2. 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. Cost of Capital www.HelpWithAssignment.com
3. 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. Cost of Capital www.HelpWithAssignment.com
4. 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. Cost of Capital www.HelpWithAssignment.com
5. 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 Weighted Average Cost of Capital www.HelpWithAssignment.com
6. 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) Weighted Average Cost of Capital www.HelpWithAssignment.com
7. An Example of Cost of Capital www.HelpWithAssignment.com
9. 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. An Example of Cost of Capital www.HelpWithAssignment.com
10. Working backwards, we get: Sales X Variable Costs 0.3X Fixed Costs 158 EBIT Interest 42 Taxes (40%) Net Income: 300 An Example of Cost of Capital www.HelpWithAssignment.com
11. 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: An Example of Cost of Capital www.HelpWithAssignment.com
12. Sales 1000 Variable costs 300 Fixed costs 158 EBIT 542 Interest 42 Taxes (40%) 200 Net Income: 300 An Example of Cost of Capital www.HelpWithAssignment.com
13. 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 An Example of Cost of Capital www.HelpWithAssignment.com
14. 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. An Example of Cost of Capital www.HelpWithAssignment.com
15. 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. An Example of Cost of Capital www.HelpWithAssignment.com
16. 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. An Example of Cost of Capital www.HelpWithAssignment.com
17. 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. An Example of Cost of Capital www.HelpWithAssignment.com
18. 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 HelpWithAssignment.com www.HelpWithAssignment.com
19. You can visit our blogs at http://www.helpwithassignment.blogspot.com http://www.helpwithasignment.wordpress.com Thank You HelpWithAssignment.com www.HelpWithAssignment.com
