COST OF CAPITAL INTRODUCTION The cost of capital is a term used in the field of financial investment to refer to the cost

of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required. Cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T = is the corporate tax rate Rf = is the risk free rate. The yield to maturity can be used as an approximation of the cost of capital. Cost of equity Equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity. Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows. Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) Where Beta= sensitivity to movements in the relevant market: Where: Es = Rf = Bs = Rm =

The expected return for a security The expected risk-free return in that market (government bond yield) The sensitivity to market risk for the security The historical return of the stock market/ equity market

Rm-Rf = The risk premium of market assets over risk free assets. The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. Expected return The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which is

CAPITAL ASSET PRICING MODEL The Capital Asset Pricing Model, which was developed in the mid 1960's, uses various assumptions about markets and investor behavior to give a set of equilibrium conditions that allow us to predict the return of an asset for its level of systematic. The CAPM uses a measure of systematic risk that can be compared with other assets in the market. Using this measure of risk can theoretically allow investors to improve their portfolios and managers to find their required rate of return.

An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over 3 years for monthly data.

The Security Market Line, seen here in a graph, describes a relation between the beta and the asset's expected rate of return. The Capital asset pricing model is a model for pricing an individual security or a portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The security market line enables us to calculate the rewardto-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM). where:

is the expected return on the capital asset is the risk-free rate of interest such as interest arising from government bonds (the beta) is the sensitivity of the expected excess asset returns to the expected excess

market returns, or also , is the expected return of the market is sometimes known as the market premium(the difference between the expected market rate of return and the risk-free rate of return). is also known as the risk premium Restated, in terms of risk premium, we find that: Security market line The security market line essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the security market line.

The relationship between and required return is plotted on the securities market line (SML) which shows expected return as a function of . The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm) Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the security market line is thus: It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. . Assumptions of CAPM 1. Aim to maximize economic utilities. 2. Are rational and risk-averse. 3. Are broadly diversified across a range of investments. 4. Are price takers, i.e., they cannot influence prices. 5. Can lend and borrow unlimited amounts under the risk free rate of interest. 6. Trade without transaction or taxation costs. 7. Deal with securities that are all highly divisible into small parcels. 8. Assume all information is available at the same time to all investors. Further, the model assumes that standard deviation of past returns is a perfect proxy for the future risk associated with a given security. Problems of CAPM The model assumes that the variance of returns is an adequate measurement of risk The model assumes that the probability beliefs of active and potential shareholders match the true distribution of returns. The model does not appear to adequately explain the variation in stock returns The model assumes that given a certain expected return, active and potential shareholders will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. The model assumes that there are no taxes or transaction costs,] The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual active and potential shareholders, and that active and potential shareholders choose assets solely as a function of their risk-return profile CAPM assumes that all active and potential shareholders will consider all of their assets and optimize one portfolio. This is in sharp contradiction with portfolios that are held by individual shareholders:

WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC. Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.[1] Calculation In general, the WACC can be calculated with the following formula[2]:

where N is the number of sources of capital (securities, types of liabilities); ri is the required rate of return for security i; MVi is the market value of all outstanding securities i. Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of MVe and cost of equity Re and one type of bonds with the total market value of MVd and cost of debt Rd, in a country with corporate tax rate t is calculated as:

Corporations need money daily to finance their operating activities, embark on investment activities and pay taxes, interest expense, etc. 1) Bonds (debt financing) 2) Issue common and preferred shares What if a corporation does both of these? It can issue bonds (which are a source of debt) and more common shares (which is a source of equity). But what's the right mix between the two? How much debt and how much equity should a company carry? The amount of debt and equity that a company must maintain can be calculated via the WACC. Weighted Average Cost of Capital is therefore an overall return that a corporation must earn on its existing assets and business operations in order to increase or maintain the current value of the current stock. For example, if Jubali and Co. s WACC is 15% and current stock price is 28$, then the company must earn a 15% return on its existing assets and business operations (net income) in order to maintain the stock price at $28. The last thing that corporations would wish to happen is their stock price falling down! The formula for WACC is:

[Rd x D/V x (1-5)] + [Re x E/V] Rd = Bond's yield to Maturity (I/Y in Calculator) D = Market Value (Present Value) of Bonds (1 - t) = 1 - tax rate = Interest tax shield deductibility of interest expense Re = Shareholder's return requirement V = Total value of all capital (Debt + Equity) Example Emmanuel Corp. has issued 10,000 units of bonds that are currently selling at 98.5. The coupon rate on these bonds is 6% per annum with interest paid semi-annually. The maturity left on these bonds is 3 years. The company has 2,000,000 common shares outstanding with the current stock price at $10 / share. The stock beta is 1.5, risk free rate for government bonds is 4.5% and the Expected Return on the Stock Market is 14.5%. The tax rate for the corporation is 30% Bond Calculations Stock Calculations N=3x2=6 I/Y = ? (Rd) PV = 0.985 x 10,000 x $1000 = $9,850,000 (D) PMT = (-10,000,000 x 0.06) / 2 = $300,000 FV = $-10,000,000 P/Y = 2 C/Y = 2 Solution: I/Y = 6.56% Re = Rf + B[Rm - Rf] Re = 0.045 + 1.5 [0.145 0.045] Re = 0.045 + 0.15 = 0.195 (19.5%) Market Value of Equity = E Stock price x common shares O/S $10 x 2,000,000 = $20,000,000

V = Total Capital Structure V = 9,850,000 (bonds debt) + 20,000,000 (equity of common shares) V = 29,850,000 Summary o Rd = 6.56% = 0.0656 D = 9,850,000 V = 29,850,000 D/V = 9,850,000 / 29,850,000 Re = 0.195 E = 20,000,000 E/V = 20,000,000 / 29,850,000 = 0.67 (1-T) = (1 - 0.3) = 0.7 WACC = [Rd x D/V x (1-5)] + [Re x E/V] [(0.0656) (0.33) (0.7)] + [(0.195) (0.67)] = 0.01515 + 0.1307 = 0.1458 -> 14.58% Interpretation of WACC A WACC of 14.58% means Emmanuel Corporation must earn a return of 14.58% on all its assets and business operations in order to maintain the current stock price at $10 per share. If

Emmanuel Corporation wants its stock price to go higher, it must achieve a return rate greater than 14.58%

References
1. ^ French, Craig W. (2003). "The Treynor Capital Asset Pricing Model". Journal of Investment

Management 1 (2): 6072. SSRN 447580.

2. ^ a b Luenberger, David (1997). Investment Science. Oxford University Press. ISBN 9780195108095. 3. ^ Bodie, Z.; Kane, A.; Marcus, A. J. (2008). Investments (7th International ed.). Boston: McGraw-Hill.

p. 303. ISBN 0071259163.

4. ^ Arnold, Glen (2005). Corporate financial management (3. ed. ed.). Harlow [u.a.]: Financial

Times/Prentice Hall. pp. 354.

5. ^ Mandelbrot, B.; Hudson, R. L. (2004). The (Mis)Behaviour of Markets: A Fractal View of Risk, Ruin,

and Reward. London: Profile Books.

6. ^ Daniel, Kent D.; Hirshleifer, David; Subrahmanyam, Avanidhar (2001). "Overconfidence, Arbitrage,

and Equilibrium Asset Pricing". Journal of Finance 56 (3): 921965. doi:10.1111/0022-1082.00350.

7. ^ Roll, R. (1977). "A Critique of the Asset Pricing Theorys Tests". Journal of Financial Economics 4:

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