Financial management

Cost of capital determine the capital structure

MBA
(Banking & Finance)

CONTENTS AT A GLANCE
S NO HEADINGS REVIEW OF LITRATURE
1 2 4 Cost of Capital (Introduction) Overall Cost of Capital Definition Overall Cost of Capital 5 Cost of capital Cost of equity capital Cost of debt Cost of preferred stock (capital) Weighted average cost of capital Capital asset pricing model 5 6

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Capital Structure Definition Theory of Capital Structure Determining the Capital Structure

PAK ELECTRON LIMITED

6 Introduction History Vision Mission Products Financial Data Cost of Capital Nature of Business Accounting Policies Basis of Preparation Key operational and financial data Financial report References

PRACTICAL STUDY

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IN THE NAME OF ALLAH THE MOST BENIFICIENT, THE MOST MERCIFUL

ACKNOWLEDGEMENT

COST OF CAPITAL
INTRODUCTION Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital. The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous. Cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments with similar risk profiles to determine the "market" cost of equity. The cost of capital is often used as the discount rate, the rate at which projected cash flow will be discounted to give a present value or value. It is alternatively referred to as the opportunity cost of capital or the required rate of return. It is calculated based on the expected average rate of return of investors in a firm. The rates of return that a company has to offer finance providers to induce them to buy and hold a financial security

OVERALL COST OF CAPITAL DEFINITION

The overall cost of a firm is the proportionate average of the costs of the various components of the firm. The overall cost of capital includes the following: Cost of capital Cost of equity capital Cost of debt Cost of preferred stock (capital) Weighted average cost of capital Capital asset pricing model

COST OF CAPITAL
Cost of capital is the required rate of return on the various types of financing or the cost of capital is the expected return that is required on investments to compensate you for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average basis (WACC).

COST OF EQUITY CAPITAL

Cost of equity capital is the required rate of return on investment of the common shareholders of the company. Cost of equity = Risk free rate of return + Premium expected for risk.

COST OF DEBT
The cost of debt is required rate of return on investment of the lenders of a company. The cost of debt is computed by taking the rate on a non-defaulting bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of

equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this is used for large corporations only.

COST OF PREFFERD STOCK(CAPITAL)

Cost of preferred stock (capital) is the required rate of return on the investment of the preferred shareholders of the company.