Financial Management-I: chapter 4 Cost of capital.pptx

Financial Management-I: chapter 4 Cost of capital.pptx

1. CHAPTER 4 SECURITY VALUATION AND COST OF CAPITAL FINANCIAL MANAGEMENT I

2. 4.1. Cost of Capital: An Overview of Cost of Capital 4.1.1 . What Impacts the Cost of Capital? 4.1.2 . Significance of Cost of Capital 4.1.3 . Capital Structure 4.7.4 . Major Types of Cost of Capital 4.1.5 . The Specific Cost of Capital 4.1.5.1.Cost of Preferred Stock (kp) 4.1.5.2 . The Cost Common Stock (ks ) 4.1.5.3 . The Cost of Equity From new 4.1.5.4. Cost of Retained Earnings (Kr ) 4.1.5.5. Cost of Debt ( Kd ). 4.1.6 . The Weighted Average Cost of Capital 4.1.7 . The Marginal Cost of Capital (MCC )

3. An Overview of Cost of Capital The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the market place . Based on the evaluations of riskiness of each firm, investor will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firms bonds and stocks. T he cost of capital is the required rate of return that the firm must pay to generate funds , it becomes a guideline for measuring the profitability’s of different investments .

4. As firms usually use more than one type of financing , cost of capital is thus a weighted average of the specific costs of the several sources . we ought always to use the weighted average cost of capital , and not an individual cost of funds , as our discount rate for investment decisions . When we compute a firms weighted average cost of capital , we are simply calculating the average of its costs of money from all investors , those being creditors and stockholders .

5. What Impacts the Cost of Capital? 1 . Riskiness of earnings. 2 . The debt to equity mix of the firm. 3 . Financial soundness of the firm. 4. Interest rate levels in global market place. cost of capital is as the opportunity cost of funds , since this represents the opportunity cost for investing in assets with the same risk as the firm . The firm, given its riskiness , must strive to earn the investors opportunity cost . If the firm does not achieve the return investors expect (i.e . the investors opportunity cost), investors will not invest in the firms debt and equity . As a result, the firms value (both their debt & equity) will decline .

6. Significance of Cost of Capital Cost of capital is useful as a standard for :- 1. Evaluating investment decisions 2. Designing a firms debt policy, and 2. Appraising the financial performance of top management Capital Structure It is the mixture of long term sources of funds used by affirm. The primary objective of capital structure decision is to mix the market value of long term sources of bonds. The mix is called optimal capital structure which minimize the firms overall cost of capital .

7. Major Types of Cost of Capital (Sources of Capital) The major sources capital is:- 1 . Specific cost of capital. A. Cost of Debt ( Kd ). B. Cost of Preferred Stock ( Kp ). C. Cost of Common Stock (Ks). D. Cost of Retrained Earnings (Kr). 2. Weighted Average Cost of Capital (WACC) 3. Marginal Cost of Capital (MCC)

8. The Specific Cost of Capital : A firm’s capital is supplied by its creditors and owners . Firms raise capital by borrowing it (issuing bonds to investors or promissory notes to banks) or by issuing preferred or common stock. The overall cost of a firms capital depends on the return demanded by each of these suppliers is called the specific cost of capital. In the following section, we estimate the Cost of debt capital ( kd ), T he cost of capital raised though a preferred stock issue ( kp ) T he cost of equity capital supplied by common stock holders ( KS) for internal equity and kn for external equity.

9. The Cost Debt ( kd ) When a firm borrows money at a stated rate of interest, determining the cost of debt, kd , is relatively straight forward. The lenders ( creditors ) cost of capital is the required rate of return on either a company’s new bonds or promissory note . The firm’s cost of debt when it borrows money by issuing bonds is the interest rate demanded by the bond investor . When borrowing money from an individual or financial institution, the interest rate on the loan is the firm’s cost of debt.

10. The cost of debt to the borrower : the firms cost of debt is the investors required rate of return on debt adjusted for tax and flotation costs . This is because interest on debt is a tax deductible expenses ; it reduces the firm's taxable income by the amount of deductible interest . The interest deduction, therefore, reduces taxes by an amount equal to the product of the deductible interest and the firm’s tax rate . Flotation costs which are costs incurred in issuing debt securities increases the cost of debt .

