Cost of capital and investment theory

Cost of Capital and Investment Theory

INTRODUCTION

Cost of capital is the cost it must pay to raise funds; either by selling bonds, borrowing. or equity financing

Most of the companies define cost of capital in one among the two ways:

Is financing cost which lead the organization to pay when they borrow funds, either by securing a loan or by selling bonds, or equity financing.

Another way is to evaluate a potential investment (example major purchase)

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Cost of capital sometime used to set the hurdle rate, or threshold return rate that a proposed investment must exceed in order to receive funding.

Normally, cost of capital percentages can vary greatly between different companies or organizations, depending on such factors as the organization‘s credit worthiness and perceived prospects for survival and growth

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Example In 2011 a company with an AAA credit rating, or the US treasury, can sell bonds with yield somewhere between 4% and 5% which might be taken as the cost of capital for these organizations. At the same the same time, organizations with lower credit rating where by the future prospects are viewed as “speculative” by the bond market it might have to pay 10% or 15% or even more.

Weighted average cost of capita (WACC)

WACC is the rate that a company is expected to pay on average to all its security holders to finance its asset.

The WACC is commonly referred to as the firm’s cost of capital. Obviously it dictated by the external market and not by management.

The WACC represent the minimum return that a company must earn on existing asset base to satisfy its creditors, owners and other providers of capital or they will invest elsewhere (Fernandes , Nuno.2014)

Weighted average cost of capita (WACC) Normally companies raise fund from different

numbers of sources such as: Common stocks Preferred stocks Exchangeable debt Convertible debt Etc.

Weighted average cost of capita (WACC) The WACC is calculated taking into account the

relative weight of each component of the capital structure. The more complex the company’s capital structure the more laborious it is to calculate the WACC.

Weighted average cost of capita (WACC) In general the WACC is calculated with the following

formula:

Weighted average cost of capita (WACC)Where; N is the number of sources of capital ri is the required rate of return for security i.

Mvi is the market value of security i.

Weighted average cost of capita (WACC) In the case where the company is financed with only

equity and debt, the average cost of capital is computed as follows:

Weighted average cost of capita (WACC)Where: D is the total debt. E is the total shareholder’s equity. Ke is the cost of equity. Kd is the cost of debt.

Weighted average cost of capita (WACC) Tax effects (basic formula). Tax effects can be incorporated into this formula.

For example, the WACC for a company financed by one type of shares with the:

Weighted average cost of capita (WACC)Where : Mve is the total market value of equity Re is the cost of equity MVd is the total market value of debt Rd is the cost of debt t is the corporate tax.

Weighted average cost of capita (WACC) Assume newly formed corporation XYZ needs to

raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares of stock at $100 each to raise the first $ 600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.

Corporation XYZ then sells 400 bonds for $1000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return so ABC’s cost of debt is 5%.

Weighted average cost of capita (WACC) Corporation XYZ’s total market value is now

($600,000 equity+ 400,000 debt) =$ 1million and its corporate tax is 35%.

Now lets calculate the corporation XYZ’S weighted average cost of capital.

Weighted average cost of capita (WACC)Where : 400,000 = Mve is the total market value of equity 6% = Re is the cost of equity 600,000= MVd is the total market value of debt 5%= Rd is the cost of debt 35%= t is the corporate tax.

Weighted average cost of capita (WACC) WACC= .Re + .Rd (1-t) = .0.06 + .0.05 (1-0.35) =0.024 + 0.03(1-0.35) = 0.024 +0.0195 = 0.044 = 4.4%

Weighted average cost of capita (WACC) Corporation ABC’S weighted average cos of capital

is 4.4% This means for every $ 1 corporation XYZ raises

from the investors, it must pay its investors almost $ 0.05 in return

Cost of debt.

Is the overall average rate an organization pays on all its debts, typically consisting primarily of bonds and bank loans.

Is expressed as annual percentage Is among the company capital structure ( include

preferred stock, common stock, and cost of equity).

Cost of debt

Cost of debt is presenting in two ways: Before tax. After tax.

Cost of debt.

