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FINANCIAL MANAGEMENT 2 COST OF CAPITAL The term cost of capital is frequently used interchangeably with the firms: o Required

d Rate of Return o Hurdle Rate for Investment o Discount Rate for New Investment o Opportunity Cost of Fund Regardless of the term used the basic concept is the same, the cost of capital: Is the rate that must be earned on an investment project, if the project is to increase the value of the common stockholders investment. It is the appropriate basis for evaluating the periodic performance of a division or even an entire firm. It becomes the key determinants of the capital cost associated with a firms cost capital. Investors Required Rate of Return o Is the minimum rate of return to attract an investor to purchase or hold a security. Two (2) basic considerations between firms cost of capital and investors required rate of return. o Cost of Capital has taxes When a firm borrows money to finance the purchase of an asset, the interest expense is deductible for federal income tax calculations. o Cost of Capital has flotation cost Flotation cost is the underwriters spread and issuing cost associated with the issuance and marketing of new securities. example: o A firm sells new shares of common stock for P 25.00 per share but, incurs transaction cost (floatation cost) of P 5.00 per share. Assume that the investors required rate of return is 15% for each P 25.00 per share. Solution: P 20 K (Cost of Capital) = P 25 x 15% = P 3.75 (Must be earned each year to satisfy the investors required return) K = P 3.75 / P 20.00 = 18. 75 % (Since the firm has only P 20 to invest the cost of capital is calculated as the rate of return of 18.75% that must be earned on the P 20 net proceeds which produce a peso return of P

Three (3) Determinants of Individual Cost of Capital o Cost of Debt The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company's capital structure, which also includes the cost of equity. Cost of Debt without Any Adjustment (Kd) = Amount of Interest / Amount of Loan X 100 In case, company issues the bonds or debenture on premium, at that time, we can calculate cost of debt by following formula Cost of Debt (Kd) = Interest amount/ (Amount of debenture + Amount of premium) X 100

In case, company issues the bonds or debenture on discount, at that time, we can calculate cost of debt by following formula Cost of Debt (Kd) = Interest Amount/ (Amount of Debenture Amount of Discount) X 100 If we have to compare cost of debt with cost of equity, then we have to calculate it after adjustment of tax because interest is deducted from profit before tax but dividend is deducted from profit after tax. Cost of Debt = Amount of Interest (1 Tax Rate) / Amount of Loan X 100 For example, interest rate of company is 10% before tax; calculate cost of debt after tax of 30% Cost of Debt = 10 % X (1-30%) = 7% o Cost of Preferred Stock Is a unique type of ownership in a firm, its dividends are senior to, or take priority over, the payment of those on common stock. The amount of dividends that will be paid to the holders of preferred shares may be stated as a percent of its par value, or as a flat peso amount. Cost of Preferred Stock (Kps) = preferred stock dividend/price of preferred stock Example: On March 26, 201, Fr Motor Company had an issue of preferred stock trading on the NYSE that had a closing price of P 23.45 and paid an annual dividend of P 2.25 per share. Assume that if the firm were to sell an issue of preferred stock with the same characteristics, as its outstanding issue, it would incur flotation cost of P2.00 per share and the shares would sell for their March 26, 2012, closing price what is Fords cost of preferred stock? Solution: Kps = P 2.25 / (P23.45 P 2.00) = 10.49 % o Cost of Common Stock Equity Is estimated by determining the rate at which the investor discounts the expected dividends to determine the share value. That is, the amount an investor is willing to pay for a share of stock is determined by his view of the future dividends potential of the security

Cost of debt is the main method of cost of capital in finance and financial management. Cost of debt is calculated on the debt, bonds, loan or debentures by multiplying interest rate with given amount of debt. If rate is not given, then you can also calculate cost of debt rate. This rate is called Kd. Cost of Debt without Any Adjustment (Kd) = Amount of Interest / Amount of Loan X 100 In case, company issues the bonds or debenture on premium, at that time, we can calculate cost of debt by following formula Cost of Debt (Kd) = Interest amount/ (Amount of debenture + Amount of premium) X 100 In case, company issues the bonds or debenture on discount, at that time, we can calculate cost of debt by following formula Cost of Debt (Kd) = Interest Amount/ (Amount of Debenture Amount of Discount) X 100 If we have to compare cost of debt with cost of equity, then we have to calculate it after adjustment of tax because interest is deducted from profit before tax but dividend is deducted from profit after tax. Cost of Debt = Amount of Interest (1 Tax Rate) / Amount of Loan X 100 For example, interest rate of company is 10% before tax; calculate cost of debt after tax of 30% Cost of Debt = 10 % X (1-30%) = 7%
Cost Of Equity What Does Cost Of Equity Mean? In financial theory, the return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. Investopedia explains Cost Of Equity Let's look at a very simple example: let's say you require a rate of return of 10% on an investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a combination of dividends and share appreciation you require a $1.00 return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70, which, combined with the $0.30 from dividends, gives you your 10% cost of equity. The capital asset pricing model (CAPM) is another method used to determine cost of equity. Read more: http://www.investopedia.com/terms/c/costofequity.asp#ixzz1YMJtUqwm Cost Of Debt What Does Cost Of Debt Mean? The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company's capital structure, which also includes the cost of equity. Investopedia explains Cost Of Debt A company will use various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to the overall rate being paid

