Cost of Capital - Corporate Finance Need help!q

I am really having a hard time to grasp this topic. :frowning: Iโ€™m from a non-finance background and when I see the sample end of chapter questions, for those with computations, I am having a brain freeze. At this point in time, for June 2012 exam, I am already on panic mode. :frowning: I would REALLY REALLY appreciate it if anyone can lend me their notes for this topic or at least help me to undestand this topic, Thanks in advanced for any help :expressionless:

Alright. Iโ€™m going to run through this for you and try to be very basic. Donโ€™t be insulted by this, I just know you said non-finance background. A company can finance itself with equity, debt, or both. One of the most important issues in finance is the adequate use of debt. Debt, in the form of bonds, has a lower required rate of return and a tax break but is a contractual fixed cost, so it has to be paid regardless of performance. The reason it has a lower required rate of return is that in bankruptcy, debt holders have a claim on residual assets of the firm before equity. So this means if the company goes under, debt holders are more likely to recieve payment. Lower risk, lower yield.

Equity is the amount financed by capital, either by owners or others. The rate of return is a function of the risk of the deal. Higher equity returns are related to higher risk. Preferred stock will generally have lower cost than common stock, because preferred stock is a step below debt in bankruptcy and above general stock. This means that if the company goes under, preferred stock is more likely to get paid vs common stock.

The cost of debt will be the market yield of debt. If bond sells at par, the cost of debt will equal the coupon payment. However, if bonds are selling at a discount in the market, this means investors are requiring a higher rate of return. If we issued more bonds today, that market rate is what weโ€™d have to price our debt at. We take this cost of debt and multiply it time 1 - tax rate, because interest payments are tax deductions.

The cost of equity is the required rates of return. For common stock, this will be CAPM. For preferred stock, this will be stated coupon over market value (or par, if market is not given). CAPM takes the risk free rate, takes the market expected premium, and increases/decreases this by the relative risk of the asset compared to market (measured by Beta). If Beta is 1, its the same as market premium. Beta > 1, more risky. Beta < 1, less risky. Negative betas mean it moves in opposite directions of the market. For example, a company which buys and sells Gold would have more business during recessions than expansions (negative beta).

Once we have the above costs, we take the capital structure and do a weighted average. Say we had a 50% Debt/Equity. This DOES NOT mean 50% debt, 50% equity. Think of it this way. 50% D/E means 100 D divded by 200E. So this is really 100/300 = .33% D and 66% equity.

To understand WACC, understand CAPM and DDM. Sometimes, youโ€™l know stock price, ROE, dividend, and have to find K.

WACC = Compute Int in a PV Calculations (1-t) (% of total) + Cost of Preferred (% of total) + CAPM (% of Total).

For another application of WACC, for the income appraisal method, we take NOI divided by a cap rate. That cap rate represents a required rate of return for the investor. The CFA text does not go into this, but a simple cap rate calculation would be this for if you wanted to be a house paying 20% down:

80% financed with debt and 20% financed with equity.

80% debt * (Current Mortgage Rates) * (1-t) + 20% (Required Return on Equity Investments.) = Cap Rate.

Then youโ€™d take NOI / Cap rate to get the value of the property. The cap rate would be your personal WACC, as opposed to a company.

Hope this helps