COST OF

CAPITAL

Cost Of EQUITY Cost Of DEBT

COST OF CAPITAL: -
Cost of capital is the Cost of Funds Used to finance a business. Typically,
corporate obtain financing through a combination of issuing equity in the form of
shares and by taking a debt through borrowing from banks or issuing bonds.
The people who provide finance to a company also want to earn a return on
their investment combined those factors comprise a company's overall cost of
capital

The cost of debt is the interest that companies pay

Cost of equity is the compensation investors demand in exchange of owing a
company’s share

The overall cost of capital is the Weighted average of company capital sources
also known as the WEIGHTED AVERAGE COST OF CAPITAL (WACC )

Cost of capital is used to discount future cash flow from potential project and
estimate flow from the project and estimate their NET PRESENT VALUE (NPV)

Companies want an optimal financing Mix. Debt has tax advance over equity
financing, but to much debt results to high leverage leading to high interest rates
to compensate lenders for the risk of higher default.

Cost of capital to analyse whether or not to start with the project. As long the
COC is below the Rate of Return that the company earn by using its capital it’s a
good investment
Cost Of Debt (Kd)
The cost of debt is the total interest amount or effective interest rate a company
owes on debt instruments like bonds and loans. In other words, the cost of debt
is the minimum interest rate debt holders need to offer financing support to
borrowers. The total debt cost can be before or after tax.

FORMULA
Cost of debt = Total interest rate x (1 – total tax rate)

If a company takes out a $100,000 loan with a 7% interest rate, the cost of
capital for the loan is 7%. Because payments on debts are often tax-deductible,
businesses account for the corporate tax rate when calculating the real cost of
debt capital by multiplying the interest rate by the inverse of the corporate tax
rate. Assuming the corporate tax rate is 30%, the loan in the above example
then has a cost of capital of 0.07 X (1 - 0.3) or 4.9%.

Cost Of EQUITY (Ke)

The cost of equity is the return that a company must realise in exchange for a
given investment to the shareholder

This return can be in the form of

DIVIDEND
STOCK APPRECIATION
BETA is a risk Measure
FORMULA
Cost of Equity = Risk-Free Rate + (Beta * Equity Risk Premium).

Cost Of debt = RF + (Rm – RF) Beta

RF = Risk-free rate (Investing.com > 10Year Govt Bond)
Rm = Market Rate of Return (Any Country Stock Market Return)
 BETA
The beta (β) of an investment security (i.e., a stock) is a measurement
of its volatility of returns relative to the entire market. It is used as a
measure of risk. A company with a higher beta has greater risk and also
greater expected returns.

Calculation
Regression Approach (statistical)
Bottom-Up Approach (Relative)

[ Market Beta is always 1 ]

 DEBT HAS TAX ADVANTAGE OVER EQUITY FINANCING

COMPONENTS OF COST OF EQUITY

Breaking down the equity cost reveals elements that collectively shape this
critical financial metric. Let’s look at them in detail.
1. Risk-free rate
The foundation of the equity fee rests on the risk-free rate, often determined by
government bonds. The rate signifies the minimum return investors demand for
an investment without risk. It serves as a baseline against the measurement of
additional risk associated with investing in stock market. The risk-free rate
should reflect the yield to maturity (YTM) on default-free government bonds of
equivalent maturity as the duration of the projected cash flows.

2. Equity risk premium

Building upon the risk-free rate, the equity risk premium quantifies the extra
compensation shareholders demand for the increased risk of investing in equities
compared to risk-free assets. Besides the current market sentiment, the
premium reflects economic conditions and investor confidence.
3. Beta
Beta measures a stock’s volatility with the market. A beta more than 1 shows
higher volatility. It implies greater risk and potentially higher market rate of
return. A company’s beta significantly influences its equity fee. A higher beta
translates to a higher equity expenditure for the increased risk.
4. Market risk premium
It is the difference between the expected return on the overall market and the
risk-free rate. Market risk premium mirrors the collective perception of investors’
anticipated returns from the market.
5. Company-specific risk
Beyond systemic market risk, a company’s unique operational and financial risks
also contribute to its equity cost. Factors like industry trends and financial
stability impact how investors perceive the risk of the company’s equity.

