Professional Documents
Culture Documents
• Some
S P li i i
Preliminaries
• Cost of Debt and Preference
• Cost
C off Equity
E i
• Determining the Proportions
• Weighted Average Cost of Capital
• Weighted Marginal Cost of Capital
• Floatation Costs and the WACC
• Divisional and Project Cost of Capital
• Cost of Capital in Practice
• Determining the Optimal Capital Budget
• Factors Affecting the Weighted Average Cost of Capital
COST OF CAPITAL
• The
Th cost off capital
i l reflects
fl expectedd return
• The company
p y cost of capital
p ((WACC)) is the right
g
discount rate for an investment which is a carbon copy
of the existing firm.
COST OF DEBT
n I F
P0 = +
t = 1 (1 + rD)t (1 + rD)n
P0 = current price of the debenture
I = annual interest payment
n = number of years left to maturity
F = maturity value
rD is computed through trial-and-error. A very close
approximation
pp is:
I + (F – P0)/n
rD =
0 6P0 + 0.4F
0.6P 0 4F
ILLUSTRATION
Approximate yield :
11 + (100 – 95) / 5
= 12.37 percent
0.6 x 95 + 0.4 x 100
COST OF EQUITY
• Security
S i Market
M k Line
Li Approach
A h
Illustration
Rf = 7%, E = 1.2, E(RM) = 15%
rE = 7 + 11.2
2 [15 – 7] = 16
16.6%
6%
INPUTS FOR THE SML
Whil there
While th i disagreement
is di t among finance
fi titi
practitioners, th
the
following would serve.
• The risk-free rate may be estimated as the yield on long-
term bonds that have a maturity of 10 years or more.
• The market risk premium may be estimated as the
difference between the average return on the market
portfolio and the average risk-free rate over the past 10
to 30 years.
• The beta of the stock may be calculated by regressing the
monthly returns on the market index over the past 60
months or so.
BOND YIELD PLUS RISK
PREMIUM APPROACH
Yield on the
Cost of = long-term bonds + Risk
equity of the firm premium
years.
Source
S off Capital
C i l Proportion
P i Cost
C Weighted
W i h d Cost
C
(1) (2) [(1) x (2)]
Debt 0.60 16.0% 9.60%
Preference 0.05 14.0% 0.70%
Equity 0.35 8.4% 2.94%
WACC = 13.24%
13 24%
WEIGHTED MARGINAL COST OF CAPITAL
SCHEDULE
The procedure for determining the weighted marginal cost of
capital involves the following steps:
TFj
BPj =
wj
where BPj is the breaking point on account of financing source
j TFj is
j, i the
h totall new financing
fi i from
f source j at the
h breaking
b ki
point, and wj is the proportion of financing source j in the
capital structure.
p
4. Prepare the weighted
g marginal
g cost of capital
p schedule which
reflects the WACC for each level of total new financing.
DETERMINING THE OPTIMAL
Return,
CAPITAL BUDGET
Cost (%)
A
18 Investment Opportunity Curve
B
17
16 C
15 14.6%
14 14.0%
13.2% D
13
E
12 Marginal Cost of Capital Curve
11
10 Optimal Capital Budget