Capital Component

One of the types of capital used by firms to raise money. Various types of debt, preferred cost and common equity are called capital components. The cost of each component is called component cost of that particular type of capital.

Cost of Debt kd(1-T)

Reason for using after tax cost of debt in calculating WAAC: The value of the firms stock ,which we want to maximize depends on after-tax cash flows. Because interest is a deductible expense ,it produces tax savings that reduce the net cost of debt, making the after tax cost of debt less than before-tax cost.

Cost of preferred Stock ( kp)

The rate of return investors require on the firms preferred stock.kp is calculated as the preferred dividend divided by the current price. No tax adjustments are made when calculating kp because preferred dividends, unlike interest on debt ,are not deductible. Therefore there are no tax savings associated with the use of preferred stock.

Cost of retained earnings (ks)

The rate of return required by stockholders on the firms common stock. The cost of debt and preferred stock are based on the returns investors require on these securities , similarly ,the cost of common equity is based on the rate of return investors require on companys common stock . New common stock is raised in two ways By retaining some of the current years' earnings By issuing new common stock . Ke:The designation for the cost of common equity raised by issuing new stock or external equity. Expected Rate of return = D1/P0+g = ks

The CAPM Approach

Step 1:Estimate the risk free rate , kRF ,generally taken to be either the U.S. treasury bond rate or the short term (30-day) treasury bill rate. Step 2:Estimate the stocks beta coefficient , bi , and use it as and index of the stocks risk. The i signifies the ith companys beta. Step 3: Estimate the expected rate of return on the market ,or on an average stock , Km. Step 4:Substitute the preceding values into the CAPM equation to estimate the required rate of return on the stock in questionKs = kRF + (kM kRF ) bi

Approaches..continued Bond Yield plus Risk Premium Approach

Ks = Bond yield + risk premium Dividend yield plus growth rate /Discounted cash flow approach P0 = D1 / (1+ks )1 + D2 / (1+ks )2 + .. P0 = D1 /ks - g We can solve for Ks the obtain required rate of return on common equity..Ks = D1/ P0 + expected g

Cost of new Common Stock, ke

The cost of external equity ;based on the cost of retained earnings ,but increased for floatation costs. Cost of equity for new stock issues = D1/P0(1-F) +g Flotation Cost The percentage cost of issuing new common stock. Retained Earnings Break even point The amount of capital raised beyond which new common stock must be issued. Addition to retained earnings / equity fraction 1

Composite or WAAC
Target (optimal) capital structure The percentage of debt, preferred stock, common equity that will maximize the firms stock price The target proportions of a debt ,preferred stock, and common equity along with the cost of these components are used to calculate the firms weighted average cost of capital. WAAC = wd kd ( 1-T) + wp kp + wc ks wd ,wp,wc are the weights used for debt, preferred and common equity. WAAC represents the marginal cost of capital (MMC) Marginal cost of capital The cost of obtaining another dollar of a new capital ;the weighted average cost of last dollar of a new capital raised. Factors that Affect WAAC It is affected by no of factors some are beyond a firms control which are as follow:

Factors the firm cannot control

The level of interest Rates If the interest rates in the economy rise , the cost of debt increase because firms will have to pay bondholders more to obtain debt capital. Tax Rates Tax rate which are largely beyond the control of an individual firm have an important effect on cost of capital. Tax rates are used in the calculation of component cost of debt. In addition there are less apparent ways in which tax policy affects the cost of capital. Factors the firm can control Capital structure policy A firm can change its capital structure and such a change can affect its cost of capital. Dividend Policy Firm can obtain new equity either through retained earnings or by issuing new common stock , but because of flotation costs, new common stock is more expensive than retained earnings. Since retained earnings is income that has not been paid out as dividends, it follows that dividend policy can affect cost of capital because it affects the level of retained earnings.

Some problem Areas in cost of capital

Depreciation generated funds The largest single source of capital for many firms is depreciation. The cost of depreciation-generated funds is approximately equal to the weighted average cost of capital from retained earnings and low-cost debt. Privately owned firms There is a serious question about how one should measure the cost of equity for a firm whose stock is not traded. Tax issues are especially important in these cases. As a general rule , the same principles of cost of capital estimation apply to both privately held and publicly owned firms. Small Businesses Small businesses are generally privately owned , making it difficult to estimate their cost of equity. Cost of capital for projects of different Riskiness It is difficult to measure projects risks, hence to assign risk adjusted discount rates to capital budgeting projects of different degrees of riskiness

Estimating Project Risk

Stand Alone Risk The risk an asset would have if it were a firms only asset and if investors owned only one stock. it is measured by the variability of the assets expected returns. Corporate, or within firm risk Risk not considering the effects of stockholders diversification ;it is measured by a projects effect on uncertainty about the firms future earnings. 2

 Market, or Beta risk That part of a projects risk that cannot be eliminated by diversification ; it is measured by the projects beta coefficient.