Cost of Capital

In: Business and Management

Submitted By tonarrie
Words 758
Pages 4
Cost of Capital

Pfizer is researched drug corporation that increases their own inventive pharmaceutical goods. Pfizer's global income exceeds $65 billion with a marketplace fissure close to 140 billion. The organization was founded in 1849 by two cousins, Charles Pfizer and Charles Ehart with the mission of learning and evolving new and better, ways to prevent and treat disease and improve the well-being of people. (History, 2014) This paper shall present to the reader Team B’s prospective of the week five video assignment. Our breakdown shall include a brief explanation on the cost of capital, capital asset pricing model, capital base, and capital structure.
Cost of Capital
The cost of capital is the least adequate rate of return on resource development that must be earned to be accepted by management. Owners use cost of capital to finance their business. Cost of capital refers to the cost of debt or cost of equity. Various corporations use a mixture of equity and debt to investment their productions. In general cost of capital to the industry may result from a subjective standard of all capital resource. In finance, this process is referred as the weighted average cost of capital (WACC). The cost of capital can change depending on the company; it also may rely on different aspects such as profitability, borrowing, and operating history.
Capital Asset Pricing Model

The capital asset pricing model (CAPM) is defined as, the association amongst risk and probable risk that is used in value of precarious securities" (Capital Asset Pricing Model, 2013). In finance, CAPM is used to establish a supposedly suitable obligatory charge on return of an asset. If that advantage is to be added to a previously expanded assortment, providing resources non-diversifiable peril. There is a standardized holding period assumed by the CAPM in order for the returns on…...

Similar Documents

Cost of Capital

...Jeremy Masem FIN 685 10/21/12 Cost of Capital paper The relationship between the method and assumptions made with respect to placing a value on a financial instrument and determining the capital cost for each of these instruments is intertwined. Similar factors are involved in both calculations. Issues surrounding estimating the future cost of capital and placing a value on a financial instrument are similar too. A WACC formula makes it clear that the problem of discount rate determination can be separated in the problem of determining the financial weights and the problem of determining the segment cost of capital (e.viaminvest.com). A company’s assets are generally financed by either debt or equity. The weighted average cost of capital is the average costs of these sources of financing, each of which is weighted by its respective use in the given situation. These sources of financing are financial instruments. Similar to how a company’s assets are generally financed, preferred stock has characteristics of both equity and debt. Preferred shares generally have a dividend requirement that makes them appear similar to debt. When placing the financial value on a bond, bond valuation includes calculating the present value of the bond’s future interest payments or cash flow, and the bond’s value upon maturity, also known as its face value (investopedia.com). A simplified stock valuation model is usually based on the general principle that the price of a common stock...

Words: 418 - Pages: 2

Cost of Capital

...Cost of Capital- Coffee Industry Group No. 4 Submitted to- Group Members- Prof. Sarath Babu Himakshi Mallik Vitash Sharma Rahul Rishav Avinash M Kopparapu Prudhvi Nadh Cost of Capital- Coffee Industry We have taken into consideration two firms- New World Coffee and New York Yankees. ESTIMATING COST OF EQUITY FOR A PRIVATE FIRM • Basic Problem: Most models of risk and return (including the CAPM) use past prices of an asset to estimate its risk parameters (beta(s)). Private firms and divisions of firms are not traded, and thus do not have past prices. • • Solution 1: Estimate the beta, based upon comparable firms, and after adjusting for risk. o Step 1: Collect a group of publicly traded comparable firms, preferably in the same line of business, but more generally, affected by the same economic forces that affect the firm being valued.  A Simple Test: To see if the group of comparable firms is truly comparable, estimate a correlation between the revenues or operating income of the...

Words: 1594 - Pages: 7

Cost of Capital

...1. If a corporation has an average tax rate of 40 percent, what is the approximate, annual, after-tax cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950? Flotation costs are 1% of face value. The interest payments are semi-annual. PV = 950 – (1000*.01) = 940, FV = -1000, PMT = 120/2 = -60, N = 15 x 2 = 30, I = ? Before tax cost of debt = 6.46 x 2 = 12.92% After-tax cost of debt = 12.92(1-.4) = 7.75% 2. A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. What is the cost of the preferred stock? Cost of preferred = 10/(100-2) = 10.2% 3. A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6 percent. What is the estimated cost of common stock equity (retained earnings)? Cost of RE = 6 + (14-6)1.2 = 15.6% 4. A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. The coupon payment is semi-annual. Additionally, the firm's marginal tax rate is 40 percent. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10...

