MK2 MATERI 02 COST OF CAPITAL

Summary

This lecture delves into the concept of cost of capital, discussing both individual and overall cost of capital. The video explains how cost of capital represents the expenses a company incurs to secure financing and how it influences project decision-making. It covers key concepts such as cost of debt, equity, and the weighted average cost of capital (WACC). Additionally, the lecturer provides practical examples for calculating these costs, emphasizing their importance in financial management. The session highlights the calculations needed for long-term debt and equity, as well as the relationship between risk and financing costs.

Takeaways

• 😀 The cost of capital represents the expenses a company incurs to finance its operations and projects, and is the minimum return required to increase the company's value.
• 😀 There are two main components of the cost of capital: individual cost of capital (for each funding source) and the overall weighted average cost of capital (WACC).
• 😀 The basic principle is that if the expected return on a project is higher than the cost of capital, the project is considered acceptable, otherwise it is rejected.
• 😀 A practical example illustrates how the weighted average cost of capital (WACC) is calculated by combining the costs of debt and equity in appropriate proportions.
• 😀 Long-term debt, such as bonds, incurs certain costs, including the 'before-tax cost of debt,' and must also consider tax impacts to calculate the 'after-tax cost of debt.'
• 😀 The process of calculating the cost of long-term debt involves taking the coupon rate and applying the bond issuance costs, while also considering tax effects.
• 😀 In the case of equity financing, the cost of capital includes the return expected by shareholders, which can be calculated using dividend discount models (e.g., Gordon Model).
• 😀 When a company issues preferred stock, the cost of capital is derived from the dividends paid to preferred shareholders divided by the net proceeds from the stock sale.
• 😀 The cost of common stock is calculated based on expected dividends and the growth rate of those dividends, using a dividend discount model for valuation.
• 😀 The weighted average cost of capital (WACC) is calculated by assigning weights to each source of capital (debt, equity, and preferred stock) based on their respective proportions in the company's overall capital structure.

Q & A

What is the cost of capital?

The cost of capital represents the minimum return that a company must earn on its investments to increase the value of the company. It is the cost incurred by a company to obtain the necessary funds for its investments.

What are the two categories of cost of capital discussed in the lecture?

The two categories of cost of capital discussed are individual cost of capital (cost of debt, preferred stock, and common stock) and the overall cost of capital, which is the weighted average cost of capital (WACC).

How is the cost of debt calculated?

The cost of debt is calculated as the interest paid on the debt, adjusted for taxes. The after-tax cost of debt is found by multiplying the pretax cost of debt by (1 - tax rate).

What is the role of WACC in financial decision-making?

WACC represents the overall cost of capital for a company, factoring in the weighted average of all capital sources (debt, preferred stock, and equity). It helps in evaluating investment projects and ensuring that the returns meet or exceed the required costs of funding.

Why might a company reject a project even if the expected return is positive?

A company might reject a project if the cost of financing (cost of capital) is higher than the expected return. If the financing costs exceed the expected returns, the project would reduce the company's value, making it undesirable.

What is the Gordon Growth Model and how is it used in calculating the cost of common stock?

The Gordon Growth Model is used to estimate the cost of common stock by dividing the expected dividend per share by the current stock price, then adjusting for the expected dividend growth rate. This model assumes that dividends will grow at a constant rate indefinitely.

What does 'cost of preferred stock' refer to?

The cost of preferred stock refers to the cost associated with issuing preferred shares, which typically involves paying dividends to preferred shareholders before common shareholders. It is calculated as the dividend rate divided by the net proceeds from issuing the preferred stock.

How is the weighted average cost of capital (WACC) calculated?

WACC is calculated by multiplying the cost of each type of capital (debt, preferred stock, equity) by its respective weight in the overall capital structure, then summing the results. It provides the average cost of capital, considering each component’s proportion.

Why is the cost of equity typically higher than the cost of debt?

The cost of equity is typically higher than the cost of debt because equity holders face greater risk than debt holders. Debt is secured and has priority in case of liquidation, while equity holders are last in line, which makes equity riskier and thus more expensive.

What factors contribute to the difference between debt and equity in terms of cost?

The difference in cost between debt and equity arises due to the risk involved. Debt is less risky as it is paid before equity in case of liquidation and often comes with tax advantages. Equity is more expensive because it involves higher risk for the investors, who expect higher returns in exchange.