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2.
COST OF CAPITAL
Practice: Example 3,
Volume 4, Reading 36.
2.3
2.2
FinQuiz Notes 2 0 1 5
Reading 36
Reading 36
Cost of Capital
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Cost of Debt
Practice: Example 4,
Volume 4, Reading 36.
Reading 36
Cost of Capital
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3.3
3.2
RF
i
= Risk-free asset *
= sensitivity of stock return to changes in the
market return**
E (RM)
= expected return on the market
E (RM) RF = expected market risk premium
NOTE:
Reading 36
Cost of Capital
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) ROE
where,
re
D1
P0
g
D1/ P0
=
=
=
=
=
cost of equity
expected dividend for the next period
current market value of the stock
expected growth rate of dividends
forward annual dividend yield
4.
4.1
where,
= estimated intercept
Reading 36
Cost of Capital
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,
1 1
, ,
1 1
NOTE:
1 1
1 1
4.2
Country Risk
Reading 36
Cost of Capital
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NOTE:
When a company that is solely financed with common
equity raises additional capital via debt, then due to tax
advantages, companys WACC will decrease as
additional capital is raised.
As more and more capital is raised by a company, cost
of different sources of financing increases. Hence,
typically, MCC schedule is upward sloping.
Break point: It is the amount of capital at which cost of
one of the components of the capital changes. A break
point is calculated as:
Breakpoint =
!"# $ %&'(#&) &# *+(%+ #+, - !.%,/- % -# $ %&'(#&) %+&"0,-
. ' .#( " $ ",* %&'(#&) .&(-,1 $. #+, - !.%,
where,
CRP = Country Risk Premium
3) Using country credit ratings to estimate the expected
rates of returns for countries that have credit ratings
but do not have equity markets. It involves following
steps:
Estimating reward to credit risk measures for a
large sample of countries which have both credit
ratings and equity markets.
Applying this ratio to countries without equity
markets based on countrys credit rating.
4.3
4.4
Flotation Costs
$
1 %
Reading 36
Cost of Capital
Limitation of method:
This method is inaccurate because it involves adjusting
PV of the future cash flows by a fixed percentage.
Advantages:
This method is useful when specific project
financing cannot be easily identified.
It helps to demonstrate how costs of financing a
company change as its internally generated
equity (R/E) exhaust and a company needs to
raise externally generated equity (new stock
issues).
b) By adjusting the initial project cost: The correct way to
account for flotation costs is by adjusting initial project
cost. It involves:
i. Estimating the dollar amount of the flotation cost
associated with the project, and
ii. Adding that cost to the initial cash outflow for the
project.
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Example: Suppose
Thus,
WACC= 7.2%
PV of cash inflows = $69,591
If flotation costs are not tax deductible:
NPV = $69,591 $60,000 $1,800 = $7,791
If flotation costs are tax deductible:
NPV = $69,591 $60,000 $1,800 (0.60) = $8,511