Words: 460 - Pages: 2

Nike Cost of Capital

...NIKE, INC. COST OF CAPITAL Context: Estimating Cost of Equity with different methods. Compute WACC Nike’s current price per share= $ 42.09 Question: Is it undervalued or overvalued to make buy /sell decision? Forecasts for Cash flows, Dividend growth, EPS estimates for NIKE are given. Interest rate #’s, Betas, Book values on debt and equity are given. Also historical performance #s are given. At 12% WACC Nike is overvalued and hence sell decision; At 11.17% correct valuation; WACC below 11.17% , undervaluation and hence buy decision. Exhibit 2 : The bottom table shows the sensitivity of share price to discount rate. The issue is which discount rate (WACC) to use to make the decision. Lower the discount rate, higher the estimate of stock price. How do you estimate WACC? Weights of Debt and Equity Cost of Debt and Cost of Equity Overall Assessment of the firm: Exhibit 1 Uneven growth rate in revenue, operating income and net income from negative to low positive. All profit margin #s are relatively stable. Market share has declined. Company’ plans: (1) New Products in shoes and Athletic Apparel; (2) Expense Control Revenue growth target= 8-10% Earnings growth target=15% Both are substantially higher than the recent performance. Methodologies for Valuing a Firm 1. Estimating Cash flows per share; Take a good look at Exhibit 2. Exhibit 2 has information for ten years. Question: Why is terminal value given at the end of year...

Words: 725 - Pages: 3

Capital Cost

...THE COST OF CAPITAL The investor-supplied items- debt, preferred stock, and common equity- are called capital components. Increases in assets must be financed by increases in these capital components. The cost of each component is called its component cost. For example, Allied can borrow money at 10%, so its component cost of debt is 10%. These costs are then combined to form a weighted average cost of capital, which is used in the capital budgeting process. rd interest rate on the firm’s new debt = before-tax component cost of debt. It can be found in several ways, including calculating the yield to maturity on the firm’s currently outstanding bonds. rd(1-T) after tax component of debt, where T is the firm’s marginal tax rate. rD(1-T) is the debt cost used to calculate the weighted average cost of capital. The after-tax cost of debt is lower than the before-tax cost because interest is deductible. rp component cost of preferred stock, found as the yield investors expect to earn on the preferred stock. Preferred dividends are not tax-deductible, hence, the before- and after-tax costs of preferred are equal. rs component cost of common equity raised by retaining earnings, or internal equity. It is also defined as the rate of return that investors require on the firm’s common stock. Most firms, once they have become well established, obtain all of their new equity as retained earnings, hence, rS is their cost of all new equity. re component cost of...

Words: 431 - Pages: 2

Cost of Capital

... = = 2.594 or, 1 + g = (2.594)1/10 or, g = 1.10 - 1 = 0.10 or 10% b. Calculation of flotation cost in percent Flotation cost in percent = = = 0.10 or 10% c. Cost of retained earning (ks) = = = 0.1951 or 19.51% d. Cost of external equity (ke) = + g = = 0.2057 or 20.57% Illustration 5 Compute the after-tax cost of the following, assuming that a firm has a tax rate 30 percent: a. A bond, sold at par, with a 10.4 percent coupon. b. A preferred stock, sold at Rs 100 with a 10 percent coupon and a call price of Rs 110, if the company plans to call the issue in 5 years c. A common stock selling at Rs 16 and paying a Rs 2 dividend, which is expected to be continued indefinitely. d. The same common stock if dividends are expected to grow at the rate of 5 percent per year and the expected dividend in year 1 is Rs 2. e. Compute weighted average cost of capital by using the component cost of capital computed above in (a), (b) and (d) if the firm has 30 percent debt, 20 percent preferred stock, and the balance common stock. Solution GIVEN, Tax rate (t) = 30% a. After-tax cost of bond (kdt) Coupon interest rate = 10.40% kdt = kd (1 - t) = 10.40% (1 - 0.30) = 7.28% b. Cost of preferred stock (kPS) Call price = Rs 110...

