 Cost of equity

 Cost of debt and preffered stock

 Weighted average cost of capital

Cost of Capital

 Basic concepts
Individuals have to decide where to invest the income they have saved. The goal, obviously, is
to gain the highest return possible. To determine which assets are profitable and which are not,
investors need a point reference. This point of reference is known as the required rate of
return (RRR).
Given individual preferences and market conditions, investors establish an expected rate return
for each asset they may purchase. Expected returns are the future receipts investors anticipate
receiving for taking the risk of making investments. If the expected return from an asset falls
belo the required rate of return , the investment will not be made. If certain assets are
expected to return more than the required rate of return, they will be bought.

 Cost of capital as a benchmark for investment decisions.

A manager of a firm with the responsibility for making investment decisions, uses a similar
point of reference. This point of reference, the firm’s required rate of return, is called the cost
of capital. The firm must earn a minimum rate of return to cover the cost of generating funds
to finance investments, otherwise, no one will be willing to buy its bonds, preferred stock and
common stock. The goal of a financial officer is to achiee the highest efficiency and profitability
from assets and at the same time , keep the cost of the funds that the firm generates from
various financing sources as low as possible. In other words the cost of capital is the rate of
return (cost) that a firm must pay investors to induce them to risk their fund and purchase the
bonds, preferred stock, and common stock issued by the firm.
Factors that determine the cost of capital include the riskiness of earnings, the proportion of
debt exposure in the capital stucture, the financial soundness of the firm, and the way investors
evaluate the firm’s securities. If expected earnings or cash flow is volatile, the debt is high and
the firm lacks a sound financial record, investors will buy its securities only if high returns are
paid to compensate them for taking the risk. In contrast, steadily growing earnings, low debt,
and a good financial background will enable the firm to issue securities at low cost.
Clearly, the cost of capital is one of the major factors used in the determination of the value of
the firm. In finance, the cost of capital is the same as the discount rate. High tisk means a high
cost of capital, while low risk means a low cost of capital. Moreover a high cost of capital
usually means a low valuation for securities, and a low discount rate means a high value for the
securities of a firm. Since the sale of these securities provides firms with funds for investments,
the cost of financing increases whten the value of securities is low and is decreases when their
value is high. The benckmark for determining whether the return of a firm’s securities are high
or low is the cost of capital.

 Cost of capital as a measure or profitability

The role played by the cost of capital in the investment decision process can be explained in
another way. When a firm issues securities it is expected to pay a return to its bond and
stockholders. This payment represents a cost. Funds raised by the issue of stocks and bonds are
invested for the purpose of generating invome fot the firm. This income, usually referred to as
cash flow , is measured by calculating the present values of the returns generated from
investments and comparing them to the cost of the investments.

Cost of equity
A company's cost of equity refers to the compensation the financial markets require in order to
own the asset and take on the risk of ownership. One way that companies and investors can
estimate the cost of equity is through the capital asset pricing model (CAPM). To calculate the
cost of equity using CAPM, multiply the company's beta by its risk premium and then add that
value to the risk-free rate. In theory, this figure approximates the required rate of return based
on risk.
Cost of Equity vs. Cost of Capital
A company's cost of capital refers to the cost that it must pay in order to raise new capital
funds, while its cost of equity measures the returns demanded by investors who are part of the
company's ownership structure.
Cost of equity is the percentage return demanded by a company's owners, but the cost of
capital includes the rate of return demanded by lenders and owners.

What is a Dividend Growth Model?

The easiest way to estimate the cost of equity capital is to use the dividend growth model.
The dividend growth model determines if a stock is overvalued or undervalued assuming that
the firm’s expected dividends grow at a value g forever, the price per share of the stock, P 0 will
be written:

where,

D0 - the dividend just paid

D1 - the next period’s projected dividend

g – dividends constant growth rate

RE (E stands for equity) for the required return on the stock - RE = D1/P0 + g

Because RE is the return that the shareholders require on the stock, it can be interpreted as

the firm’s cost of equity capital.

Advantages and Disadvantages of the Approach The primary advantage of the dividend
growth model approach is its simplicity. It is both easy to understand and easy to use. However,
there are a number of associated practical problems and disadvantages.

First and foremost, the dividend growth model is obviously only applicable to compa- nies that
pay dividends. This means that the approach is useless in many cases. Further- more, even for
companies that do pay dividends, the key underlying assumption is that the dividend grows at a
constant rate. As our example above illustrates, this will never be exactly the case. More
generally, the model is really only applicable to cases in which rea- sonably steady growth is
likely to occur.

A second problem is that the estimated cost of equity is very sensitive to the estimated growth
rate. For a given stock price, an upward revision of g by just one percentage point, for example,
increases the estimated cost of equity by at least a full percentage point. Be- cause D1 will
probably be revised upward as well, the increase will actually be somewhat larger than that.