What are the components of the cost of debt?

Four components of the cost of debt are interest rate, flotation costs, risk
premium, and tax savings. These elements determine the total debt cost,
including a borrower’s credit rating and debt type.
1. Interest rate is an annual percentage of the principal amount a creditor
charges a lender on the outstanding loan amount. Organizations usually use
loans to fund operations and buy assets, making the interest rate the cost of
money. That’s why the same amount of money can be expensive when the
interest rate is high and vice versa.
2. Flotation cost refers to the legal, registration, audit, and underwriting fees a
business incurs while issuing new securities. Even though flotation costs are
considerably less for loans, they can add to the total cost of capital in case of
high loan amounts.
3. Risk premium is the higher rate of return borrowers pay lenders over and
above the risk-free return rate. Investors consider risk premiums a form of
compensation for their relatively risky investments. The premium amount may
vary depending on the borrowing company’s financial health, overall economic
outlook, and industry.
4. Tax savings refer to the interest amount a business entity shows as the
deductible amount from its income while calculating income taxes.
 Net present value
Net present value (NPV) is used to determine the CURRENT VALUE of all future
cash flow generated by a project or Investment. It includes the initial capital
investment.
Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. NPV is used
in capital budgeting and investment planning to analyze a project's projected
profitability. If the net present value of a project or investment, is negative it
means the expected rate of return that will be earned on it is less than the
discount rate and this project should not be excepted
 Net present value (NPV) is a calculation that takes a future stream of cash
flows and discounts them back into the present day.

NPV = cash flow ÷ (1+i)t − initial investment

(where "i" is the required rate of return and "t" is the number of time periods)

Disadvantage
 How does an investor know which discount rate to use.
 It unforeseen (not anticipated or expected) Variable cost
 IRR
The Internal Rate of Return (IRR) is the discount rate that makes the net present
value (NPV) of a project zero. In other words, it is the expected compound
annual rate of return that will be earned on a project or investment.
The term internal refers to the fact that the calculation excludes external factors,
such as the risk-free rate, inflation, the cost of capital, or financial risk.
 WACC
Weight average cost of capital measures a company’s cost to borrow money
given the proportion amount of each type of debt and equity a company taken
on. A company's debt to equity or its capital structure might include Common
stock, Preferred Stock and bonds.
WACC is used internally by a company’s management as part of determining
whether it would be profitable for a company to finance a new project. It is also
used by investors as one way to value the company’s share to decide where to
invest .
The HIGHER the WACC the LESS likely it is the company is creating value
because it has to overcome more expensive borrowing costs in order to make a
profit .

Marry is considering an investment in XYZ Company. She determines that the

company is producing a 10% return and calculates that the company’s WACC is
8% by subtracting the WACC from the return she sees that for every dollar spent
it crates to $ 0.02 of the value for every dollar it invested.

If XYZ had a WACC of 15% it would be destroying $0.05 of the value for every
dollar it invest.
If XYZ had a WACC of 10% the company would neither creating or destroy value
but remaining stagnant.

Weighted average cost of capital (WACC) is a company's average after-tax cost

of capital from all sources, including common stock, preferred stock, bonds, and
other forms of debt. It represents the average rate that a company expects to
pay to finance its business.
 Terminal value (TV)
Terminal value (TV) is the estimated value of a business or asset at the end of its
useful life or forecasting period. Terminal value takes into account all changes in
value that are expected to occur before the maturity data such as interest it also
assumes steady growth rate
The terminal value of a bond value of it All future class flow + Mature Value.

When businesses grow more than the economy (GDP) or Industry

However, due to the time value of money the terminal value must be translated
or calculated into present value to be meaningful
Two commonly used methods to calculate a terminal value are perpetual growth
(Gordon Growth Model) and exit multiple. The former assumes that a business
will continue to generate cash flows at a constant rate forever. The latter
assumes that a business will be sold for a multiple of some market metric.

