Source of long term capital and cost of capital

Presented by Sudhira Kumar Nahak Ankita Subudhi

sources of long-term capital do firms use?

Long-Term Capital Long-Term Debt Preferred Stock Common Stock New Common Stock

Retained Earnings

Source of Long term capital

Shares (Shareholders are part owners of a company) Ordinary Shares (Common Stock Equities): Ordinary shareholders have voting rights Dividend can vary Last to be paid back in event of collapse Share price varies with trade on stock exchange Preference Shares: (preferred share) Paid before ordinary shareholders Fixed rate of return Cumulative preference shareholders have right to dividend carried over to next year in event of non-payment New Share Issues arranged by merchant or investment banks Rights Issue existing shareholders given right to buy new shares at discounted rate Bonus or Scrip Issue change to the share structure increases number of shares and reduces value but market capitalisation stays the same

Source of Long term capital

Loans/debts (Represent creditors to the company not owners)
Debentures fixed rate of return, first to be paid Bank loans and mortgages suitable for small to medium sized firms where property or some other asset acts as security for the loan Merchant or Investment Banks act on behalf of clients to organise and underwrite raising finance Government/EU may offer loans in certain circumstances
Grants

Cost of capital
It is the minimum required rate of return from the capital expenditures
Business riskrisk inherent in firms operations Financial riskrisk inherent in using debt
=

Where

b = Premium for business risk f = premium for financial risk

= Cost of capital = Normal rate of return at zero risk level

The Purpose of the Cost of Capital

The cost of capital is the average rate paid for the use of the firms capital funds
Capital refers to money acquired for use over long periods
Generally used to start businesses and acquire long-lived assets

The cost of capital provides a benchmark against which to evaluate investment returns Rule is equivalent to

Projects should not be undertaken unless they return more than the cost of the funds invested in them => the cost of capital. Project IRR exceeds the cost of capital Project NPV > 0 when calculated at the cost of capital

Cost of Debt
Debt Issued at Par
INT kd i B0

Debt Issued at Discount or Premium(redeemable )

INTt Bn B0 t t 1 (1 k ) (1 kd )n d
n

Tax adjustment

After-tax cost of debt kd (1 T )

X ltd. issues Rs. 50,000 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital
7

Cost of Preference Capital

Irredeemable Preference Share
PDIV kp P0

Redeemable Preference Share

PDIVt Pn P0 = + t t 1 (1 k ) (1 k p ) n p
n

Cost of Equity Capital

Q. Periwinkle Inc. paid a dividend of $1.65 last year and its stock is currently selling for $33.60 a share. The company is expected to grow at 7.5% indefinitely. Estimate the firms cost of retained earnings. A. Write equation 13.7 and substitute for Periwinkles expected return and the cost of RE.

Example

cost of RE = ke

D 0 (1 g) g P0 $1.65(1.075) .075 $33.60 .053 .075 12.8%

What is WACC?
WACC is the cost of capital for a business that raises capital from more than one source Public companies raise money by selling
Debt Preferred stock Common Stock

WACC reflects the overall mix of securities in the capital structure

The Weighted Average Calculation

Q: Calculate the WACC for the Zodiac Company given the following information about its capital structure. Capital Component Value Cost

Debt
Preferred Stock Common stock

$60,000
50,000 90,000 $200,000

9
11 14

Example

A: First calculate the capital structure weights based on the values given. For example the weight of debt is $60,000 $200,000 = 30%. Next, each components cost is multiplied by its weight and the results are summed as shown:

Capital Component
Debt Preferred Stock Common stock

Value
$60,000 50,000 90,000 $200,000

Weight
30% 25% 45% 100%

Cost
9 11 14 WACC = 2.70% 2.75% 6.30% 11.75 %