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TopicNine:CompanyCostofCapital0
LectureOutlineThislecturewilldiscuss:Thecompanycostofcapital,withregardto:CalculationofthecompanycostofcapitalEstimationofthecostofdebtcapitalEstimationofthecostofequitycapitalTheimpactofcorporatetaxonthecompanycostofcapitalThecalculationandforecastingoffreecashflows,including:CashflowreportinginfinancialstatementsPreparationoffreecashflowforecasts
Valueofafirm
ThecompanycostofcapitalShareholdersDebtholders$10millioninvestedOpportunitycost=16%Annualcost=$1.6million$10millioninvestedInterestrate=10%Annualcost=$1millionCOMPANY
Whatisthecostofcapital?
TotalrequiredreturnRequiredreturn/investedcapital$2.6m/$20m=13%
Totalrequiredreturn(cont’d)OrcalculateusingtheWeightedAverageCostofCapital(WACC)asfollows:where: D=marketvalueofdebt E=marketvalueofequity rd=costofdebt re=costofequity
Example:WACCThemarketvalueofdebtandequityofacompanyare$10millioneach.Thedebtholdersofthecompanychargeaninterestrateof10%p.a.whiletheequityholdersrequireareturnof16%ontheirinvestment.Whatisthecompanycostofcapital?
ThecostofdebtcapitalIntopic4,thefollowingexpressionwasusedtofindthevalueofadebtsecurity: where: D = themarketvalueofthedebt n = thetimetomaturityofthedebt C = thedollarinterestpaidonthedebt F = thefacevalueofthedebt rd = thediscountrate=THECOSTOFDEBT
EstimatingthecostofdebtThereareseveralapproaches:Assumethedebtisrisk-free,andusethe10-yeargovernmentbondyieldAdd100–200basispoints(1–2%)tothe10-yearbondyieldtoallowforriskUsethefollowingequation: where: netinterest=interestpaid-interestreceived averagenetdebt=reportedbookvalueofdebt-cash
TheaftertaxcostofdebtBecauseinterestexpensesaretaxdeductableweoftenwanttheaftertaxcostofdebt:=rd(1-tc)where:rd=
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