11. Thus, the after tax cost of debt, kd , is computed as follows : Example- Aldi Co. issues Br. 1,000,000, 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital. Given :- Ki = 8% T = 50% Required :- Kd = ? Solution Kd = (1 – t) Ki Kd = (1 – 0.5) x 0.08 Kd = 0.04 or 4 %

12. Thus, the after tax cost of debt, kd , is computed as follows: Example 1 :- Assume that MULU Co. is to issue long term notes, investors will pay Br, 1 000 per note when they are issued if the annual interest payment by the firm is Br 1 00.The firm’s tax rates is 45%, and flotation costs are 2 %. calculate the cost of this debt . Given I nterest= Br, 100 principal= Br, 1000 Tax rate= 45% Floatation costs= 2%

13. Thus, the after tax cost of debt, kd , is computed as follows: So/n:- Kd =Ki [(1-T) / (1-F)] =10% [(1-0.45)/(1-0.02)] =10% (0.55/0.98) =10% (0.5612) =0.1 (0.5612) =0.05612 = 5.612 %

14. Cost of Preferred Stock ( kp ) The cost of preferred stock ( kp ) is the rate of return investors require on a company’s new preferred stock plus the cost of issuing the stock . Therefore , to calculate kp ; a firm’s managers must estimate the rate of return that preferred stock holders would demand and add in the cost of the stock issue. Because preferred stock investors normally buy preferred stock to obtain the stream of constant preferred stock dividends associated with the preferred stock issue, their return on investment can normally be measured by dividing the amount of the firm’s expected preferred stock dividend by the price of the shares . The cost of issuing the new securities known as flotation cost includes investment bankers’ fees and commissions , and attorneys' fees . These costs must be deducted form the preferred stock price paid by investors to obtain the net price received by the firm.

15. The following equation shows how to estimate the cost of preferred stock

16. The Cost of Common Stock ( ks ) ( Cost of Internal Equity ) The cost of common stock equity, ks is the rate at which investors discount the expected dividends of the firm to determine its share value. Two techniques for measuring the cost of common stock equity capital are available. One uses the constant growth valuation model (Gordon growth model); the other uses the capital asset pricing (CAPM)

17. The Capital Asset Pricing Model ( CAPM) Approach to Estimating ( ks ): a firm may pay dividends that grow at changing rate . it may pay dividends that grow at changing rate ; it may pay no dividends at all for the managers of the firm may believe that market risk is the relevant risk. In such cases, the firm may chose to use the capital asset pricing model (CAPM) to calculate the rate of return that investors require for holding company’s common stock according to the degree of non diversifiable risk present in

18. The Cost of Equity from new Common Stock ( kn ) The cost incurred by a company when new common stocks is sold at the cost of equity from new common stock ( Kn ) Capital from existing stock holders is internal equity capital , i.e. the firm already has these funds. In contrast, capital from issuing new stock is external equity capital . The firm is trying to raise new funds from outside source. New stock some times finance a capital budgeting project the cost of this capital includes not only stockholders’ expected returns on their investment but also flotation costs incurred to issue new securities. flotation costs makes the cost of using funds supplied by new stock holders slightly higher than using retained earnings supplied by the existing stockholders.

19. Cost of Retained Earnings ( Kr) The cost of retained earnings , Kr, is closely related to the cost of existing common stock since the cost of equity obtained by retained earnings is the same as the rate of return investors require on the firm’s common stock .

20. 2. The Weighted Average Cost of Capital (WACC) A firm’s weighted average cost of capital (WACC) is a composite of the individual costs of financing , weighted by the percentage of financing provided by each source. Therefore , a firm’s WACC is a function of T he individual costs of capital and The makeup of the capital structure the percentage of funds provided by long term debt , preferred stock and common stock. Thus , the computation of the cost of capital requires three things. 1 ) Compute the cost of capital for each and every source of financing used by the firm. 2) Determine the weight percentage of each financing in the capital structure of the firm . 3) Calculate the firm’s weighted average cost of capital (WACC) using the values in (1 ) & (2)

21. The Marginal Cost of Capital ( MCC) Because external equity capital has a higher cost than retained earnings due to flotation costs the weighted cost of capital increases for each dollar of new financing. Therefore lower cost of capital sources are used first. In fact the firms cost of capital is a function of the size it’s total investment. A schedule or graph relating the firm’s costs of capital to the level of new financing is called the weighted marginal cost of capital (WMCC). It is used to determine the discount rate to be used in the firm’s capital budgeting process.

22. END-OF-CHAPTER-FOUR THANK YOU FOR ATTENTION