Cost of Capital Final Ppt1

8/8/2019 Cost of Capital Final Ppt1

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Submitted to

Prof. Indra Bharadwaj

Submitted BY

Mehul Shukla

Jasvinder Kaur

Mohd.Azhar

Manya SrivatavaDevashish Misra


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Agenda

y Introduction About Cost Of Capital

y

Importance Of cost Of Capital

y Determination Factors Of Cost OF Capital

yOf Cost of Capital

y Cost Of Debt

y Cost of debt Issued at Premium


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Cost of Capital?y When we say a firm has a cost of capital of, for example,

12%, we are saying:

y The firm can only have a positive NPV on a project if return

exceeds 12%y The firm must earn 12% just to compensate investors for the

use of their capital in a project

y The use of capital in a project must earn 12% or more, not

that it will necessarily cost 12% to borrow funds for theproject

A firms overall cost of capital must reflect the required return on

the firms assets as a whole


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Importance of Cost of Capital

y Capital Budgeting Decisions

y Capital Structure Decisions


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Determination Factors of Cost of CapitalProblems in Determination

1. Controversy regarding the dependence of cost of capital upon

the method and level of financing

2. Computation of cost of equity

3. Computation of cost of retained earnings and

depreciation funds

4. Future costs versus historical costs

5. Problem of weights


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Computation of cost of capital

y Cost of Debt

y Cost of preference capital

y Cost of equity capital

y Cost of retained earnings


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COST OF DEBTy Adebenture or bind may be issued at par or at a

discount or premium as compared to its face value.The contractual rate of interest or the coupon rateforms the basis for calculating the cost of debt.

y Debt issued at par: The before-tax cost of debt is therate of return required by lenders. It is simply equal tothe contractual (or coupon) rate of interest.

y Kd= i = INT/ Bo

yWhere kd = before tax cost of debt

y i= coupon rate , Bo = issue price of the bond, INT =amount of interest

y Interest = Face value of debt* interest rate


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Example

y Company decides to sell a new issue of 7year15 percent

bonds of Rs 100 each at a par. If the company realizes thefull face value of Rs 100 bond and will pay Rs 100 and thebefore tax cost of debt will simply equal to the rate ofinterest of 15%.

y I0= C1/(1+k)+C2/(1+k)2+.......Cn/(1+k)n

y Cash outflow are Rs15 intrest per year for 7 years and Rs100at the end of 7thyear in exchange for Rs100 now.


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y 100=15/(1+kd)+15/(1+kd)2+15/(1+kd)3+15/(1+kd)4+15/(1

+kd5)+15/(1+kd)6+15/(1+kd)7+100/(1+kd)7

100=15(PVFA7,kd)+100(PVF7,kd)

y By the trial and error method we find that discount rate(kd) which solves the equation, is 15%

y100=15(4.160)+100(.376)= 62.40+ 37.60=100

y The before tax cost of bond is the rate, which theinvestment should yield to meet the outflows to bond

holders.


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ISSUED AT DISCOUNT AND PREMIUMy I0=C1/(1+k)+C2/(1+k)

2+.......Cn/(1+k)n Eq(1)

y Kd=i=INT/B0 Eq(2)

y As we seen earlier two formulas give only identical resultsonly when dept is issued at par or redeemed at par.

y If we calculate debt before tax cost of debt

y B0= INTt/(1+kd)t+Bn/(1+kd)

n Eq(3)

y Where Bn is the repayment of debt


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y It shows B0=F or B0>F or B0


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THANK YOU

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Cost of Capital Final Ppt1