Week 8 and 9 Costofcapitalandinvestmenttheory

Cost of Capital and Investment
Theory
INTRODUCTIO
N
 Cost of capital is the cost it must pay to raise funds;
either by selling bonds, borrowing. or equity financing
 Most of the companies define cost of capital in one
among the two ways:
 Is financing cost which lead the organization to pay when
they borrow funds, either by securing a loan or by
selling bonds, or equity financing.
 Another way is to evaluate a potential investment
(example major purchase)
Cont
…
 Cost of capital sometime used to set the hurdle rate, or
threshold return rate that a proposed investment must
exceed in order to receive funding.
 Normally, cost of capital percentages can vary greatly
between different companies or organizations, depending
on such factors as the organization‘s credit worthiness and
perceived prospects for survival and growth
Cont
…
 Example In 2011 a company with an AAA credit rating, or
the US treasury, can sell bonds with yield somewhere
between 4% and 5% which might be taken as the cost of
capital for these organizations. At the same the same
time, organizations with lower credit rating where by the
future prospects are viewed as “speculative” by the bond
market it might have to pay 10% or 15% or even more.
Weighted average cost of capita
(WACC)
 WACC is the rate that a company is expected to pay on
average to all its security holders to finance its asset.
 The WACC is commonly referred to as the firm’s cost of
capital. Obviously it dictated by the external market and
not by management.
 The WACC represent the minimum return that a company
must earn on existing asset base to satisfy its creditors,
owners and other providers of capital or they will invest
elsewhere (Fernandes , Nuno.2014)
(WACC)
 Normally companies raise fund from different numbers of
sources such as:
 Common stocks
 Preferred stocks
 Exchangeable debt
 Convertible debt
 Etc.
(WACC)
 The WACC is calculated taking into account the relative
weight of each component of the capital structure. The
more complex the company’s capital structure the more
laborious it is to calculate the WACC.
(WACC)
 In general the WACC is calculated with the following
formula:
(WACC)
Where;
 N is the number of sources of capital
 ri is the required rate of return for security i.
 Mvi is the market value of security i.

(WACC)
 In the case where the company is financed with only
equity and debt, the average cost of capital is computed
as follows:
(WACC)
Where:
 D is the total debt.
 E is the total shareholder’s equity.
 Ke is the cost of equity.
 Kd is the cost of debt.
(WACC)
 Tax effects (basic formula).
 Tax effects can be incorporated into this formula. For
example, the WACC for a company financed by one type
of shares with the:
(WACC)
Where :
 Mve is the total market value of equity
 Re is the cost of equity
 MVd is the total market value of debt
 Rd is the cost of debt
 t is the corporate tax.
(WACC)
 Assume newly formed corporation XYZ needs to raise $1
million in capital so it can buy office buildings and the
equipment needed to conduct its business. The company
issues and sells 6,000 shares of stock at $100 each to raise
the first $ 600,000. Because shareholders expect a return
of 6% on their investment, the cost of equity is 6%.
 Corporation XYZ then sells 400 bonds for $1000 each to
raise the other $400,000 in capital. The people who
bought those bonds expect a 5% return so ABC’s cost of
debt is 5%.
(WACC)
 Corporation XYZ’s total market value is now ($600,000
equity+ 400,000 debt) =$ 1million and its corporate tax
is 35%.
 Now lets calculate the corporation XYZ’S weighted
average cost of capital.
(WACC)
Where :
 400,000 = Mve is the total market value of equity
 6% = Re is the cost of equity
 600,000= MVd is the total market value of debt
 5%= Rd is the cost of debt
 35%= t is the corporate tax.
(WACC)
𝑀𝑉𝑒 𝑀𝑉𝑑
 WACC= .Re + .Rd
(1-t)
𝑀𝑉𝑒+𝑀𝑉𝑑 𝑀𝑉𝑑+𝑀𝑉𝑒
400,000 600,000
= 400,000+600,000
.0.06 + 600,000+400,000
.0.05 (1-0.35)
=0.024 + 0.03(1-0.35)
= 0.024 +0.0195
= 0.044
= 4.4%
(WACC)
 Corporation ABC’S weighted average cos of
capital is 4.4%
 This means for every $ 1 corporation XYZ raises from the
investors, it must pay its investors almost $ 0.05 in return
Cost of debt.
 Is the overall average rate an organization pays on all its

debts, typically consisting primarily of bonds and bank
loans.
 Is expressed as annual percentage
 Is among the company capital structure ( include
preferred stock, common stock, and cost of equity).
Cost of debt
 Cost of debt is presenting in two ways:

