Financial Analysis: Detailed Cost of Capital Report

This report provides a comprehensive overview of the cost of capital, a crucial concept in financial decision-making and capital budgeting. It explores the sources of capital, including equity, preferred stock, and long-term debt, and defines the cost of capital as the return investors expect. The report details the calculation of the cost of equity using the Gordon growth model and the Security Market Line (SML) approach, along with their advantages and disadvantages. It also covers the cost of preferred stock and the after-tax cost of debt, including the use of the yield to maturity (YTM) on bonds. A significant portion of the report focuses on the weighted average cost of capital (WACC) and how to calculate it, including capital structure weights and the impact of flotation costs on the cost of equity and preferred stock. The summary concludes with the key components of cost of capital: equity, preferred stock, and debt, and how WACC is a required rate of return on the overall firm.

Cost of capital
Abstract
Cost of capital which is utilized as a financial standard assumes a critical part in
capital budgeting decisions. It is the discount rate applied for assessing the allure of
investment projects. An investment task can be acknowledged whether it has a positive net
present value. Additionally, financial decisions taken by the management of a firm are
fittingly assessed utilizing the weighted average cost of capital. The cost of capital impacts
debt policy of a firm. While planning the extent of debt and equity in the capital structure, a
firm targets limiting the overall cost of capital. The cost of capital is broadly utilized in
choosing about the way of financing at a specific place of time. It plays a significant part in
dividend decisions. Cost of capital is one of the significant measurements which chooses the
measure of investment in current assets. Keeping the significance of cost of capital in
corporate finance, this chapter will basically cover the cost of equity, cost of preferred
stock ,cost of debt and weighted average cost of capital.

01.Sources of capital
 Liability
 Equity
02.What is the cost of capital
 The return the firm’s investor could expert to earn if they invested in securities with
comparable degrees of risk.
 The firm’s cost of capital will be the overall or average required rate of return on the
aggregate of investment project.
 The cost that company has to pay as dividends, interests , etc. in obtaining capital
from the sources like ordinary shares, preference shares or debentures.
03.Sources of long term capital
Sources Equity Preferred stock Long term debts
Cost Dividend Dividend Interest
03.1.Cost of Equity (Re) (Common stock)
 Return that equity investors require on their investment in the firm. (Ross, Westerfi
eld, & Jordan )
 Investors require compensation for the risky they take.
 Can calculated using,
a) Gordon growth model
b) Security market line approach
03.1.1.Advantages and disadvantages of Gordon growth model
Capital Structure
Firm’s cost of capital = cost of debt capital + cost of equity capital
Re = (D1 / P0) + g
Re = Rf + β (Rm - Rf)
D1 – Next dividend P0 – Current price
g – Growth rate
Rf = risk free rate β = beta coefficient
(Rm - Rf) = market risk premium

Advantages Disadvantages
Simple Applicable only to companies that pay
dividends
Easy to understand Does not consider risk
03.1.2.Advantages and disadvantages of SML approach
Advantages Disadvantages
Adjust for risk If estimates are poor Re will be inaccurate
Applicable to companies other than just
those with steady dividend growth
Rely on past to predict future, but economic
conditions can change quickly.
03.2.Cost of preferred stock (Rp)
 Dividend must be distributed before any other dividends are paid to the common
stock.
 Has a fixed dividend paid every period forever.
03.3.Cost of Debt (After tax Rd)
 Rd is the return that lenders require the firm’s debt
 Simply the interest rate the firm must pay on new borrowing.
 Before tax cost of long term debt YTM on bonds.
 Interest is tax deductible.Therefore cost of debt is calculated on after tax basis.
04.Weighted average cost of capital (WACC)
 The weighted average cost of capital after-tax (WACC) is found by weighting the cost
of every particular kind of capital in the firm's capital structure to track down the
average cost of funds as long run. (HARGRAVE, n.d.)
 Value of the firm
Rp = (D / P0) D1 – Next dividend P0 – Current price
Rd = YTM = {coupon payment + [(par value - market) / N ]} /{[par + 2(market)] /
3}
After tax Rd = Rd (1-T) T - Tax rate
Value = Equity + Debt

04.1.Capital structure weight
Illustration
Suppose you have a market value of equity equal to Rs.700 million and market value of debts
equal to Rs.200 million and market value of prefeered stock is Rs.100 million. Compute
capital structure weight ?
We = 700/(700+300) = 0.7 = 70%
Wd = 200/(700+300) = 0.2 = 20%
Wp = 100/(700+300) = 0.1 = 10%
05.Flotation cost
 While raising new capital,company incurs cost which is paid as a fee to the
investment bankers or cost incurred by a company in issuing its securities to public.
 When there is a flotation cost,
05.1.Cost of equity with flotation cost
05.2.Cost of preferred stock with flotation cost
WACC = (We * Re ) + (Wd * Rd ) + (Wp * Rp )
Re = [D1 / P0(1-F)] + g F – flotation cost
Rp = [D / P0(1-F)] F – flotation cost

Summary
 Cost of capital consists,
 Cost of equity
 Cost of preferred stock
 Cost of debt
 Cost of equity can calculated using Gordon growth model or SML approach
 Cost relating to the preferred stock is a fixed dividend
 Cost of debt is after tax interest rate
 The significant concept is the weighted average cost of capital, or WACC, which we
deciphered as the required rate of return on the overall firm
 Determine how WACC can be calculated.