Cost of Capital¶
Depends primarily on the use of funds, not the source, because every investment has a different risk associated with it.
Debt is almost always the cheapest source of capital, but has some trouble associated with it. This will be covered in a future topic.
It is always calculated as WACC (Weighted average cost of capital)
Lower the WACC the better
| Alias Name | Perspective of |
|---|---|
| Required return | Investor |
| Appropriate discount rate | Firm |
| Compound rate | Calculations |
| Opportunity cost of capital | idk |
- Cost of equity
- Cost of debt/distress
Uses¶
- WACC is used to value the entire firm
- Evaluate return for projects
- Evaluate performance of firm
Some Notes¶
- Growing companies have high WACC, as they have risks associated with them
- It is better if WACC decreases over time
Calculation¶
\[ \begin{aligned} \text{WACC} = \quad & w_l \times k_l (1-\tau) \\ + & w_b \times k_b (1-\tau) \\ + & w_p \times k_p \\ + & w_c \times k_c \end{aligned} \]
| Term | Meaning | Formula |
|---|---|---|
| \(w_d\) | Proportion of debt | \(\frac{n_d}{n_d + n_p + n_c}\) |
| \(w_p\) | Proportion of preference shares | \(\frac{n_p}{n_d + n_p + n_c}\) |
| \(w_c\) | Proportion of common shares | \(\frac{n_c}{n_d + n_p + n_c}\) |
| \(k_l\) | Pre-Tax Cost of Loan (Interest Rate) | |
| \(k_l (1-\tau)\) | Post-Tax Cost of Loan | |
| \(k_b\) | Pre-Tax Cost of Bond (Yield to Maturity) | |
| \(k_b (1-\tau)\) | Post-Tax Cost of Bond | |
| \(k_p\) | Cost of preference shares | \(\frac{D_p}{P_p}\) |
| \(k_c\) | Cost of common shares | |
| \(\tau\) | Tax rate | Available |
Interest is tax-deductable, hence it gives ‘tax shield’
CAPM¶
Capital Asset Pricing Model
Describes relation between systematic risk and expected rate of return of risky investments.
Expected return on a risk investment depends on
- Risk-free rate (return rate of bond)
- Risk premium, depending on \(\beta\), where \(\beta\) is the sensitivity of the stock wrt the market
\[ \begin{aligned} k &= r_\text{min} \\ &= r_f + \beta \Big[ R_m - r_f \Big] \end{aligned} \]
where
- \(r_\text{min} =\) Required return of investment
- \(r_f =\) Risk-Free rate
- \(r_m =\) Stock market return
- Take only recent data (say, 1 year or so)