Summary
Summary Cost of Capital
- Institution
- University Of Cape Town (UCT)
Summary of 2 pages for the course Corporate Financial Management at UCT (Complete summary)
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By: maryamgopal • 3 year ago
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MODULE 8: COST OF CAPITALWeighted Average Cost of Capital (WACC)
Companys cost of using long-term funds provided by suppliers (ordinary shares,
preference shares and debt holders)
Application is future oriented
Formula
𝑊𝐴𝐶𝐶 = (𝐾𝑑(1 − 𝑡)𝑊𝑑) + (𝐾𝑒𝑊𝑒) + (𝐾𝑝𝑊𝑝)
𝐷 𝐸 𝑃
= (𝐾𝑑(1 − 𝑡) ) + (𝐾𝑒 ) + (𝐾𝑝 )
𝑉 𝑉 𝑉
Determining the Capital Structure Weights
1. Target Capital Structure (consistent with WACC application)
What firm strives to achieve long-term
Set at a level that minimizes WACC
2. Market Values (only if securities are publicly traded – reflects current risk and value)
Debt and prefs: get market price/discount future cash flows
Listed ordinary shares: Market value = price per share x nr of listed shares
3. Book Value
Only appropriate if they represent future target capital structure
Estimating the component cost of each source of capital
Use current/marginal costs
Take current cost of raising new finance today.
Use effective annual rates
For simplicity, we use nominal rates.
Include effects of corporate tax (Kd only)
Kd is given as a before tax figure, interest on debt is a tax deductible
expense, reduction in tax paid is accounted for by reducing cost of debt.
Cost of Debt
Represents RRR on debt plus any costs associated with raising debt.
Non-redeemable/in perpetuity
Observe YTM on similar debt (direct)
Observe price on similar debt issues and solve for YTM (indirect)
𝐶
𝑃𝐵 =
𝑖
𝐶
𝑖=
𝑃𝐵
Issuance/flotation costs: costs incurred by company when it raises new capital via debt,
prefs or equity.
𝐶
𝑎𝑠 𝑎 % ∶ 𝐾𝑑 =
𝑃𝐵 (1 − 𝑓𝑐%)
𝐶
𝑎𝑠 𝑎 𝑓𝑙𝑎𝑡 𝑓𝑒𝑒 ∶ 𝐾𝑑 =
𝑃𝐵 − 𝑓𝑐
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