Where:
 TV = terminal value
 FCF = free cash flow
 n = year 1 of terminal period or final year
 g = perpetual growth rate of FCF
 WACC = weighted average cost of capital
Example
For instance, if the cash flow at the end of the initial forecast period is $100 and
the discount rate is 10.0%, the TV comes out to $1,000 ($100 ÷ 10.0%).
But as mentioned earlier, the perpetuity growth method assumes that a
company’s cash flows grow at a constant rate perpetually.
Because of this distinction, the perpetuity formula must account for the fact that
there is going to be growth in cash flows, as well. Hence, the denominator
deducts the growth rate from the discount rate.
If the cash flow at the end of the initial projection period is $100 and the discount
rate is 10.0% but this time around, there is a perpetuity growth rate of 3%, the
terminal value comes out as ~$1,471.
 Terminal Value = ([$100 x (1 + 3.0%)] ÷ [10.0% – 3.0%]) = ~$1,471

Exit multiple method Example

If a company's yearly sales total is $200,000,000 and other companies have sold
for an average of 10 times their yearly sales, the TV is $2,000,000,000. The
calculation is:
 $200,000,000 x 10 = $2,000,000,000
 Dividend Discount Model (DDM)

The dividend discount model (DDM) is a quantitative method used to

predict the price of a company's stock based on the theory that its present-
day price is worth the sum of all of its future dividend payments when
discounted back to their present value.

The Dividend Discount Model (DDM) states that the intrinsic value of a
company is a function of the sum of all the expected dividends, with each
payment discounted to the present date.

DDM is the way of applying Net Present Value Analysis to estimate the
future dividend a stock will pay. those dividends are discounted back to
their present value.

If the

PRESENT VALUE OF FUTURE DIVIDEND >(MORE) CURRENT MARKET VALUE

It means the market value of the stock is undervalued

Present Value of Futre Dividend =

DIVIDEND PER SHARE / (DISCOUNTED RATE – DIVIDEND GROWTH

RATE
 Gordon Growth Model (GGM)
GGM is used to calculate the intrinsic value of a stock today based on the
stock’s expected future dividend. It is widely used by investors to
compare the predicted stock value against the actual market. The GGM
focuses strictly on the effect of future dividend ignoring other factors that
affect the market price of the stock such as new products, competition
and investor sentiment. This model is the effect for large stable
companies in mature market that have a predictable dividend growth.
The GGM is a simple and common DDM variation that assumes a stable
dividend growth rate.

 Dividends Per Share (DPS) ➝ DPS is the value of each declared

dividend issued to shareholders for each common share
outstanding, and represents how much money shareholders should
expect to receive on a per-share basis.
 Dividend Growth Rate (g) ➝ The dividend growth rate is the
projected rate of annual growth, which in the case of a single-stage
GGM, a constant growth rate is assumed.
 Required Rate of Return (r) ➝ The required rate of return is the
“hurdle rate” demanded by equity shareholders to invest in the
company’s shares with consideration towards other opportunities
with similar risks in the stock market.
Advantages and Disadvantages of the Gordon Growth Model
Advantages
 The GGM is commonly used to establish intrinsic value and is
considered the easiest formula to understand.
 The model establishes the value of a company's stock without
accounting for market conditions, which simplifies the calculation.
 This straightforward approach also provides a way to compare
companies of different sizes and in different industries.
Disadvantages
 The Gordon growth model ignores non-dividend factors (such
as brand loyalty, customer retention, and intangible assets) that can
add to a company's value.
 It assumes that a company's dividend growth rate is stable.
 It can only be used to value stocks that issue dividends, which
excludes, for example, most growth stocks.
For example, if a company’s shares are trading at $100 per share and a
minimum required rate of return of 10% (r) with plans to issue a $4.00 dividend
per share (DPS) next year, which is expected to increase by 5% annually (g).

 Value Per Share = $4.00 ÷ (10.0% – 5.0%) = $80.00

Given the output, the key takeaway here is that the share price of the
company is implied to be overpriced by approximately 25.0% ($100 vs.
$85).

