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Summary Cost of Capital

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Summary of 2 pages for the course Corporate Financial Management at UCT (Complete summary)

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  • August 17, 2016
  • 2
  • 2016/2017
  • Summary
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By: maryamgopal • 3 year ago

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MODULE 8: COST OF CAPITAL
Weighted 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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