Cost of capital

Do You Know Your COST OF CAPITAL??

Harvard Business Review July-August 2012

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Cost Of Capital

• Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities or Project with comparable degrees of risk.

• Capital Structure - The firm’s mix of long term financing and equity financing.

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• The cost of capital represents the overall cost of financing to the firm

• The cost of capital is normally the relevant discount rate to use in analyzing an investment

• The overall cost of capital is a weighted average of the various sources:

• WACC = Weighted Average Cost of Capital

• WACC = After-tax cost x weights

Prepared By - Vinay Golchha

Harvard Business Review

• Choose to Invest massive Amount.

• Corporates strategy & Companies Competitiveness for future.

• Develop Employment & Economy growth.

• Opportunities vary across industries & Companies.

• Fair Evaluation Of financial return.

• Conducted a Survey by Association for Financial Profession.

• Comprising about More then 300 Top Financial Officers assumptions they use in financial model to Quantify investment.

• 80% Use Discounted cash Flow analysis to estimates the values.

• 90% Use CAPM Model to estimate Cost Of equity.

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CAPM MODEL

)( fmf RRβRkj Cost ofcapital Risk-free

return

Average rate of returnon common stocks

(WIG)

Co-varianceof returns against

the portfolio(departure from the

average)B < 1, security is safer than WIG average

B > 1, security is riskier than WIG average

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CAPM APPROACH

Advantage: Evaluates risk, applicable to firms that don’t pay dividends

Disadvantage: Need to estimate

• Beta

• the risk premium (usually based on past data, not future projections)

• use an appropriate risk free rate of interest

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Core Six Questions

• Q 1. What’s Your Forecasting Time Horizon?

• Q 2. What’s Your Cost Of Debt?

• Q 3. What’s Your Risk Free Rate?

• Q 4. What’s the Equity – Market Risk Premium?

• Q 5. What’s Your Beta Period?

• Q 6. What’s Your Debt-to-Equity Ratio?

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5 Yrs.46%

10 Yrs.34%

15 Yrs.

6%

Other14%

Investment Time Horizon

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Current Rate On Outstanding Debt

37%

Forecasted Rate On New Issuance*

34%

Average Historical Rate29%

Cost Of Debt

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Cost Of Debt –The effective rate that a company pays on its debt.

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16%

5%

12%

46%

4%

11%

6%

Risk Free Rate

90 days

52 weeks

5 years

10 years

20 years

30 years

others

Risk Free Rate –The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

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11%

23%

49%

17%

Equity Market Premium

< 3%

3%-4%

5%-6%

7% or >7%

Equity Market Premium -The excess return that an individual stock or the overall stock market provides over a risk-free rate.

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What's your beta period?

29%

13%

15%

41%

2%

Beta Period Or Risk Of Company Stock

1

2

3

5

others

Beta - Sensitivity of a stock’s return to the return on the market portfolio

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CurrentBook Debt

To Equity30%

Targeted Book Debt to Equity28%

Current Market Debt

To Equity23%

Current Book Debt To Current Market Equity

19%

Debt-To-Equity Ratio

Debt-to-equity Ratio-It indicates what proportion of equity and debt the company is using to finance its assets.

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Thank You..