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Tax adjustment
Now,
Cost of the Existing Debt
14
n PDIVt Pn
P0
t 1 (1 k p ) t (1 k p ) n
Example
16
COST OF EQUITY CAPITAL
17
n
DIV0 (1g s ) t DIVn 1
1
Supernormal growth P0
(1k e ) t k e g n (1k e ) n
t 1
Cost
of External Equity: The Dividend Growth
Model
DIV1
ke g
P0
EPS 1 ( 1 b )
ke br (g br)
P0
EPS 1
(b 0)
P0
Example
19
Example: EPS
20
k e R f (R m R f ) j
Equation requires the following three parameters
to estimate a firm’s cost of equity:
The risk-free rate (Rf)
The market risk premium (Rm – Rf)
The beta of the firm’s share ()
Example
22
The following steps are involved for calculating the firm’s WACC:
Calculate the cost of specific sources of funds
Multiply the cost of each source by its proportion in the capital
structure.
Add the weighted component costs to get the WACC.
k o k d (1 T ) w d k d w e
D E
k o k d (1 T ) ke
DE DE
A new issue of debt or shares will invariably involve flotation costs in the
form of legal fees, administrative expenses, brokerage or underwriting
commission.
One approach is to adjust the flotation costs in the calculation of the cost of
capital. This is not a correct procedure. Flotation costs are not annual costs;
they are one-time costs incurred when the investment project is undertaken
and financed. If the cost of capital is adjusted for the flotation costs and
used as the discount rate, the effect of the flotation costs will be
compounded over the life of the project.
The correct procedure is to adjust the investment project’s cash flows for
the flotation costs and use the weighted average cost of capital, unadjusted
for the flotation costs, as the discount rate.
DIVISIONAL AND PROJECT COST OF CAPITAL
31