Topic Seven - Company Cost of Capital

# Topic Seven - Company Cost of Capital - Topic 7 Company...

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Unformatted text preview: Topic 7 Company Cost of Capital Craig Mellare University of Sydney Lecture Outline Co st of De bt Ca pi tal Co st of Eq ui ty Ca pi tal Co st of Ca pi tal (be fore/ after tax) Value of a Firm NPV = ∑ t=1 00 F t (1+r) t where : F t = net cashflows after tax but before interest r = after tax required rate of return (company cost of capital) What is the Cost of Capital? Capital Amount Annual Cost % of Total Annual Cost Equity \$2m 15% 20% \$0.3m Debt \$8m 10% 80% \$0.8m Total \$10m ? 100% \$1.1m Total Required Return Required Return/Invested Capital \$1.1m/\$10m = 11% Total Required Return (Cont’d) Or calculate using the Weighted Average Cost of Capital (WACC) as follows: D/(D+E) x r d + E/(D+E) x r e where : D = value of debt E = value of equity r d = cost of debt r e = cost of equity Example: WACC The debt and equity of a company have invested 8 million and 2 million respectively. The debtholders of a company charge an interest rate of 10% p.a. while the equity holders require a return of 15% on their investment. What is the company cost of capital? D/(D+E) x r d + E/(D+E) x r e 8/(8+2) x 0.10 + 2/(8+2) x .15 0.11 or 11% Cost of Debt Market Value of Debt = ∑ t=1 n Interest t + Principal t (1+r d ) t where n = life of debt r d = required return on debt Estimating the Cost of Debt r d = net interest/net debt Net Debt is: interest bearing debt less cash long term debt less cash excludes creditors, accrued expenses etc. Cost of Debt is: Net interest (interest paid - interest received) The borrowing rate The After Tax Cost of Debt = r d (1-t c ) where: r d = before tax cost of debt t c = the corporate tax rate eg. if r d = 10%; t c = 30% then after tax cost of debt = 10% (1-.30) = 7.0% Cost of Equity the minimum required rate of return on shares for the risk involved Estimation methods: implied from current prices modelled using the CAPM Implying the Cost of Equity...
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Topic Seven - Company Cost of Capital - Topic 7 Company...

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