Cost of Capital Flashcards
(15 cards)
What is the Cost of Capital?
The cost of capital represents the minimum required return needed on a firm’s investment projects.
It reflects the riskiness of a firm’s assets as perceived by the market.
It is the return expected by investors (equity holders, debt holders, preference shareholders) in exchange for providing capital.
What is the Weighted Average Cost of Capital (WACC)?
WACC =(E/V)RE +(P/V)RP + (D/V)RD(1−TC)
E/V = % financed with equity
P/V = % financed with preference shares
D/V = % financed with debt
RE = cost of equity
RP = cost of preference shares
RD = cost of debt
TC = corporate tax rate
How are Capital Structure Weights Calculated?
E = Market value of equity = shares outstanding × price per share
P = Market value of preference shares
D = Market value of debt = bonds outstanding × bond price
V = Total market value = E + P + D
Weights:
wE = E/V, wP = P/V, wD = D/V
What are the Methods to Estimate Cost of Equity (RE)?
CAPM/SML Approach:
Dividend Growth Model:
Estimate Cost of Equity (RE) CAPM/SML approach
RE = Rf + β(E(RM) – Rf)
Where:
Rf = Risk-free rate
β = Beta
E(RM) – Rf = Market risk premium
Estimate Cost of Equity (RE) Divdend Growth Model approach
RE = (DIV1 / P0) + g
Where:
DIV1 = Next year’s expected dividend
P0 = Current share price
g = Dividend growth rate
Example: Calculate RE using CAPM/SML
Given:
Rf = 7%, β = 1.2, MRP = 6%
RE = 7% + 1.2(6%) = 14.2%
Calculate RE using Dividend Growth Model Given:
DIV1 = $4.40, P0 = $50, g = 5.1%
RE = (4.40/50) + 0.051 = 13.9%
Cost of Debt (RD)
Represents the required return on the company’s debt (typically bonds).
Focus is on the Yield to Maturity (YTM) of existing debt, not coupon rates.
After-tax cost of debt = RD(1 – TC)
Cost of Preference Shares (RP)
Perpetuity formula:
RP = DIV1 / P0
Example:
Dividend = $3, Price = $25
RP = 3 / 25 = 12%
Factors Affecting WACC
Market conditions: Interest rates, tax rates, risk premiums
Capital structure: Equity vs debt ratio
Investment policy: Riskiness of projects undertaken
Key WACC Assumptions
Average project risk
Constant D/E ratio
Minimal leverage effect
Leverage Impact
Leverage increases ROE but also increases financial risk.
Example: Firm L (with debt) has higher ROE and EPS than Firm U (equity only), but more variability in returns.
Business Risk vs Financial Risk
Business Risk: Uncertainty in EBIT due to market factors.
Financial Risk: Extra risk for shareholders when firm uses debt.
Financial Risk Example Summary
Leveraged firms (like Firm L) show higher expected returns and higher risk (variance of ROE), compared to unleveraged firms.