Finally, this approach really does not explicitly consider risk. Unlike the SML ap- proach (which
we consider next), this one has no direct adjustment for the riskiness of the investment. For
example, there is no allowance for the degree of certainty or uncertainty surrounding the
estimated growth rate in dividends. As a result, it is difficult to say whether or not the estimated
return is commensurate with the level of risk.

The SML Approach

The security market line is commonly used by investors in evaluating a security for inclusion in
an investment portfolio in terms of whether the security offers a favorable expected return
against its level of risk.

E(RE)=Rf +βE ×[E(RM)−Rf]

Rf - the risk-free rate,

E(RM) − Rf - The market risk premium.

β - The systematic risk of the asset relative to that in an average risky asset

To make the SML approach consistent with the dividend growth model, we drop the Es
denoting expectations and henceforth write the required return from the SML, RE, as:

RE =Rf +βE ×(RM −Rf)

Advantages and Disadvantages of the Approach The SML approach has two primary
advantages. First: It explicitly adjusts for risk. Second: It is applicable to com- panies other than
just those with steady dividend growth. Thus, it may be useful in a wider variety of
circumstances.

There are drawbacks, of course. The SML approach requires that two things be esti- mated, the
market risk premium and the beta coefficient. To the extent that our estimates are poor, the
resulting cost of equity will be inaccurate. For example, our estimate of the market risk premium,
7 percent, is based on about 100 years of returns on a particular port- folio of stocks. Using
different time periods or different stocks could result in very differ- ent estimates.

Finally, as with the dividend growth model, we essentially rely on the past to predict the future
when we use the SML approach. Economic conditions can change very quickly, so, as always,
the past may not be a good guide to the future. In the best of all worlds, both approaches
(dividend growth model and SML) are applicable and result in similar answers. If this happens,
we might have some confidence in our estimates. We might also wish to compare the results to
those for other, similar companies as a reality check.

Cost of debt
Cost of debt is one part of a company's capital structure, which also includes the cost of equity.
Capital structure deals with how a firm finances its overall operations and growth through
different sources of funds, which may include debt such as bonds or loans, among other types.

The cost of debt measure is helpful in understanding the overall rate being paid by a company to
use these types of debt financing. The measure can also give investors an idea of the company's
risk level compared to others because riskier companies generally have a higher cost of debt.

Unlike a firm’s cost of equity, its cost of debt can normally be observed either directly or
indirectly, because the cost of debt is simply the interest rate the firm must pay on new
borrowing, and we can observe interest rates in the financial markets. For example, if the firm
already has bonds outstanding, then the yield to maturity on those bonds is the market-required
rate on the firm’s debt.

The Cost of Preferred Stock

Preferred stockholders have prior claim to the assets of a corporation over common stockholders.
However preferred stock has no maturity date and in the case of asset liquidation the holders of
preferred stock get paid only after short and long term debt holder claims ar satisfied.

The cost of preferred stock is the rate that the company must pay investors in order to persuade
them into investing in preferred shares of the company. In other words, it’s the rate or return
investors expect to receive based on the market price of the stock and the annual dividend
amount.

Preferred stock is commonly issued to fund new developments and projects a firm wants to
complete in the future. This allows the company to raise capital and dilute the current ownership
percentages of the common shareholders because preferred shares don’t have voting rights.
Preferred stock is also a more flexible option to a typical bond.

preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is
essentially a perpetuity. The cost of preferred stock, RP, is thus:

RP = D/P0

where D is the fixed dividend and P0 is the current price per share of the preferred stock. Notice
that the cost of preferred stock is simply equal to the dividend yield on the preferred stock.
Alternatively, preferred stocks are rated in much the same way as bonds, so the cost of preferred
stock can be estimated by observing the required returns on other, similarly rated shares of
preferred stock.

THE WEIGHTED AVERAGE COST OF CAPITAL

When the cost of capital for differebt securities has been determined , the next step is to calculate
the weighted average cos of capital. (WACC)

In other words we can say thar it is a calculation of a firm's cost of capital in which each category
of capital is proportionately weighted. All sources of capital, including common stock, preferred
stock, bonds, and any other long-term debt, are included in a WACC calculation.

WACC=(E/V)×RE +(D/V)×RD ×(1−TC)

where:

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 = Total market value of the firm’s financing

E/V = Percentage of financing that is equity

D/V = Percentage of financing that is debt

Tc = Corporate tax rate

To sum up the cost of capital is the required rate of return that a firm must achieve in order to cover the
cost of generating funds in the marketplace. Based on their evaluations of the riskiness of each firm,
investors will supply new funds to a firm onlt if it pays them the required rate of return to compensate
them for taking the risk on investing in the firm’s bonds and stocks. If indeed the cost of vapital is the
required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the
profitabilities of different investments. When there are differences in the degree of risk between the firm
and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability.