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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.

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## Understanding the Cost of Capital

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**Understanding the Cost of Capital**www.HelpWithAssignment.com**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 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 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**• 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 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**www.HelpWithAssignment.com**Formula for Cost of Capital**www.HelpWithAssignment.com**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 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 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 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 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 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 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 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 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**• 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.com**• You can visit our blogs at • http://www.helpwithassignment.blogspot.com • http://www.helpwithasignment.wordpress.com Thank You www.HelpWithAssignment.com

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