_{}overall cost of capital. Cost of Capital is calculated as

_{}weighted average of each component of capital - debt, common stock, preferred stock, and retained earnings. Each component is calculated as follows:

**Cost of Debt (Cd)**: Calculate

_{}effective interest rate.

_{}following formula is used to calculate

Cd = I ( 1 - TR) where I is Interest Rate on Debt and TR is

_{}Tax Rate.

Example 5 - Calculate

Cantor Corporation borrowed $ 100,000 at 8% interest.

_{}

_{}loan proceeds was $ 96,000 and

Cost of Debt = ($ 100,000 x .08) / $ 96,000 x ( 1 - .35) = 8.3% x .65 = 5.4%.

**Cost of Common Stock (Ccs)**: Three different methods can be used to calculate

_{}Cost of Common Stock.

_{}three methods are:

1. Dividend Growth - Dividends paid to common shareholders along with

_{}overall expected growth rate is used to calculate a cost for

_{}formula for calculating

Example 6 - Calculate

_{}Cost of Common Stock based on Dividend Growth

Cantor Corporation expects to pay a $ 6.00 dividend this year to common shareholders. Historically, dividends have grown by 2% each year. Cantor's common stock is currently selling for $ 45.00 per share.

Cost of Common Stock = ($ 6.00 / $ 45.00) + .02 = 15.3%.

2. Capital Asset Pricing Model (CAPM) -

_{}CAPM is

_{}most widely used approach to calculating

_{}CAPM uses three components to calculate

**rf**is

_{}risk free rate earned by investors (such as U.S. Treasury Bonds; (2)

**b**is

**rm**is

_{}market (such as

_{}CAPM formula is Ccs =

**rf + b ( rm - rf )**.

Example 7 - Calculate

_{}Cost of Common Stock based on CAPM

Cantor Corporation has common stock with a listed beta of 1.35.

_{}

_{}risk free rate based on Treasury Bonds is 6.5%.

Ccs = 6.5% + 1.35 ( 12% - 6.5% ) = 13.9%

3. Bond Plus - A simple approach to calculating

_{}cost of debt.

_{}formula is Ccs = Cd + risk premium.

_{}risk premium is

Example 8 - Calculate

_{}Cost of Common Stock based on Bond Plus

Referring back to Example 5, we calculated a cost of debt of 5.4%. We have estimated a market risk premium on common stock of 4%.

Ccs = 5.4% + 4.0% = 9.4%

**Cost of Preferred Stock (Cps)**: If your capital structure includes preferred stock,

_{}amount of dividends in relation to

_{}formula is Cps = Dividends / Market Price of Stock.

Example 9 - Calculate

_{}Cost of Preferred Stock

Assume we have preferred stock selling for $ 80 per share and dividends per share are $ 10.

_{}

Cps = $ 10 / $ 80 = 12.5%

**Cost of Retained Earnings**:

_{}cost of retained earnings (internal funds) within a capital structure is similar to

_{}cost of common stock. We can think of

_{}cost of common stock since no issuance costs is incurred.

After we have calculated each component cost of capital, we will calculate a weighted average based on

_{}relative market values of each component.

_{}following example will illustrate how weighted average cost of capital is calculated.

Our overall cost of capital is calculated as a weighted average based on

_{}relative market values of each component of capital. If market values are not available, use %’s derived from

_{}targeted or forecasted capital structure. If worse comes to worse, you can fall back on book values. In any event,

_{}overall cost of capital that will be used to evaluate capital investments.

### Cost of Equity and Risk

_{}Cost of Equity is

_{}rate of return required by those who invest in equity securities.

_{}expected return can be broken down into two components - Risk Free Rate and Risk Premium. A good benchmark for establishing

_{}Risk Free Rate is

_{}Risk Premium can be established by understanding two forms of risk - Business Risk and Financial Risk. In

_{}absence of debt, shareholders are confronted with one form of risk, business risk. Business Risk is

_{}risk of changes to operating income from numerous factors that influence business. When we introduce debt, we have to include financial risk. Financial Risk is

_{}use of increased debt. More debt results in higher interest payments, which impacts earnings. Consequently,

_{}Risk Premium consists of Business Risk + Financial Risk.

_{}following graph summarizes these relationships:

In

_{}addition of business risk increases

_{}required rate on stock to 10%. When we introduce debt, this adds financial risk and increases

_{}final total rate of return on stock with all forms of risk climbs from 12% to 16% over a range of Debt to Equity Ratios. Since

_{}cost of capital represents

_{}cost of capital.

## 1 comment:

Thanks for information as a manager i know how informations are helpful thanks again.

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