The cost of capital is the rate of return that a firm pays to bondholders and equity holders. Cost of capital is an important measure while making investment decisions, as any one making an investment would expect a higher return from his investment in a company compared to what he could earn from an alternative […]
Cost of Capital
Weighted Average Cost of Capital (WACC) – Practical Example and Issues
In the previous article we review the concept of weighted average cost of capital and its formula. This video provides a detailed example of WACC calculation and also discusses some of the issues while using it. The video also discusses in detail the concept of marginal cost and why a firm can’t finance itself only […]
Applications of Cost of Capital
The marginal cost of capital plays an important role in capital budgeting and investment decisions. As a firm raises more and more capital, it’s marginal cost of capital (MCC) increases. However, when a firm makes more investments, the returns from additional investments decrease. This is represented by the investment opportunity schedule (IOS). The MCC schedule […]
Calculating Cost of Debt: YTM and Debt-Rating Approach
Cost of debt refers to the cost of financing a company using debt such as a bond issue or bank loan. It is stated as an interest rat rD. Since there is a tax shield on the interest component of debt, the component used in WACC is rD (1 –t) In this article, we will […]
Issues in Estimating Cost of Debt
We discussed that the cost of debt for a company can be measured using the YTM or Debt-Rating approach. An analyst faces certain issues while estimating the cost of debt. These issues are discussed below: Floating/Fixed Rate Debt: In our previous article, our calculations assumed a fixed rate for debt. However, in reality, a firm […]
Estimating the Cost of Preferred Stock
Cost of preferred stock is the cost that the company has committed to pay to the preferred stockholders in the form of preferred dividends. For a plain vanilla preferred stock (No convertibility or callable features), the cost is calculated as follows: Cost of preferred stock, Where, D = Preferred stock dividend per share P = […]
Estimating the Cost of Common Stock
The cost of common equity is represented as re, and it is the rate of return required by the common shareholders. The cost of common equity can be measured using the following methods: 1. Capital Asset Pricing Model (CAPM) 2. Dividend Discount Model 3. Bond Yield plus Risk Premium Method Let’s discuss each of these […]
Calculating Beta Using Market Model Regression (Slope)
While calculating the cost of equity, it is important for an analyst to calculate the beta of the company’s stock. Beta of a publicly traded company can be calculated using the Market Model Regression (Slope). In this method, we regress the company’s stock returns (ri) against the market’s returns (rm). The beta (β) is represented by […]
Calculating Beta Using Pure Play Method
In the previous article, we learned about how to calculate the beta of a publicly traded company’s stock. However, the same method cannot be used for calculating the beta of a company or project that’s not traded in the market. In this article we will see how to calculate the beta of such a company […]
Estimating the Country Risk (Country Equity Premium)
In developed nations, the beta of a stock adequately captures the country risk (Historical evidence). However, this doesn’t hold true for developing nations. Therefore, the calculation of cost of equity using CAPM requires adding a country risk spread to the market risk premium. This is also called the country equity premium. The Country Risk Premium […]