COST OF EQUITY AND CAPITAL

PRICING MODEL
Presented by:
Akhilesh Dalal
Preeti Yadav
Bhushan Pednekar
Anuja Naik
REQUIRED RETURN
 The required return is the same as the appropriate
discount rate and is based on the risk of the cash flows
 We need to know the required return for an investment
before we can compute the NPV and make a decision
about whether or not to take the investment
 We need to earn at least the required return to
compensate our investors for the financing they have
provided

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REQUIRED RATE OF RETURN
CAPM

= The risk free return.

= The market risk premium.
β = The beta of the firms share.
“COST OF CAPITAL?”
 Whenwe say a firm has a “cost of capital” of, for
example, 12%, we are saying:
 The firm can only have a positive NPV on a project if
return exceeds 12%
 The firm must earn 12% just to compensate investors for
the use of their capital in a project
 The use of capital in a project must earn 12% or more,
not that it will necessarily cost 12% to borrow funds for
the project
 Thus cost of capital depends primarily on the USE
of funds, not the SOURCE of funds
COST OF EQUITY
 There are two major methods for determining the cost of
equity
 Dividendgrowth model
 SML or CAPM

15-5
THE DIVIDEND GROWTH MODEL
APPROACH
 Start with the dividend growth model formula and
rearrange to solve for RE

D1
P0 
RE  g
D1
RE   g
P0
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DIVIDEND GROWTH MODEL EXAMPLE
 Suppose that your company is expected to pay a
dividend of 1.50 per share next year. There has been a
steady growth in dividends of 5.1% per year and the
market expects that to continue. The current price is 25.
What is the cost of equity?

1 .50
RE   .051  .111  11 .1 %
25
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 ADVANTAGES AND DISADVANTAGES OF DIVIDEND
GROWTH MODEL

 Advantage – easy to understand and use

 Disadvantages
 Only applicable to companies currently paying dividends
 Not applicable if dividends aren’t growing at a reasonably
constant rate
 Extremely sensitive to the estimated growth rate – an increase
in g of 1% increases the cost of equity by 1%
 Does not explicitly consider risk

15-8
THE CAPM APPROACH
 Use the following information to compute our cost of
equity
 Risk-free rate, Rf
 Market risk premium, (RM) – Rf
 Systematic risk of asset, 

15-9
EXAMPLE
 Suppose your company has an equity beta of .58 and the
current risk-free rate is 6.1%. If the expected market risk
premium is 8.6%, what is your cost of equity capital?
 RE = 6.1 + .58(8.6) = 11.1%
 Since we came up with similar numbers using both the
dividend growth model and the SML approach, we
should feel pretty good about our estimate

15-10
ADVANTAGES AND DISADVANTAGES OF
SML
 Advantages
 Explicitlyadjusts for systematic risk
 Applicable to all companies, as long as we can estimate beta
 Disadvantages
 Have to estimate the expected market risk premium, which
does vary over time
 Have to estimate beta, which also varies over time
 We are using the past to predict the future, which is not
always reliable

15-11
COST OF EQUITY VS. DIVIDEND
GROWTH MODEL
 Dividend – growth : Limited approach Because of two
assumption:
1. Dividend per rate will grow at constant rate.
2. Expected dividend growth rate, g, should be less than
the cost of equity, ke, to arrive at the simple formula.
That is:
 Capital asset pricing
model
 Has a wider application although it is based on restrictive
assumption:
 Only condition to use is company’s share is quoted on the
stock of exchange.
 All variable in the CAPM are market determine and expected
the company share price data, they are common to all
companies'
WEIGHTED AVERAGE COST OF
CAPITAL (OVERVIEW)
 A firm’s overall cost of capital must reflect the
required return on the firm’s assets as a whole
 If a firm uses both debt and equity financing, the
cost of capital must include the cost of each,
weighted to proportion of each (debt and equity)
in the firm’s capital structure
 This is called the Weighted Average Cost of
Capital (WACC)
WEIGHTED AVERAGE COST OF CAPITAL

Ko is the WAAC
Kd(1-T) after tax cost of debt
Ke is after tax equity.
D amount of debt
E amount of equity
COMPUTATION OF WEIGHTED AVERAGE COST OF
CAPITAL

Source Amount Proportion After-tax cost Weighted

(1) % (2) (%) Cost (%)
(3) (4)

(4) = (2) * (3)

Equity Capital 450000 45 18 8.1

Reserve and 150000 15 18 2.7

Surplus
Preference 100000 10 11 1.1
capital
Debt 300000 30 8 2.4

Total 1000000 100 WACC 14.3

COMPUTATION OF WEIGHTED AVERAGE COST
OF CAPITAL(MARKET- VALUE WEIGHTS)
Source Amount Proportion After-tax cost Weighted
(1) % (2) (%) Cost (%)
(3) (4)

(4) = (2) * (3)

Equity Capital 900000 69.2 18 12.5

Preference 100000 7.7 11 0.8

capital

Debt 300000 23.1 8 1.8

Total 1300000 100 WACC 15.1

 Why do managers prefers the book value weights for
calculating WACC?
1. Firm in practice set their target capital structure I firms n
terms of book value.
2. The book value information can be easily derived from the
published source.
3. The book value and debt equity ratios are analyses by the
investors to evaluate the risk of the firm in practise
FLOTATION COSTS

 The expense involved in selling a new security issue.

 This expense includes items such as legal fees, administrative

expenses, brokerage or underwriting commission.
PROBLEM:
 Before-tax cost of debt

By trial and error method:

kd = 17.6%

Hence After-tax cost of debt: (Tax rate = 50%)

=0.176 (1 - 0.50)
= 0.088 or 8.8%
 Cost of equity:
ke = DIV 1 + g
Po(1-f)
= 1.80 + 0.07
20(1-0.1)
= 0.17 or 17%

 ‘Flotation-cost adjusted’ weighted average cost of capital:

Ko = 0.088*0.50+0.17*0.50
= 0.13 or 13%

 NPV at the discounted rate of 13%:

= -4,50,000+1,50,000*4,423
=Rs 2,13,450
 Flotation cost is not a annual cost but a one time cost
when the investment project is undertaken and financed.
 For discount rate: if cost of capital is adjusted for
flotation costs, the result will be compounded over the
life of the project hence NPV will be biased.
Ideally:
 Adjust the investment project’s cash flow for flotation
costs.
 WACC unadjusted for flotation cost = discount rate .
 Flotation Cost=0.1(2,50,000+2,50,000)
=50,000

 Net Cash Outlay =4,50,000+50,000

=5,00,000

 After-cost of debt:
=0.15(1-0.5)
= 0.075 or 7.5 %
 Costof equity:
Ke = Rs 1.80 + 0.07
Rs 20
= 0.09 + 0.07
= 0.16 or 16 percent

 WACC, without the adjustment of floatation costs:

k0= 0.075 * 0.5 +0.16 * 0.5
= 0.12 or 12 %

 The NPV investment project :

= -500000 + 150000* 4.564

= Rs 1,84,600
THANK YOU