Words: 8307 - Pages: 34

The Cost of Capital

...Cost of Capital Introduction This paper examines key elements of a cost of capital policy to facilitate objective management and allocation of corporate funds. In order for a company to make long-term investments to grow, whether that is new equipment, new products or other assets, managers must be aware of the cost of acquiring any of these assets. The obvious objective for these managers is to earn more than the cost of capital and in doing so will increase their company’s market value. If they fail to adequately estimate their cost of capital and their long-term investments fall beneath the cost of capital, their company’s market value will decline as a result. This ongoing battle of managing and calculating the cost of capital and how to budget them accordingly is extremely important in providing the necessary goals of increasing value to their company’s stockholders. The information that managers use will ultimately dictate the outcomes of their company’s cost of capital policy and how the allocate corporate funds. This paper will highlight several processes and elements managers use in determining capital cost. Functions for Decision Making When corporate managers think about the cost of capital and cost allocation, there are several factors that must be analyzed and weighed. First, managers need to look at the general economic condition for their industry as well as overall market. These would include the demand and supply of capital within the economy, and...

Words: 1057 - Pages: 5

Cost of Capital

...Case 12 “Best practices “in Estimating the Cost of Capital The Cost of Capital The purpose of this case is to present evidence on how some of the most financially sophisticated companies and financial advisers estimate capital costs. This evidence is valuable in several respects. First, it identifies the most important ambiguities in the application of cost-of-capital theory, setting the stage for productive debate and research on their resolution. Second, it helps interested companies benchmark their cost-of-capital estimation practices against best-practice peers. Third, the evidence sheds light on the accuracy with which capital costs can be reasonably estimated, enabling executives to use the estimates more wisely in their decision-making. Fourth, it enables teachers to answer the inevitable question, “How do companies really estimate their cost of capital?” Survey Findings The detailed survey results appear in Exhibit 2. The estimation approaches are broadly similar across the three samples in several dimensions. • Discounted Cash Flow (DCF) is the dominant investment-evaluation technique. • WACC is the dominant discount rate used in DCF analyses. • Weights are based on market not book value mixes of debt and equity.8 • The after-tax cost of debt is predominantly based on marginal pretax costs, and marginal or statutory tax rates. • The CAPM is the dominant model for estimating the cost of equity. Some firms mentioned other multi-factor asset-pricing...

Words: 2606 - Pages: 11

Mariott Cost of Capital

...| | |Marriott Corporation: | |Cost of Capital | Concepts Covered Cost of Equity: Cost of Equity is the minimum rate of return a firm must offer to the shareholders. This is necessary as the shareholders who have taken a risk in investing would be waiting for returns. The formula for Cost of Equity is given by: Cost of Equity = (Dividend per share/ Current Market Value of Stock) * Growth rate of Dividends Cost of debt: - Cost of debt is the effective interest rate that a company pays on its debt. Cost of debt is usually calculated after the interest expenses are deducted Cost of debt = Cost of Debt before tax (i.e. Interest rate) * (1-Tax Rate) WACC: Weighted average cost of capital is one of the measures to calculate the cost of capital of the firm. Weighted Average Cost of Capital is the minimum return a firm must earn on existing assets to keep its stock price constant and satisfy its creditors and owners. [pic] c = weighted average cost of capital y = Expected rate of return on equity (cost of equity) b...

Words: 2487 - Pages: 10

Cost of Capital

...Week 5 Cost of Capital Video Pfizer corporation is a research based pharmaceutical company in fact they are the world’s largest. They develop their own products, in a risky environment where a new product may have hundreds of millions of dollars invested in it and may fail and not be a viable product. Development of these types of products causes some significant cost of capital challenges for Pfizer. Pfizer’s capital structure like many large publicly held corporations is made up primarily of debt, the money the firm has borrowed, and equity both from retained earnings and the equity investors have contributed by purchasing stock. Pfizer has eight billion outstanding shares of common stock in the market. A key challenge the company faces is providing enough financing to fund these risky and sometimes long term R&D projects. They have significant revenue of $65B per year but that alone does not mean they will have the cash in the right place at the right time. First it is important that Pfizer selects the right R&D projects to fund. They prioritize R&D projects based on the rank order of the projects values using financial metrics and select projects that will provide a good return for their shareholders. When selecting projects they determine a productivity index using the NPV of the project in the numerator and the present value of the costs in the denominator. This is a “bang for the buck” approach to determine how much return you believe you will get for...

