CALCULATION OF COST OF CAPITAL

A Break Down of Risk

Competition may be stronger or weaker than expected Project may do better or worse than expected Firm Specific Actions/ Risk that affect only one firm Entire sector may be affected by action

Source: Aswath Damodar

Exchange rate and Political risk

Interest rate, Inflation & news about economy Market Actions/ Risk that affect all investments Cannot affect

Affects few firms Firms can Investing in Acquiring Diversifying reduce by lots of competitor across projects s sectors Investors can Diversifying across domestic reduce by stocks

Affects many firms Diversifying across countries Diversifying Diversifying globally across asset classes

CAPM Assumptions

There are no transaction costs and securities are infinitely divisible All assets are correctly valued and information flows freely Investors are diversified across all asset classes

Historical Risk Premium - USA

CAPITAL STRUCTURE THEORIES

Broad Assumptions

There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares There are no corporate taxes. This assumption is removed later The dividend payout ratio is 100%. That is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings The total assets are given and do not change. The investment decisions are, in other words, assumed to be constant The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the equity capital The operating profits (EBIT) are not expected to grow All investors are assumed to have the same subjective probability distribution of the future expected EBIT for a given firm Business risk is constant over time and is assumed to be independent of its capital structure and financial risk Perpetual life of the firm

CAPITAL STRUCTURE THEORIES

MM Aproach

Proposition

The overall cost of capital (Ko) and the value of the firm (V) are independent of the capital structure. The Ko and V are constant for all degrees of leverage. The total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class

The cut off rate for investment purposes is completely independent of the way in which an investment is financed

Assumptions
1.

Perfect capital markets

Securities are infinitely divisible Investors are free to buy/ sell securities Investors can borrow without restrictions on the same terms and conditions the firm can There are no transaction costs Information is perfect, that is, each investor has the same information which is readily available to him without cost Investors are rationale and behave accordingly

2.

3.

4. 5.

All investors have the same expectation of firms net operating income (EBIT) with which to evaluate the value of the firm Business risk is equal among all firms within similar operating environment The dividend payout ratio is 100% There are no taxes. This assumption is removed later.

Implications of the assumptions

There are no taxes Managers have stockholder interests at heart and do whats best for stockholders No firm ever goes bankrupt Equity investors are honest with lenders; there is no subterfuge or attempt to find loopholes in loan agreements Firms know their future financing needs with certainty

What happens to the trade off between debt and equity? How much should a firm borrow?

The Debt Equity Tradeoff

Source: Aswath Damodara

Advantages of Debt Tax Benefit Added discipline

Disadvantages of Debt Expected Bankruptcy Cost Agency Cost Loss of Flexibility

Capital Structure is irrelevant to the valuation of the firm

Limitations

Risk perception Cost Convenience Double leverage Transaction costs Taxation

Factors for designing capital structure

Liquidity Aspect Control

Nature of industry
Stability

of cash flows Life cycle stage

Timing of Issue