Question

Q1a) What influences the Cost of Equity of a firm? Explain

Q1b) Explain how the Capital Asset Pricing Model provides a good estimate of the Cost of Equity.

Q1c) Explain the formula: Cost of Debt = Loan Interest rate (1 – tax rate)

Q1d) Provide proof that the formula in 1c. is correct in the case of a firm having an EBIT of $100,000, debt of $600,000 with 10% interest, and a tax rate of 40%.
Hint: Calculate for tax payment amounts.

Answer 1

1a) Cost of equity is determined by calculating the average return on investment that can be expected based on returns generated by the larger market. Thus, since market risk directly affects cost of equity funding, it also directly affects the total cost of capital.

1b) The Capital Asset Pricing Model is a basis of how financial markets price securities and hence estimate the expected return on capital investments. The model determines a method for quantification of risk and converting the risk into expected return on equity. Cost of Equity is generally computed by Capital Asset Pricing Model.

Cost of equity = Risk free rate of return + Premium expected for risk.

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

1c) For determining the cost of debt, a company must determine the total interest expense it is paying for all the debts in a year. Then, it divides the number by total of all its debts. The result is the cost of debt. The cost of debt formula is the effective interest rate multiplied by (1-tax rate).

1d) As per the formula, Cost of debt = 10(1-40%) = 6%

Lets check the formula, EBIT = $100,000

Interest = 10% of $600,000 = $60,000

EBT = $100,000 - $60,000 = $40,000

Tax @ 40% = $40,000 * 40% = $16,000

Earnings after Tax = $40,000 -$16,000 = $24,000

If we take cost of debt after tax as 6%, then the Earnings after Tax will be as follows:

Interest = 6% of $600,000 = $36,000

EBT = $100,000

Tax @ 40% = $100,000 * 40% = $40,000

Earnings after tax but before Interest = $100,000-$40,000 = $60,000

Earnings after tax after Interest = $60,000 - $36,000 = $24,000

Hence, Earnings after Tax is same in both case.

Therefore, the formula Cost of Debt = Loan Interest rate (1 – tax rate) is proved.