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Chapter 15 Finman

This chapter discusses calculating a company's weighted average cost of capital (WACC). The WACC aids business and investors in evaluating investment opportunities by discounting future cash flows to present value. It is used to determine if investments are worth the risk compared to the return. A company's WACC is calculated using the component costs of debt, preferred shares, and ordinary equity, weighted based on the target capital structure. Calculating WACC helps companies evaluate budget decisions and investment opportunities.

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338 views

Chapter 15 Finman

This chapter discusses calculating a company's weighted average cost of capital (WACC). The WACC aids business and investors in evaluating investment opportunities by discounting future cash flows to present value. It is used to determine if investments are worth the risk compared to the return. A company's WACC is calculated using the component costs of debt, preferred shares, and ordinary equity, weighted based on the target capital structure. Calculating WACC helps companies evaluate budget decisions and investment opportunities.

Uploaded by

Erica
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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BY CLAIRE T.

DELVO

CHAPTER 15
CALCULATING THE COST
OF CAPITAL
This chapter ask the question of ‘ How
much must the firm pay to finance its
operation and expansion using debt
and equity sources?’
Used by the companies to judge whether a
capital project is worth the expenditure of
resources.

To determine whether an
investment is worth the risk
compared to the return.

WHY DO WE
NEED TO
COMPUTE
THE COST OF
CAPITAL?
Why is it important?
• The cost of capital aids business and investors in evaluating all
investments opportunities.
• It does so by turning future cash flows into present value by
keeping it discounted.
• Also aid in making key company budget calls that use company
financial sources as capital.
• Also known as opportunity cost of making specific investment in
the company..
Investors face different kinds of risks associated with
debt, preferred share and ordinary equity(component
costs) so that their required rate of return for each debt
and equity source differ as well as the firm uses
combination of different financing resources, the
investors required rate of return must be calculated.

The weighted average is generally used since firm


seldom use equal amounts of debt and equity sources.
Component cost used in the average
required rate of return to know whether
dividends paid to either ordinary equity
or preferred shareholders are not tax
deductible while interest to debt holders
are tax deductible.
• Investor supplied items – debt, preferred shares , and
ordinary shares are called capital components.
• The capital components are combined to form a
Weighted Average Cost of Capital (WACC).
• Not included as part of investor-supplied capital if they
do not come directly from investors.
Cost of Debt
• Minimum rate of return required by suppliers of debt.
• The before tax cost of debt is an interest rate a firm
must pay on its new debt.
• The after tax cost of debt is used to calculate the WACC.

After-tax cost of debt = Interest rate (1-Tax rate)


Cost of Preferred Share
• Preferred share is a hybrid security that has characteristics of both debt and
equity.
• Under PFRS, if the preferred share is considered as debt, the computation of the
cost of debt will apply.
• However if the preferred shares have a fixed dividend payments and no stated
maturity dates, the component cost of new preferred shares is computed as
follows:
Annual dividend per share on preferred share / Net proceeds from sale of preferred share
Cost of Ordinary Equity Share
• Does not represent a contractual obligation to make specific payments thus makes it
more difficult to measure than the other.
• Business firms raise equity capital externally through sale of ordinary shares and
internally through retained earnings(APPROPRIATED R.E)
• Cost of new ordinary equity share is higher than the cost of retained earnings because of
the floatation costs involved in selling new ordinary equity share which reduce the net
proceeds of the firm.
• Cost of Equity : The CAPM Approach, Bond Yield Plus Risk Premium Approach, Dividend
Yield Plus Growth Rate Approach, Discounted Cash Flow Approach, Earnings – Price Ratio
Method
• Cost of New Ordinary Equity Shares
• Cost of Retained Earnings
When must External Equity be used?
• Because of floatation costs, pesos raised by selling new stock must ‘work harder’ than
pesos raised by retained earnings.
• Therefore, firm should utilize retained earnings to the greatest extent possible.
• However, if a firm has more good investment opportunities that can be financed with
retained earnings plus the debt and preferred share supported by those retained earnings,
it may need to issue new ordinary equity or ordinary share.
• The total amount of capital that can be raised before new shares must be issued is defined
as the retained earning breakpoint.
Addition to the retained earnings for the year / Equity fraction
Problem to Consider with Estimates of Cost of Capital

• Privately owned firms


• Measurement Problems
• Capital Structure Weights
• Cost of Capital for Projects of Differing Risk
Determination of Weighted Average Cost of Capital
• Historical Weights
a) Book Value Weights
b) Market Value Weights
• Target Weights

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