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Debt and Equity Financing

Cost of Debt and Equity

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Cost of Debt

• Example of Debt Financing• Debt: Jones Industries borrows $600,000 for

10 years with an annual payment of $100,000. What is the expected interest rate (cost of debt)?

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Cost of Debt

Solution:

• Borrowing 600,000 • Period 10 years • Yearly payments 100,000 • Expected Interest rate(EPR) To be calculated (Cost of Debt)

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Cost of Debt

• The expected rate of return is the "annualized effective compounded rate” that makes the net present value of all cash flows (both positive and negative) from a particular investment equal to zero.

• NPV = NET*1/(1+EPR)^year• In this case it is 10.56%

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Cost of Debt

Time period (Years) Dates Cash inflows and outflows

01/01/2012 (600,000)

1 12/31/2012 100,000

2 12/31/2013 100,000

3 12/31/2014 100,000

4 12/31/2015 100,000

5 12/31/2016 100,000

6 12/31/2017 100,000

7 12/31/2018 100,000

8 12/31/2019 100,000

9 12/31/2020 100,000

10 12/31/2021 100,000

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Cost of DebtFormula for calculation of Present Value Present values of Cash inflows and outflows

(600,000)

100,000((1+10.56%)^-1) 90,450

100,000((1+10.56%)^-2) 81,813

100,000((1+10.56%)^-3) 74,000

100,000((1+10.56%)^-4) 66,933

100,000((1+10.56%)^-5) 60,541

100,000((1+10.56%)^-6) 54,759

100,000((1+10.56%)^-7) 49,530

100,000((1+10.56%)^-8) 44,800

100,000((1+10.56%)^-9) 40,522

100,000((1+10.56%)^-10) 36,652

Total (0)

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Cost of Equity

• Example of Equity Financing:• Internal common stock: Jones Industries has a

beta of 1.39. The risk-free rate as measured by the rate on short-term US Treasury bill is 3 percent, and the expected return on the overall market is 12 percent. Determine the expected rate of return on Jones’s stock (cost of equity). Here are the details:

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Cost of Equity

Jones Total Assets $2,000,000

Long- & short-term debt $600,000Common internal stock equity $400,000New common stock equity $1,000,000

Total liabilities & equity $2,000,000

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Cost of Equity

• Formula for Cost of Equity• Cost of equity = Risk free rate of return + Beta

x where;

• Beta= sensitivity to movements in the relevant market.

• X=market rate of return- risk free rate of return

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Cost of Equity

• Beta 1.39• Risk free rate of return 3%• Market expected rate of return 12%• X (12%-3%) 9%

Cost of equity = 3% + (1.39 * (12% - 3%)) =15.51%

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Weighted Average Cost of Capital (WACC)

• WACC weights the cost of equity and the cost of debt by the percentage of each used in a firm’s capital structure

• WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)– (E/V)= Equity % of total value– RE= Return on equity %– (D/V)= Debt % of total value– RD = Return on debt %– (1-Tc)*= After-tax %

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Weighted Average Cost of Capital (WACC)

• WACC=(1,400,000/2,000,000) x 15.51% + (6,00,000/2,000,000) x 10.56% x (1 - 15%)

• WACC= 13.55%