Cost of Capital

Question 1

What is the Cost of Capital?

Answer 1

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.

Question 2

What is the Weighted Average Cost of Capital (WACC)?

Answer 2

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

Question 3

How are Capital Structure Weights Calculated?

Answer 3

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

Question 4

What are the Methods to Estimate Cost of Equity (RE)?

Answer 4

CAPM/SML Approach:
Dividend Growth Model:

Question 5

Estimate Cost of Equity (RE) CAPM/SML approach

Answer 5

RE = Rf + β(E(RM) – Rf)
Where:

Rf = Risk-free rate

β = Beta

E(RM) – Rf = Market risk premium

Question 6

Estimate Cost of Equity (RE) Divdend Growth Model approach

Answer 6

RE = (DIV1 / P0) + g
Where:

DIV1 = Next year’s expected dividend

P0 = Current share price

g = Dividend growth rate

Question 7

Example: Calculate RE using CAPM/SML
Given:
Rf = 7%, β = 1.2, MRP = 6%

Answer 7

RE = 7% + 1.2(6%) = 14.2%

Question 8

Calculate RE using Dividend Growth Model Given:
DIV1 = $4.40, P0 = $50, g = 5.1%

Answer 8

RE = (4.40/50) + 0.051 = 13.9%

Question 9

Cost of Debt (RD)

Answer 9

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)

Question 10

Cost of Preference Shares (RP)

Answer 10

Perpetuity formula:
RP = DIV1 / P0

Example:
Dividend = $3, Price = $25
RP = 3 / 25 = 12%

Question 11

Factors Affecting WACC

Answer 11

Market conditions: Interest rates, tax rates, risk premiums

Capital structure: Equity vs debt ratio

Investment policy: Riskiness of projects undertaken

Question 12

Key WACC Assumptions

Answer 12

Average project risk

Constant D/E ratio

Minimal leverage effect

Question 13

Leverage Impact

Answer 13

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.

Question 14

Business Risk vs Financial Risk

Answer 14

Business Risk: Uncertainty in EBIT due to market factors.

Financial Risk: Extra risk for shareholders when firm uses debt.

Question 15

Financial Risk Example Summary

Answer 15

Leveraged firms (like Firm L) show higher expected returns and higher risk (variance of ROE), compared to unleveraged firms.