For example: A company with a marginal income tax rate of 35% and a before tax cost of debt of 6%, the after tax cost of debt is found as follows:

After tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate) = (0.06) x (1.00 – 0.35) = (0.06) x (0.65) = 0.039 or 3.9%

Cost of debt.

The cost of debt also help the company to make decision regarding asset acquisition or other investment which acquired with borrowed funds.

Cost of Equity (COE)

COE measures the returns demanded by stock market investors who will bear the risks of ownership.

Is expressed as an annual percentage Is a part of company capital structure

Normally a high cost of equity the market view of the company’s future is risky, thus, it lead the greater return to attract the investment. And the lower is opposite.

Cost of Equity (COE)

There are two ways approaches to estimate cost of equity:

Dividend Capitalization Model Approach. Capital asset pricing model (CAPM) approach.

Dividend Capitalization Model Approach Cost of equity = (Next year's dividend per share +

Equity appreciation per share) / (Current market value of stock) + Dividend growth

For example: a stock whose current market value is $8.00, paying

annual dividend of $0.20 per share. If those conditions held for the next year, the investor's return would be simply 0.20 / 8.00, or 2.5%. If the investor requires a return of, say 5%, one or two terms of the above equation would have to change:

Dividend Capitalization Model Approach If the stock price appreciates 0.20 to 8.20, the

investor would experience a 5% return: (0.20 dividend + 0.20 stock appreciation) / (8.00 current value of stock).

If, instead, the company doubled the dividend (dividend growth) to 0.40, while the stock price remained at 8.00, the investor would also experience a 5% return.

Capital asset pricing model (CAPM) approachHelps to calculate investment risk and how much return on investment we should expect.Cost of equity = (Market risk premium) x ( Equity beta) + Risk free rate Consider a situation where the following holds for one

company's stock:

Market risk premium: 4.0%Equity beta for this stock: 0.60Risk free rate: 5.0%

Cost of equity = (4.0%) x (0.60) + 5.0% = 7.4%

Capital asset pricing model (CAPM) approach A beta of 0 indicates the stock tends to rise or fall

independently from the market. A negative beta means the stock tends to rise when

the market falls and the stock tends to fall while the market rises.

A positive beta means the stock tends to rise and fall with the market

INVESTMENT THEORY Investment theory is the theory which help the

investors to make a decision regarding investment. It encompasses the body of knowledge used to

support the decision making process of choosing investment for various purposes.

It include: Portfolio theory Capital asset pricing model (CAPM) Arbitrage pricing theory Efficient market hypothesis Rational pricing

COST OF CAPITAL AND INVESTMENT DECISION

The cost of capital to the owners of a firm is simply the rate of interest on the bonds, and has derived the familiar proposition that the firm, acting rational, will tend to push investment to the point where the marginal yield on physical assets is equal to the market rate of interest.

The importance of cost of capital help the management to make rational decision to the firm. Each firm face a trade-off between two main criteria:

The maximization of the firm profit The maximization of the firm market value


The first criteria propose that, a firm investment decision to the assets would be worth acquiring if it will increase the net profit only if the expected yield from such asset will exceed the capitalization rate of capital acquired.

On other hand, base on the second investment criteria, the asset would be worth acquiring if it can adds more to the current market value per share of the firm.


The decision toward any firm’s investment depends on various factors including the cost of raising capital

Miller and Modigliani conclude that: “if the firm acting for the best interest of its

shareholders (maximizing the market value) will invest on the assets if and only if expected rate of return that will boost up the shareholder’s value and it exceed the rate of interest to which the firm pays for raising the fund regardless the type of security want to invest”.


Under the M&M theory propose the assumption to support the theory that:-

The firm must be trading in perfect competitive market.

The effect of corporate taxes are eliminated. Investors are rational to the extend can change with

market fluctuations. The firm has fixed investment policy. No risk or uncertainty.


CONCLUSION If the assumption are held constant, under M&M

theory, the cost of capital become key factor determining which asset to invest, how to finance the investment, and which criteria to deal with.

Prepared by MONZUR MORSHED PATWARY

Business

Cost of capital and investment theory