COST OF CAPITAL
Managerial Finance
Costs involved in obtaining fund are called cost of capital.
Capital is the or used to generate either by in or a different
Capital can be classified into two major types:
1. Dept: It is provided by the creditor of the organization to receive the predetermined rate of interest.
2. Equity: It is provided by the owner of the organization to receive the dividend.
Cost of long term dept
The cost of long term dept is the after tax cost today of raising long term funds through borrowing
Before tax cost of dept and after tax cost of dept
EBIT –interest = EBT – tax = EAT
Calculation of cost of capital is implemented to reduce the available earnings for distribution
Cost of long term dept can be calculated in following three ways
-Quotation:
1. When the net proceeds from sale of a bond equal its per value, the before tax cost is just equal to the coupon interest rate.
2. Yield to Maturity (YTM) can be considered as before tax cost of dept in case of similar risk bond.
-Calculation:
In this technique before tax cost of capital is determined by calculating internal rate of return. The cost of maturity can be calculated using a financial calculator, an electronic spreadsheet or a trial and error technique. It represents the annual before tax cost of the dept.
-Approximation:
After tax cost of dept ki = kd (1-T)
Cost of preferred stock
Preferred Stock: A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights. The precise details as to the structure of preferred stock are specific to each corporation. However, the best way to think of preferred stock is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). Also known as "preferred shares".
Kp = Dp / Np
Cost of Common Stock
Common Stock: A security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy. Common stockholders are on the bottom of the priority ladder for ownership structure. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt holders have been paid in full.
CAPM (Capital Asset Pricing Model)
Constant Growth Valuation Model
1. Po = D1/rs-g
2. rs = D1/Po + g
Here,
Po =value of the common stock
D1 =per share dividend expected in the end of the year 1
g = constant growth of the dividend
rs =required return on common stock
Costs involved in obtaining fund are called cost of capital.
Capital is the or used to generate either by in or a different
Capital can be classified into two major types:
1. Dept: It is provided by the creditor of the organization to receive the predetermined rate of interest.
2. Equity: It is provided by the owner of the organization to receive the dividend.
Cost of long term dept
The cost of long term dept is the after tax cost today of raising long term funds through borrowing
Before tax cost of dept and after tax cost of dept
EBIT –interest = EBT – tax = EAT
Calculation of cost of capital is implemented to reduce the available earnings for distribution
Cost of long term dept can be calculated in following three ways
-Quotation:
1. When the net proceeds from sale of a bond equal its per value, the before tax cost is just equal to the coupon interest rate.
2. Yield to Maturity (YTM) can be considered as before tax cost of dept in case of similar risk bond.
-Calculation:
In this technique before tax cost of capital is determined by calculating internal rate of return. The cost of maturity can be calculated using a financial calculator, an electronic spreadsheet or a trial and error technique. It represents the annual before tax cost of the dept.
-Approximation: After tax cost of dept ki = kd (1-T)
Cost of preferred stock
Preferred Stock: A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights. The precise details as to the structure of preferred stock are specific to each corporation. However, the best way to think of preferred stock is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). Also known as "preferred shares".
Kp = Dp / Np
Cost of Common Stock
Common Stock: A security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy. Common stockholders are on the bottom of the priority ladder for ownership structure. In the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debt holders have been paid in full.
CAPM (Capital Asset Pricing Model)
Constant Growth Valuation Model
1. Po = D1/rs-g
2. rs = D1/Po + g
Here,
Po =value of the common stock
D1 =per share dividend expected in the end of the year 1
g = constant growth of the dividend
rs =required return on common stock
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