A PRESENTATION BY

GROUP #4

MUHAMMADAQIBISHTIAQ
MUHAMMADOSAMAAQIL
MUHAMMADASADALI
S.M.ABBASALIRIZVI
COURSE NO.ACT-512(BASICFINANCE)

PRESENTED TO

Mr.IRSHADALI

CostofCapital

Weighted-Average Cost of Capital

(WACC)

Where,

% of debt in capital structure

Yield to maturity on existing/new debt; this is the before-tax

cost of debt
After-tax cost of debt, where t is the marginal tax rate
only interest on debt is paid pre-tax

Cost of preferred stock

Cost of common equity

% of preferred stock in capital structure
% of common equity in capital structure

Weighted-Average Cost of Capital

(WACC)
Measures the returns demanded by all providers of capital

As an opportunity cost
Incorporates debt tax shields
Risk and return

WACC (EXAMPLE)
Suppose the Widget Company has a capital structure composed of the
following, in billions:
Capital Structure (%)
Debt
10
20 %
Common equity
40
80 %
If the before-tax cost of debt is 9%, the required rate of return on equity is
15%, and the marginal tax rate is 30%, what is Widgets weighted average cost
of capital?
Solution:
WACC
=
=

=
[(0.20)(0.09)(1 0.30)] + [(0.8)(0.15)]
0.0126 + 0.120
0.1325, or 13.25 %

Target Capital Structure

The proportions (based on market values) of

debt, preferred stock, and equity that the firm
expects to achieve over time

Costs of the Different sources of

capital
Costs of Capital
Cost of Debt
Yield to Maturity

Debt Rating

Cost of Preferred
Equity
Return on
Preferred Stock

Cost of Common
Equity

Capital Asset
Pricing Model
Dividend
Discount Model
Bond Yield Plus
Risk Premium

Cost of Debt
The after-tax cost of debt, ri as stated in the following
equation:

after-tax cost of debt =

rd (1 T)

Cost of Debt (cont.)

Flotationcosts
1. Underwriting costs
2. Administrative costs
Duchess Corporation, a major hardware manufacturer, is
contemplating selling $10 million worth of 20-year, 9% coupon
bonds with a par value of $1,000. Because current market
interest rates are greater than 9%, the firm must sell the bonds at
$980. Flotation costs are 2% or $20.
. The net proceeds to the firm for each bond is therefore $960
($980 $20).

Cost of Debt (cont.)

Alternative approaches
1. Yield-to-maturityapproach: Calculate the yield to
maturity on the companys current debt.
2. Debt-ratingapproach: Use yields on comparably rated
bonds with maturities similar to what the company has
outstanding.

Cost of Debt (EXAMPLE)

Yield-to-Maturity Approach
Consider a company that has
$100 million of debt outstanding
that has a coupon rate of 5%, 10
years to maturity, and is quoted at
$98. What is the after-tax cost of
debt if the marginal tax rate is
40%?
Assume
semi-annual
interest.

Debt-Rating Approach
Consider a company that has
nontraded $100 million of debt
outstanding that has a debt-rating
of AA. The yield on AA debt is
currently 6.2%. What is the aftertax cost of debt if the marginal
tax rate is 40%?

Solution:
ri = 0.05 (1 0.4) = 3.156%

Solution:
ri = 0.062 (1 0.4) = 3.72%

The cost of debt capital is 3.156%

The cost of debt capital is 3.72%

Affects on Cost of Debts

Using Greater Amounts of Debt

Current Economic Conditions

Getting of New Fund

The Cost of Preferred Stock

The costofpreferredstock,rp , is the ratio of the
preferred stock dividend to the firms net proceeds
from the sale of preferred stock.

The Cost of Preferred Stock (EXAMPLE)

Wells Fargo & Company has 3,500,000 shares of $1,000 par
value non-cumulative series L preferred stock. They carry
annual fixed coupon rate of 7.5%. The preferred stock has a
current market price on 29 December 2012 of $1,225.45. Find
the cost of preferred stock?
Annual dividend payment = 7.5% of $1,000 = $75

Affects on Cost of Preferred Stocks

Prevailing Interest Rates

Company Performance

Call Provision

The Cost of Common Equity

Ways to determine cost of common stock equity

1. Dividend Growth Model OR Discounted Cash flows (DCF)

2. Capital Asset Pricing Model (CAPM)
3. Bond-Yield-Plus-Risk Premium

The Cost of Common Equity (cont.)

Dividend

Growth Model OR Discounted Cash flows (DCF)

The discounted cash flow (DCF) approach uses the consensus

future dividend estimates with the stock price to determine the
marginal investors required return () for a stock

Where,

g = firms expected constant growth rate

= ROE x retention rate

The Cost of Common Equity (cont.)

Capital Asset Pricing Model (CAPM)

A common stock has a beta of 1.2 with respect to the

domestic stock index. The risk-free rate is 4.75% and the
domestic market risk premium () is 6%.

=+

=4.75%+1.2(6%)
=11.95%.

The Cost of Common Equity (cont.)

Bond Yield Plus Risk Premium

The risk premium for this firm

ranges from 2% to 4%,
and is expected to be 3%.

Bond # 1

Bond # 2

20

20

Yearstocall

Couponrate

6.00%

8.50%

$926.29

$1,121.00

Maturityvalue

$1000

$1000

YTM

6.67%

7.34%

YTC

9.85%

6.67%

MostlikelyYield

6.67%

6.67%

Yearstomaturity

Price

= 6.67% + 3.00%
= 9.67%.
The range of estimates is
between 8.67% and 10.67%.

Affects on Cost of Common Equity

Current price

Net Income

Stockholders' Equity

Thank you
Q/A