A504C293 - Module 9 The Cost of Capital and Capital...

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1 Module 9 The Cost of Capital and Capital Structure Theory
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2 Learning Objectives Understand the cost of capital Calculate the cost of each component Calculate the weighted average cost of capital Discuss the effect that tax and other external factors have on the capital structure and on the cost of capital Understand the concept of an optimal capital structure Discuss the factors that impact on an entity’s financing strategies
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3 Components of Capital A firm’s value is defined as a function of the cash flows generated from the assets constituting the firm. Assets of a firm are obtained by selling financial assets in the capital market. Financial assets may be in the form of debt securities (ex: debentures, mortgage loans), equity securities such as ordinary shares, preferred shares, and convertible debt. Therefore, the components of capital include: Various type of debts Preference and ordinary shares Retained earnings i.e. liability and equity compose the capital structure
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4 Sources of Finance Likely to be Sources of Finance Likely to be Found in the Balance Sheet Found in the Balance Sheet Debt: overdrafts trade creditors commercial bills notes mortgage loans debentures convertible notes unsecured notes Equity: Equity:     ordinary shares ordinary shares     preference shares preference shares     retained earnings retained earnings
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5 Cost of Capital Cost of Capital Minimum rate of return needed to compensate suppliers of capital for committing resources to an investment. The returns received by investors in securities must be provided by the issuers of those securities and, from the issuer s viewpoint, the return demanded by investors is effectively a cost (cost of capital).
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6 Cost of Equity: ordinary shares ( 29 ( 29 ( 29 ( 29 = + = + + + + + + = 1 0 2 2 1 0 1 1 ...... 1 1 t t e t e e e k D P K D K D K D P where: P 0 = the current price of shares D t = the dividend paid in year t k e = the required return on shares In Module 4 we saw that the value of equity is based on the present value of future dividends:
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7 Cost of Ordinary Shares: constant dividend approach
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A504C293 - Module 9 The Cost of Capital and Capital...

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