Assignment only for Dr.Keloki
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caverk_m4_a2.pptxCost of Debt and Equity Module 4 Assignment 2 Argosy Online University
Katrina Caver
06/30/15
Debts is borrowing which allows a investor to finance the business therefore having to pay interest on the borrowings. The cost of debt is the interest which a business has to pay on the borrowings and normally it is taken after tax as it is the tax deductible expense.
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WACC
Definition of WACC
How to calculate cost of debt
Weighted average cost of capital is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds and any other long-term debt (Kahn,1985). The cost of debt is calculated by taking the rate on a risk-free bond in which the duration matches with the term organization of the corporate debt, and then add a default premium. It can also be used to discount future cash flows.
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WACC
Beta
Risk Free Rate
Expected return
Cost of Equity Re
Cost of debt Rd
Debt & Equity
The two primary sources of financing
How to calculate WACC effectively
Cost of Equity(CAPM) = (Rm-Rf)*Beta
Cost of Debt = Interest Payments
A company has two primary sources of financing - debt and equity - and, in simple terms, WACC is the average cost of raising that money. WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the WACC value (Kahn, 1985). Cost of equity can also be computed by using the Dividend Valuation Model and Capital Asset Pricing.
CAPM Model:
k.e = (Rm-Rf)*beta
Rm = Market return
Rf= Risk free return
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CALCULATIONS
Debt 600000 10.50% 0.0315
Equity 1400000 15.5% 0.10857
2000000 14.0%
Cost of Equity3+1.39(12-3) 15.5%
WACC = k.e*equity/Equity + Debt + k.d (1-t)*Debt/ Equity + Debt
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Market Rate
What rate is applied on cost of debt
In case the company is not paying market rates, an appropriate market rate payable by the company should be estimated (Patterson, 1995) .
Market rate is rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt.
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Tax
The net cost of the debt
As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment (Patterson, 1995.
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Return on Investment
Return on equity investment in a company
Equity holders' required rate of return as a cost
Equity shareholders expect to obtain a certain return on their equity investment in a company. From the company's perspective, the equity holders' required rate of return is a cost, because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop (Beltrame & Cappelletto, 2014) .
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Capital
It is useful for investors to see if projects or investments or purchases are worthwhile to undertake.
It is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others (Beltrame & Cappelletto, 2014) .
It has also been explained as the minimum return a company can make to repay capital providers.
Value for Shareholders
WACC which represents minimum rate of return company must earn to create value for shareholders and debt holders.
Weighted Average Cost of Capital is the cost of capital determined by weighting the companies after tax cost of debt with its cost of equity.
WACC is equally important to increase value and is used as a strategic decision making tool(Glen & Pinto, 1994).
Formula
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is de
WACC
Beta
Risk Free Rate
Expected return
Cost of Equity Re
Cost o debt Rd
Reference
Kahn, J. (1985). On cost of equity capital estimation: Theory and practice.
Patterson, C. (1995). The cost of capital theory and estimation. Westport, Conn.: Quorum Books.
Beltrame, F. & Cappelletto, R. (2014). Estimating SMEs cost of equity using a value at risk approach: The capital at risk model. Basingstoke: Palgrave Macmillan
Glen, J. & Pinto, B. (1994). Debt or equity? how firms in developing countries choose. Washington, D.C.: World Bank.
Cost of Debt
PVIF6
Interest ratex in PVIF formula
1-1/1+x^10)/x
The x in PVIF formula is6.01477310.50%
Cost of Equity
3+1.39(12-3)15.5%
WACC to be used as required rate of return
Debt60000010.50%0.0315
Equitgy140000015.5%0.10857
200000014.0%