BETA is the RISK measure

 Time Value of Money
The time value of money is a basic financial concept that holds that
money in the present is worth more than the same sum of money to be
received in the future.
This is true because money that you have right now can be invested and
earn a return, thus creating a larger amount of money in the future.
“A DOLLAR TODAY IS ALWAYS WORTH MORE THAT A DOLLAR
TOMORROW”

In this example, $11,000 is 10% greater than $10,000 — this serves as

the minimum required rate of return if you would be indifferent between
these investment options.
For the second option to make sense from a monetary perspective, the
returns should exceed that of the 1st option, i.e. if you receive the
$10,000 on the present date and receive a return >10%, you should pick
the first option, as it is more profitable.
Present Value (PV) = FV ÷ [1 +( i ÷ n) ^(n × t)
Where:
 PV = Present Value
 FV = Future Value
 i = Annual Rate of Return (Interest Rate)
 n = Number of Compounding Periods Each Year
 t = Number of Years
 Present Value Factor
The Present Value Factor (PVF) estimates the present value (PV) of cash
flows expected to be received on a future date.
The present value factor (PVF), also known as the present value interest
factor (PVIF), is a mathematical tool that estimates the current value of a
future cash flow. It's based on the concept of time value of money (TVM),
which states that money today is worth more than the same amount in
the future.
Financial Risk
Financial risk is the possibility of losing money on an investment or a business
venture. Some more common and distinct financial risks include credit risk,
liquidity risk, and operational risk.
Financial risk is a type of danger that can result in the loss of capital to
interested parties

Categories of

Financial risk

Credit risk

 Settlement risk
 Concentration risk
 Sovereign risk
 Default risk

Market risk

 Interest rate risk

 Inflation risk
 Currency risk
 Equity risk
 Commodity risk
 Volatility risk
 Systemic risk

Liquidity risk

 Refinancing risk
 Deposit risk
 Margining risk

Investment risk

 Model risk
 Execution risk
  Valuation risk

Business risk

 Reputational risk
 Operational risk
 Country risk
 Political risk
 Legal risk
 Moral hazard

Profit risk

Non-financial risk

 Stranded asset
 DCF
Discounted cash flow (DCF) modeling is a financial model that estimates a
company's value by forecasting and discounting its future cash flows. DCF
models are used to determine the value of an investment today, based on how
much money it's expected to generate in the future.
DCF model is simply a forecast of a company's unlevered free cash flow
discounted back to today's value, which is called the Net Present Value (NPV).

(Growth rate)to project the future cash

Discounted Back
Today’s CASH Future Free Cash Flow
Today’s Value

Enterprise Value
Equity Value

The three main components of the DCF formula are: Cash flow (CF), Discount
rate (r), and Number of periods (n).

The main difference between unlevered free cash flow (UFCF) and levered free
cash flow (LFCF) is that UFCF does not account for interest payments and other
financial obligations(Depreciation), while LFCF does:
 Unlevered free cash flow
The cash available to all capital providers before interest payments and other
financial obligations are taken into account. UFCF is calculated as EBITDA minus
CapEx minus working capital minus taxes.
 Levered free cash flow
The cash available to equity shareholders after interest payments and other
financial obligations are taken into account. LFCF is the cash flow that a
company can use to pay dividends and make investments
What Is Free Cash Flow to the Firm (FCFF)?
Free cash flow to the firm (FCFF) represents the amount of cash flow from
operations available for distribution after accounting for depreciation expenses,
taxes, working capital, and investments. FCFF is a measurement of a company's
profitability after all expenses and reinvestments. What is the Cash flow
available to all the stakeholders (Equity, debtholder,etc )

Free Cash Flow to Equity (FCFE)?

Free cash flow to equity (FCFE) is a measure of how much cash is available to
the equity shareholders of a company after all expenses, reinvestment, and debt
are paid. FCFE is a measure of equity capital usage.
Formula of DCF

Enterprise value = FCFF / WACC

Equity Value = FCFE / Ke