by the company to use debt financing. The measure can also give investors an idea as to the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt. To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal tax rate (before-tax rate x (1-marginal tax)). If a company's only debt were a single bond in which it paid 5%, the before-tax cost of debt would simply be 5%. If, however, the company's marginal tax rate were 40%, the company's after-tax cost of debt would be only 3% (5% x (1-40%)). Read more: http://www.investopedia.com/terms/c/costofdebt.asp#ixzz1YMKFGJ4a Weighted Average Cost Of Capital - WACC What Does Weighted Average Cost Of Capital - WACC Mean? A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a project, using the formula: NPV = Present Value (PV) of the Cash Flows discounted at WACC. Investopedia explains Weighted Average Cost Of Capital - WACC Broadly speaking, a companys assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Read more: http://www.investopedia.com/terms/w/wacc.asp#ixzz1YMLq11eY Hurdle Rate What Does Hurdle Rate Mean? The minimum amount of return that a person requires before they will make an investment in something. Investopedia explains Hurdle Rate This is the rate of return that will get someone "over the hurdle" and invest their money. Read more: http://www.investopedia.com/terms/h/hurdlerate.asp#ixzz1YMMIXuqO Q: Cost of Common Equity

COST OF COMMON EQUITY? Percy Motors has a target capital structure of 40% debt and 60% common equity, with no preferred stock. The yeild to maturity on the company's outstanding bonds is 9%, and its tax rate is 40%. Percy's CFO estimates that the company's WACC is 9.96%. What is Percy's cost of common

equity? (HINT: Without preferred stock, so WACC= (wd)(rd)(1-T)+(wc)(rs). Given WACC, rd, wd, wc, and T, solve the cost of common equity, rs) Solution Cost of Capital Percy Motors has a target capital structure of 40 percent debt and 60 percent common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 9 percent, and its tax rate is 40 percent. Percy's CFO estimates that the company's WACC is 9.96 percent. What is Percy's cost of common equity? WACC = WdKd(1 - T) + WcKs where Wd is the weight of debt Kd is the cost of debt T is the tax rate Wc is the weight of common stock Ks is the cost of common stock Then, we can replace the information found to find WACC. WACC = WdKd(1 - T) + WcKs = [0.40 x 0.09(1 - 0.40)] + (0.60 x Ks) 0.0996 = 0.0216 + 0.60Ks Ks = 0.13 Required Rate Of Return (RRR) What Does Required Rate Of Return (RRR) Mean? The rate of return needed to induce investors or companies to invest in something. Investopedia explains Required Rate Of Return (RRR) For example, if you invest in a stock, your required return might be 10% per year. Your reasoning is that if you don't receive 10% return, then you'd be better off paying down your outstanding mortgage, on which you are paying 10% interest. Read more: http://www.investopedia.com/terms/r/requiredrateofreturn.asp#ixzz1YMOA1u2C Rate Of Return

What Does Rate Of Return Mean? The gain or loss on an investment over a specified period, expressed as a percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security plus realized capital gains. Investopedia explains Rate Of Return A rate of return measurement can be used to measure virtually any investment vehicle, from real estate to bonds and stocks to fine art, provided the asset is purchased at one point in time and then produces cash flow at some time in the future. Financial securities are commonly judged based on their past rates of return, which can be compared against assets of the same type to determine which investments are the most attractive. Read more: http://www.investopedia.com/terms/r/rateofreturn.asp#ixzz1YMOID4Cd Capital Budgeting What Does Capital Budgeting Mean? The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. Also known as "investment appraisal". Investopedia explains Capital Budgeting Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.

