Cost of Capital for Equity and Debt Holders- myassignmenthelp

Question: Discuss about theCost of Capital for Equity and Debt Holders. Answer: Cost of debt Face value of debt = $1,800,000 Maturity = 2 years Coupon rate = 5.8% p.a paid semi annually The debt rating of the company is AAA, hence according to the credit rating table the yield on bond for 2 years is 0.26%. Cost of debt = 0.26% Cost of Preference share Annual dividend = $0.56 Price of share = $9.30 Cost of preferred capital = annual dividend / price of share = 0.56 / 9.3 = 6% Cost of Equity Risk free rate is considered as the 10 year yield on AAA rated bond which is 0.76%. Beta = 1.4 Market risk premium = 9.6% Cost of equity = Rf + (Beta * market risk premium) = 0.76% + (1.4*9.6%) = 13.7% For weights of each capital, the market value is determined as follows: Market value of debt Price of bond = C*F * ((1-(1+r)-t) / r = 0.029 * 1800000 * ((1-(1+0.0026)-4) / 0.0026 = $207,449.8 Market value of preferred capital No. of shares = 400,000 Market value = 400000 * 9.3 = 3,720,000 Market value of equity Dividend = $0.72 Growth rate for next three years = 8% Constant growth rate = 2% Year Growth rate Dividend 0 $0.72 1 8% $0.78 2 8% $0.84 3 8% $0.91 4 2% $0.93 Price of share = expected dividend / (cost of equity growth rate) Price of share at end of 3rd year = 0.93 / (13.7% - 2%) = $7.95 Present value of cash flows Year Cash Flow Present value 1 $0.78 $0.68 2 $0.84 $0.65 3 $0.91 $0.62 3 $7.95 $5.41 Total present value $7.36 No. of equity share = 1700000 Market value of equity = 1700000 * 7.36 = $12,509,137 WACC Capital Market Value Weights Cost of capital Weighted cost of capital Debt $2,07,449.80 0.01 0.0026 0.00003 Preferred capital $37,20,000.00 0.23 0.06 0.01358 Equity $1,25,09,137.26 0.76 0.137 0.10426 $1,64,36,587.06 1 11.8% Hence the WACC is 11.8% WACC as the discount rate Weighted average cost of capital is the cost of capital of a company that takes into consideration the cost of all the sources of capital used in a business for funding projects and investments. The sources of funds available to a business are debt, equity, preferred stock and retained earnings. Equity is generally the most expensive source of finance and retained earnings the cheapest. WACC shows the interest that the company will have to pay for every dollar invested. The equity holder and debt holders expect a return on their investment and this cost of capital measures the expected returns of the equity and debt holders. WACC is the minimum return that the company should produce for its investors. While evaluating a project under capital budgeting, a cost of capital is required to discount the cash flows to their present value because the rate used to discount the cash flows should represent the expected after tax returns of the different providers of capital. This is to see if the project gives a positive NPV and also two similar projects with different time frame can be compared using a discount rate as all the cash flows are discounted to the present (Young, 2002) In general the companies mostly use WACC as that cost of capital. This is because WACC incorporates all the risk associated with the different sources of finance like debt and equity. When the company is undertaking a project of similar risk as that of the existing projects of the company, it is appropriate to use the WACC as the discount rate. For example, a manufacturer of textiles increases the number of looms from 650 to 100, in this case the industry and the business is the same and there is no change in risk , hence it is preferable to use WACC as the cost of capital. This also means that as a result of the new project, there is no change in the capital structure of the company. This means the ratio of debt and equity should not change due to the new project and should be what it was in the balance sheet. However, WACC cannot be used as a discount rate for projects with a risk different from the existing projects risks. In such cases, the WACC of the company similar to the new project should be taken into consideration or the cost of equity can be calculated using the CAPM model. For riskier projects, a higher discount rate may be used and for less risky projects, a lower discount rate should be used. Bibliography Young, L. (2002, September). Determining the Discount Rate forGovernemnt Projects. New Zealand Treasury: Working Paper 2/21.