Question

Explain how to estimate the cost of capital. In particular, explain how to estimate the equity cost of capital, list two different methods to estimate the debt cost of capital, and how to calculate the weighted average cost of capital for a given debt-equity ratio.

Answer 1

Ans 1

Cost of Capital

Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk.

The cost of capital metric is used by companies internally to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return. The cost of capital depends on the mode of financing used.

Cost of Capital Formula = (Weight of Debt x Cost of Debt)+(Weight of Preference Share x Cost of Preference Share)+(Weight of Equity x Cost of Equity)

Where

Cost of debt = Interest Expense * (1 – Tax Rate) ÷ Amount of outstanding debt

Cost of Preference Share = Dividend on preference share ÷ Amount of Preferred Stock

Cost of Equity = Risk-Free Return + Beta * (Average Stock Return – Risk-Free Return)

Ans 2

Equity Cost of Capital

The cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital.

Cost of Equity Formula= Risk free rate of return + Beta × (market rate of return – risk free rate of return)

OR

Rf + βi * [E(Rm) – Rf]

Where

E(Ri) = Expected return on asset

Rf = Risk-free rate of return

βi = Beta of asset i

E(Rm) = Expected market return

Ans 3

Debt Cost of Capital

The cost of debt is the return that a company provides to its debtholders and creditors.

There Are two Type of Debt

1) Irredeemable debt:-

Irredeemable debt is debt that has no specific redemption date or maturity period. The issuing authority or entity pays a specified interest rate periodically but provides no data on when principal will be returned.

Formula of Irredeemable debt

Cost of irredeemable debt (Kd) = I/NP (1 – t)

Where, I = Annual interest payment,

NP = Net proceeds from issue of debenture or bond, and

t = Tax rate.

2)Redeemable debt

A redeemable debt is a debt that a borrower can repay prior to its maturity. The borrower usually pays a premium, or fee, to the bondholder when a debt is redeemed.

Formula of Redeemable debt

Before Tax =Kd= 1+(RV-NP) / n

(RV+NP)/2

Where

RV= Redeemable Value

NP = Net Proceeds

I=Interest

After Tax=Kda=kdX(1-t)

Ans 4

Weighted average cost of capital for a debt-equity ratio

The WACC formula is calculated by dividing the market value of the firm's equity by the total market value of the company's equity and debt multiplied by the cost of equity multiplied by the market value of the company's debt by the total market value of the company's equity and debt multiplied by the cost of debt.

Formulas

Weight of Debt = Debt / Equity
(Debt / Equity) +1

Weight of Equity= 1       
(Debt / Equity) +1