 Before tax.
 After tax.
Cost of debt.
 For example: A company with a marginal income tax rate

of 35% and a before tax cost of debt of 6%, the after tax
cost of debt is found as follows:
 After tax cost of debt = (Before tax cost of debt) x (1 –
Marginal tax rate)
= (0.06) x (1.00 – 0.35)
= (0.06) x (0.65)
= 0.039 or 3.9%
Cost of debt.
 The cost of debt also help the company to make decision

regarding asset acquisition or other investment which
acquired with borrowed funds.
Cost of Equity (COE)
 COE measures the returns demanded by stock

market investors who will bear the risks of ownership.
 Is expressed as an annual percentage
 Is a part of company capital structure
 Normally a high cost of equity the market view of the

company’s future is risky, thus, it lead the greater return
to attract the investment. And the lower is opposite.
Cost of Equity (COE)
 There are two ways approaches to estimate cost of

equity:
 Dividend Capitalization Model Approach.
 Capital asset pricing model (CAPM) approach.
Dividend Capitalization Model
Approach
 Cost of equity = (Next year's dividend per share + Equity
appreciation per share) / (Current market value of stock)
+ Dividend growth
 For example:
 a stock whose current market value is $8.00, paying
annual dividend of $0.20 per share. If those conditions
held for the next year, the investor's return would be
simply 0.20 / 8.00, or 2.5%. If the investor requires a
return of, say 5%, one or two terms of the above equation
would have to change:
Dividend Capitalization Model
Approach
 If the stock price appreciates 0.20 to 8.20, the investor
would experience a 5% return: (0.20 dividend + 0.20 stock
appreciation) / (8.00 current value of stock).
 If, instead, the company doubled the dividend (dividend
growth) to 0.40, while the stock price remained at 8.00,
the investor would also experience a 5% return.
Capital asset pricing model (CAPM)
approach
Helps to calculate investment risk and how much return on
investment we should expect.
Cost of equity = (Market risk premium) x ( Equity beta) + Risk
free rate
 Consider a situation where the following holds for one
company's stock:
 Market risk premium: 4.0%

Equity beta for this stock: 0.60
Risk free rate: 5.0%
 Cost of equity = (4.0%) x (0.60) +
5.0%
= 7.4%
Capital asset pricing model (CAPM)
approach
 A beta of 0 indicates the stock tends to rise or
fall independently from the market.
 A negative beta means the stock tends to rise when the
market falls and the stock tends to fall while the market
rises.
 A positive beta means the stock tends to rise and
fall with the market
INVESTMENT THEORY
 Investment theory is the theory which help the investors
to make a decision regarding investment.
 It encompasses the body of knowledge used to support the
decision making process of choosing investment for
various purposes.
 It include:
 Portfolio theory
 Capital asset pricing model (CAPM)
 Arbitrage pricing theory
 Efficient market hypothesis
 Rational pricing
COST OF CAPITAL AND
INVESTMENT DECISION
 The cost of capital to the owners of a firm is simply the
rate of interest on the bonds, and has derived the familiar
proposition that the firm, acting rational, will tend to
push investment to the point where the marginal yield on
physical assets is equal to the market rate of interest.
 The importance of cost of capital help the management to
make rational decision to the firm. Each firm face a
trade-off between two main criteria:
 The maximization of the firm profit
 The maximization of the firm market value
COST OF CAPITAL AND
INVESTMENT DECISION
 The first criteria propose that, a firm investment decision
to the assets would be worth acquiring if it will increase
the net profit only if the expected yield from such asset
will exceed the capitalization rate of capital acquired.
 On other hand, base on the second investment criteria,
the asset would be worth acquiring if it can adds more to
the current market value per share of the firm.
COST OF CAPITAL AND
INVESTMENT DECISION
 The decision toward any firm’s investment depends on
various factors including the cost of raising capital
 Miller and Modigliani conclude that:
 “if the firm acting for the best interest of its shareholders
(maximizing the market value) will invest on the assets if
and only if expected rate of return that will boost up the
shareholder’s value and it exceed the rate of interest to
which the firm pays for raising the fund regardless the
type of security want to invest”.
COST OF CAPITAL AND
INVESTMENT DECISION
 Under the M&M theory propose the assumption to support
the theory that:-
 The firm must be trading in perfect competitive market.
 The effect of corporate taxes are eliminated.
 Investors are rational to the extend can change with
market fluctuations.
 The firm has fixed investment policy.
 No risk or uncertainty.
COST OF CAPITAL AND
INVESTMENT DECISION
CONCLUSION
 If the assumption are held constant, under M&M theory,

the cost of capital become key factor determining which
asset to invest, how to finance the investment, and which
criteria to deal with.
Prepared by MONZUR MORSHED
PATWARY

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Cost of Capital and Investment

 Mvi is the market value of security i.

 Is the overall average rate an organization pays on all its

 Cost of debt is presenting in two ways:

 For example: A company with a marginal income tax rate

 The cost of debt also help the company to make decision

 COE measures the returns demanded by stock

 Normally a high cost of equity the market view of the

 There are two ways approaches to estimate cost of

 Market risk premium: 4.0%

 If the assumption are held constant, under M&M theory,

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