% Cost of Capital (Required Rate of Return) Students will be able to understand the significance of the cost of capital and how debt and equity are used to pay off creditors for money borrowed. Drill Cost of Equity If a company has 27% debt at a cost of 9%, and 73% equity at a cost of 15%, what is the WACC? This amount is the percentage company owners expect to earn based on the money they have invested in the company Definition: the rate of return required by creditors Cost of capital is the rate required by lenders and investors who are letting the company use their money. What are the steps of the capital budgeting process? Ex: If you have $100,000 invested in a company and expect the profits to be 10%, then any profit less than that would be disappointing. 10% is the required return for the owners. Calculated by multiplying proportions of debt and equity times the capital cost for each WACC doesn't always decline as a company takes on more debt As debt increases, it increases risk creating higher cost of both debt and equity, resulting in a higher WACC Managers continually analyze various economic and company factors to arrive at the optimal capital structure

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