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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

  1. WACC is used to value the entire firm
  2. Evaluate return for projects
  3. 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)
Last Updated: 2024-05-14 ; Contributors: AhmedThahir

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