Read more: http://www.investopedia.com/terms/c/capitalbudgeting.asp#ixzz1YMOQmoXf Unlevered Cost Of Capital What Does Unlevered Cost Of Capital Mean? An evaluation that uses either a hypothetical or actual debt-free scenario when measuring the cost to a firm to implement a particular capital project. The unlevered cost of capital should illustrate that it is a cheaper alternative than a levered cost of capital investment program. A variation of the cost of capital calculation. Investopedia explains Unlevered Cost Of Capital Unlevered cost of capital will be a cheaper alternative to a levered cost of capital investment, as there are higher costs associated with the issuing of debt or preferred equity. Some of these marginal costs include, but are not limited, underwriting costs, brokerage fees, and dividend and coupon payments. Read more: http://www.investopedia.com/terms/u/unleveredcostofcapital.asp#ixzz1YMOWSxyj In the context of financial management, the term "cost of capital" refers to the remuneration required by investors or lenders to induce them to provide funding for an ongoing business. If the firm's goal is to remain profitable and to increase value to its shareholders, any use of capital must return at least its cost of capital, and optimally, an amount greater than its cost of capital. The Weighted Average Cost of Capital (WACC) is often used as a benchmark, or "hurdle rate" when evaluating new projects and businesses that would require use of the scarce resource of funding. Computing a company's cost of capital is not as simple as using, for example, the rate of interest it is charged on bank financing. The true cost of capital must be determined considering economic, market, and tax issues. Sometimes investor relations and market perception play a role in determining a company's capital structure as well. Most firms do not rely on only one type of financing, but seek to maintain an acceptable capital structure using a mix of various elements. These sources of financing include long-term debt, common stock, preferred stock, and retained earnings. In this discussion we will examine the four types of capital, their relative costs, and the methods by which a Weighted Average Cost of Capital is derived for practical use. COST OF LONG-TERM DEBT The cost of long-term debt is the after-tax cost of borrowing through the issuance of bonds. The proceeds of the bonds are reduced by the costs incurred to issue and sell the securities, called flotation costs. The following formula illustrates the computation of the before-tax cost of debt of a $1000 bond: where I = Annual interest P = Net proceeds of bond issue n = Number of years to maturity K d = Before-tax cost of debt It is important to state the cost of financing on an after-tax basis because interest on debt is tax-deductible. The before-tax cost of debt can be converted to the after-tax cost of debt by applying the following equation: where T = the firm's corporate tax rate K i = the after-tax cost of debt to the firm COST OF COMMON STOCK EQUITY The cost of common stock equity is estimated by determining the rate at which the investor discounts the expected dividends to determine the share value. That is, the amount an investor is willing to pay for a share of stock is determined by his view of the future dividends potential of the security. One method used to determine the cost of common stock equity is the Constant Growth Valuation (Gordon) Model. This model is based on the assumption that a share's value is based on the present value of all future dividends in perpetuity. The following formula illustrates the model: where K i = the cost of common stock equity D 1 = the expected dividend for the next period P o = the present value of future dividends g = the expected percentage dividend growth rate in decimal form

COST OF PREFERRED STOCK Preferred stock is a unique type of ownership in a firm. Its dividends are senior to, or take priority over, the payment of those on common stock. The amount of dividends that will be paid to the holders of preferred shares may be stated as a percent of its par value, or as a flat dollar amount. For purposes of analysis, dividends based on a percentage should be converted to dollar amounts before computation. The cost of preferred stock is determined by dividing the annual preferred stock dividend by the net proceeds from the issuance. The following formula illustrates: where D p = the annual dollar dividends N p = the net proceeds from the issuance K p = the cost of preferred stock equity COST OF RETAINED EARNINGS Earnings that are retained are either kept by the company or paid out to shareholders in the form of dividends. Therefore, retained earnings increase the shareholders equity in the company in much the same way as a new issue of common stock. Therefore, the cost of earnings retained as financing is the same as the company's cost of common stock equity. If the company can deploy its profits to get the shareholder's required return on its internal investments, stockholders are amenable to the firm's retention of earnings. However, if the company cannot manage its assets to meet this requirement, erosion of shareholder value occurs. This can happen if large amounts of low performance assets, such as cash, are retained. WEIGHTED AVERAGE COST OF CAPITAL (WACC) After the cost of each component of the capital structure is estimated, a blended or weighted average cost must be computed. The result of this calculation is the company's WACC, a piece of information that is very important to the management of the firm's assets. The WACC is used to make investment and business decisions, and is often used as a benchmark in determining a business unit's performance. To compute the WACC, multiply the specific cost of each form of financing by its proportion in the firm's capital structure, then sum the weighted values. where W i = proportion of long-term debt in capital structure W p = proportion of preferred stock in capital structure W s = proportion of common stock equity in capital structure The determination of the proportions may be based on the company's book or market value. Since the market value more closely approximates the actual dollars that would be received from the sale of the securities, this method is preferable to book, or accounting value.

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