How to calculate cost of capital?, Financial Management

To calculate the Cost of Capital, we will use the Weighted Average Cost of Capital (WACC) formula

            WACC = (E/V) X RE + (D/V) X RD X (1 - TC)
where

            E = Market Value of the firm's equity

            D = Market Value of the firm's debt

            V = Combined Market value of debt and equity = (E + D)

            RE = Cost of Equity Capital

            RD = Cost of Debt Capital

            TC = Corporate Tax Rate

Example

            Calculating the cost of capital for BAL, we get:

 

Value

Formula

Amount (Rs.)

E

 

52,726,727,061

Secured Loans (S)

 

318,335,238

Unsecured Loans (U)

 

53,031,231

Interest on S and U (ISU)

 

33,817,261

Interest Rate on S and U (RSU)

 = ISU/(S + U) * 100%

9.11

Sales Tax Deferral Liability under Package Scheme of Incentives 1983, 1988, 1993 (L)

 

5,889,623,171

Interest on L (IL)

 

0

Interest Rate on L (RL)

 = IL/L * 100 %

0

D

 = S + U + L

6,260,989,640

V

 = E + D

53,045,062,299

E/V

 = E/V

0.98

D/V

 = D/V

0.12

RD

 = (S + U)/D*RSU + L/D*RL

0.54

Tc (%)

 

35.00

RD * (1 - Tc)

 = RD * (1 - Tc)

0.35

Beta

 

0.73

RF (%)

 

6.00

RM - RF (%)

 

9.00

RE

 = RF + Beta * (RM - RF)

12.57

WACC (%)

 = (E/V)* RE + (D/V) * RE * (1 - Tc)

12.54

         

The weighted average cost of capital works out to 12.54% a year. As can be seen for BAL, 98% of the capital is in the form of equity. Only about 2% of the capital is funded through debt. It can also be observed that the interest on loans works out to be approximately 9% (excluding the Sales Tax Deferral), whereas the cost of equity works out to be around 12.5%. Since the debt part of the capital is very low (D/E ratio = 0.22), we can see that the financial risk of the company is very low.

Hence it can be seen that in the current scenario of falling interest rates on loans, BAL has a higher cost of capital than is optimum. In addition, BAL has huge reserves of surplus cash that it is unable to invest at the rates matching the cost of capital. Bajaj Auto is estimated to hold about Rs.18, 000 million in the form of loans & advances, debt/equity investments and cash in hand.

BAL is aware of this problem, as is evident from the fact that BAL decided to buyback some of its outstanding equity shares in 2001. This reduction in the capital base has reduced the cost of equity for the company. It has also reduced the huge amount of surplus cash that the company has on its hand.

Posted Date: 7/25/2012 8:43:36 AM | Location : United States







Related Discussions:- How to calculate cost of capital?, Assignment Help, Ask Question on How to calculate cost of capital?, Get Answer, Expert's Help, How to calculate cost of capital? Discussions

Write discussion on How to calculate cost of capital?
Your posts are moderated
Related Questions
Q. Explain about Invoice discounting? Invoice discounting is a technique which is able to be used to raise finance against receivables. Invoice discounting works as follows:

Commercial banks Commercial banks allow deposits liabilities to make loans assets as well as to buy government securities. Deposits are wider in range including checkable depos

The process of securitization can best be understood by taking the following example. Assume that there exists an NBFC which has hire purchase as its major busine

This is the part of after-tax personal income that is not spent.

Average of Relatives Method We have seen the construction of an index number using the aggregates method. In this section, we shall see the construction of an index using the

what are the features of branch accounting

We can compute any forward rate using the spot rate. When we tell 3 years forward rate 4 years from now, there are two elements to consider. One is the length of

1. Analyse the company's capital structure and critically assess different types of financing options available to the company. Calculate the cost of these different types of finan

Question 1 Describe the functions of merchant banking and functions of financial intermediaries Question 2 What do you understand by book building and Green shoe option

Suppose you have recently been contracted as a financial consultant to a London-based engineering company, Alpha Products Plc. The company uses three components as part of their pr