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COST OF CAPITAL
WACC
MCC
TCS
IOS
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1. INTRODUCTION
Cost of capital is important in investment decisions for
management & investors.
If return is > cost of capital, company has created value.
Cost of capital estimation requires assumptions &
estimates.
Company must estimate project-specific costs of capital.
2. COST OF CAPITAL
Cost of capital rate of return the suppliers of capital require as compensation
(opportunity cost of funds).
Marginal cost cost to raise additional funds for potential investment projects.
Cost of capital for entire company is WACC which is also referred MCC.
WACC = w r 1 t + w r + w r
where
w = proportion of debt
r = before tax cost of debt
t = marginal tax rate
, = proportion of preferred & common equity respectively.
, =
&
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2.1 Taxes & Cost of Capital
In many jurisdictions interest on debt financing is a deduction to arrive at
taxable income.
Estimating the cost of common equity capital is more challenging than the cost
of debt capital and conventional preferred equity (no stated & fixed payment).
Two methods for estimating cost of equity are:
Capital asset pricing model.
Dividend discount model.
No tax adjustment in cost of equity (payment to owner is not tax deductible).
SYS
FC
IB
CF
MP
PS
DDM
2.3 Applying the Cost of Capital to Capital Budgeting & Security Valuation
Companys MCC may as additional capital is raised, & returns as company makes additional
investments represented by IOS.
Optimal capital budget amount of capital raised and invested at which marginal cost of capital
is equal to marginal return from investing.
Upward or downward adjustment to companys WACC if systematic risk of project is above or
below the companys risk.
NPV = PV of inflows (discounted at projects cost of capital) PV of outflows.
If we are using the companys WACC to calculate project NPV, we assume:
Project has same risk as avg. risk project of company.
Constant TCS throughout useful life.
If free cash flow to firm, use weighted avg. cost of capital for company valuation.
If free CF to equity, use cost of equity to find PV of these CF.
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Dividend on Ps is not tax-deductible.
Certain number of features (e.g. call option, cumulative dividends etc) affect cost of PS & hence
require adjustment.
Where
3.1.3.4 Leases
If company uses leasing as source of capital, the
cost of leases should be included in cost of
capital.
Survey Approach
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Where
= next year dividend
= current market value
g = growth rate.
= dividend yield.
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Using comparable publicly traded companys & adjusting it for financial leverage differences.
Comparable company company with similar business risk.
Asset (unlevered) after removing effects of financial leverage.
adjustment for capital structure of company or project (lever the asset to arrive equity )
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Step I
Step II
Step III
Unlever the comparables beta
Step IV
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Floatation cost fee charged by I.B based on size & type of offering.
Debt & preferred stock ignore flotation cost (quite small amount).
Flotation cost may be substantial in equity issuance.
View about Flotation Cost
FC in Monetary terms
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f = % flotation cost as a% of issue price