Cost of capital....ppt

 Defining cost of capital
 Assumptions
 Explicit and implicit cost
 Measurement of specific costs
 Various Models
 Book value and market value weights

 Cost of capital is the minimum required rate of
earning or the cut off rate for capital expenditure.
 It is also referred to as a “hurdle” rate because this is
the minimum acceptable rate of return.
 Any investment which does not cover the firm’s cost of
funds will reduce shareholder wealth (just as if you
borrowed money at 10% to make an investment which
earned 7% would reduce your wealth.)

 Firms business and financial risks are unaffected by
the acceptance and financing of projects.
 Firms financial structure is assumed to remain fixed.

 The explicit cost of capital is associated with the
raising of funds..
 In other words, it is nothing but internal rate of
return . In capital budgeting decision, investor will see
which investment provides high internal rate of return
but which company gets the money at high internal
rate of return; it means that company is accepting
money at high explicit cost of capital.

 Implicit cost of capital is opportunity cost, if money is used
one of best alternatives for effective use of resources.
 For example: I have Rs. 100,000, I can deposit it in bank and
earn Rs.3500 as bank interest but I did not invested it in
saving bank account and invested in the shares of XYZ
company. So, my implicit cost of investment in shares will
equal to the bank interest. This is not in money form
because, it is not necessary that XYZ company give me my
cost investment in shares. But, after thinking, I take the
opportunity for getting best reward from investment, so I
have taken this decision.

 When debts are issued at par:

 Interest expense is tax deductible.
 Therefore, when a company pays interest, the actual
cost is less than the expense.

After tax k d Before tax k d 1 t

 A model that describes the relationship between risk
and expected return and that is used in the pricing of
risky securities.

 If a firm uses both debt and equity financing, the
cost of capital must include the cost of
each, weighted to proportion of each (debt and
equity) in the firm’s capital structure.
 Therefore, a firm’s overall cost of capital must
reflect the required return on the firm’s assets as a
whole
 Wd= percentage of debt to total capital
 Wp= percentage of preference share to total capital

WACC wd kd wpkp w cs k cs

 The weights that we use to calculate the WACC will
obviously affect the result.
 Therefore, the obvious question is: “where do the
weights come from?”
 There are two possibilities:
 Book-value weights
 Market-value weights

 One potential source of these weights is the firm’s
balance sheet, since it lists the total amount of long-
term debt, preferred equity, and common equity.
 We can calculate the weights by simply determining
the proportion that each source of capital is of the
total capital.

 The problem with book-value weights is that the book
values are historical, not current, values
 The market recalculates the values of each type of
capital on a continuous basis. Therefore, market
values are more appropriate
 Calculation of market-value weights is very similar to
the calculation of the book-value weights
 The main difference is that we need to first calculate
the total market value (price times quantity) of each
type of capital

Cost of capital....ppt

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