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Understanding the Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
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. ,[object Object],Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Financial managers must know the cost of capital in order to ,[object Object],Make capital budgeting decisions, ,[object Object],Help establish the optimal capital structure and ,[object Object],Make decisions concerning leasing, bond refunding and working capital management.,[object Object],Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
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.,[object Object],Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Each element of capital has a component cost that is identified by the following:,[object Object],ki = before tax cost of debt,[object Object],k­d = ki (1-t) = after tax cost of debt, where t = tax rate,[object Object],kp = cost of preferred stock,[object Object],Weighted Average Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
ks = cost of retained earnings (or internal equity),[object Object],ke = cost of external equity, or cost of issuing new common stock,[object Object],ko = company’s overall cost of capital , or a weighted average cost of capital,[object Object],The after tax weighted average cost of capital (WACC) is given by the following formula:,[object Object],WACC = ka = ke = (S/V) + kd (1-t) (D/V),[object Object],Weighted Average Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Formula for Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Suppose this firm faces a corporate tax rate of 40%, has variable expenses equal to 30% of sales, and has fixed costs of $158. ,[object Object],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. ,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Working backwards, we get:,[object Object],Sales			X,[object Object],Variable Costs		0.3X,[object Object],Fixed Costs		158,[object Object],EBIT			,[object Object],Interest			42,[object Object],Taxes (40%),[object Object],Net Income:		300,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
If sales = X, then VC = .3X and X - .3X – 158 = EBIT,[object Object],(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:,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Sales			1000,[object Object],Variable costs		300,[object Object],Fixed costs		158,[object Object],EBIT			542,[object Object],Interest			42,[object Object],Taxes (40%)		200,[object Object],Net Income:		300,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
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!,[object Object],Assuming earnings are a perpetuity, we have,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
P = EPS/Ke = ROE* BVPS/Ke,[object Object],Firm ABC has:,[object Object],Debt D of 8% annual coupon bonds with 10 years to maturity and book value of $1 m.,[object Object],Preferred shares P with 10% annual dividend and book value of $1 m.,[object Object],100,000 Common shares originally issued at $15/share for a value of $1.5 m.,[object Object],Retained earnings of $0.5,[object Object],Total of $4 m.,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Market values:,[object Object],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.,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
Similar risk preferred shares are providing yields of 8%, so the market value of the preferred shares is 100,000/.08 = $1,250,000.,[object Object],The market value of the common shares is currently $25/share, so the total market value of the shares is $2,500,000.,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
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.,[object Object],An Example of Cost of Capital,[object Object],www.HelpWithAssignment.com,[object Object]
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 ,[object Object],http://www.helpwithassignment.com/,[object Object],http://www.helpwithassignment.com/finance-assignment-help,[object Object],HelpWithAssignment.com,[object Object],www.HelpWithAssignment.com,[object Object]
You can visit our blogs at,[object Object],http://www.helpwithassignment.blogspot.com,[object Object],http://www.helpwithasignment.wordpress.com,[object Object],Thank You,[object Object],HelpWithAssignment.com,[object Object],www.HelpWithAssignment.com,[object Object]

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Understanding the cost of capital

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