Words: 629 - Pages: 3

Nike Cost of Capital

...ke, Inc. is an athletic shoe manufacturing firm. In 2000, Nike’s market share was 42 percent which was a decrease from 1997s mark of 48 percent. The firm began recording constant revenues in 1997 and net income fell from $800M to $580M. Therefore, the firm had to take action and make a more averaged priced athletic shoe while adding a push to the apparel line. After examining Nike’s financial statements we have come up with our conclusion. The weighted average cost of capital, WACC, is the rate of return required by investors. The WACC calculates the different risks associated with the individual components of the capital structure. The individual components within the WACC are preferred stock, common stock, and after-tax debt. The WACC is very important because it tells the investors if the return they are receiving is equal to the return they require depending on the risk associated with the investment. The WACC is the company’s overall rate of return and cost of capital. After much calculations, we believe Joanna Cohen’s analysis is incorrect. The reason being, when she calculated the WACC she used the book value instead of market values for the weights of debt and equity. When calculating the long term debt, Joanna should have discounted the debt that appears on the balance sheet. When calculating the risk free rate in her capital asset pricing model, Joanna used the 20 year U.S. treasury yield of 5.74% and a geometric mean of 5.90%. We chose to use the one-year U.S...

Words: 1221 - Pages: 5

Cost of Capital

...Cost of Capital Calculating Cost of Capital: * Component Costs * Capital Structure Component Costs: * Cost of debt – R d * Cost of preferred stock – R p * Cost of equity – R e Component Cost of Debt (R d) * Loan: R d = Effective Annual Rate of Loan. EAR=1+APRmm-1 * Bond: R d = YTM. P0=c×1Rd-1Rd(1+Rd)t+FV(1+Rd)t Where: “c” is dollar coupon; “FV” is Face or par value, which is $1,000; “t” is remaining years to maturity. “P 0” is current market price of bond. Note: If the bond pays semi-annual coupon, divide “C” by 2; multiply “t” by 2; and multiply answer (R d) by 2. * Cost of Preferred Stock (R p): Rp=DIVPSP0 Where: DIV is $ preferred stock dividend; or dividend yield x PAR. P 0 is current market price of preferred stock. Note: Par value of preferred stock is $100. * Cost of Equity (Re) 1. Discounted Cash Flow Model (DCF model) Re=D1P0+g Where: D 1 is next period expected dollar dividend of common stock. Or, D1=D0 x (1 + g). “g” is constant dividend growth rate of common stock. P0 is current market price of common stock. 2. Capital Asset Pricing Model (CAPM) Re=Rf+E(Rm)-Rf×β Market Risk Premium Market Risk Premium Where: R f is risk-free rate. E(R m) is expected return on market.  is beta of company. Estimating beta: Rstock=c+β×Rmarket+e Capital Structure: * Debt * Long-term debt * Interest-bearing short-term debt used to finance long-term assets...

Words: 712 - Pages: 3

Cost of Capital

...Quiz 11 Cost of Capital 1(11-2) NPV and IRR F I Answer: b EASY [i]. A basic rule in capital budgeting is that If a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False 2(11-2) Mutually exclusive projects F I Answer: b EASY [ii]. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR. a. True b. False 3(11-3) IRR F I Answer: b EASY [iii]. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. a. True b. False 4(11-4) Multiple IRRs F I Answer: b EASY [iv]. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False 5(11-5) Reinvestment rate assumption F I Answer: b EASY [v]. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False 6(11-6) Modified IRR F I Answer: b EASY [vi]. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects...

Words: 1417 - Pages: 6

Cost of Capital

...COST OF CAPITAL The Marietta Corporation, a large manufacturer of mufflers, tailpipes, and shock absorbers, is currently carrying out its financial planning for next year. In about two weeks, at the next meeting of the firm's board of directors, Frank Bosworth, vice president of finance, is scheduled to present his recommendations for next year's overall financial plan. He has asked Donna Botello, manager of financial planning, to gather the necessary information and perform the calculations for the financial plan. The company’s divisional staffs, together with corporate finance department personnel, have analyzed several proposed capital expenditure projects. The following is a summary schedule of acceptable projects (defined by the company as projects having internal rates of return greater than 8 percent): Project Investment Amount Internal Rate of Return (in Millions of Dollars) A $10.0 25% B $20.0 21% C $30.0 18% D $35.0 15% E $40.0 12.4% F $40.0 11.3% G $40.0 10% H $20.0 9% All projects are expected to have one year of negative cash flow followed by positive cash flows over the remaining years. In additions, next year’s projects involve modifications and expansion of the company’s existing facilities and products. As a result, these projects are considered to have approximately the same degree of risk as the company’s existing assets. Botello feels that this summary schedule and detailed supporting documents provide her with the necessary...

Words: 402 - Pages: 2

Cost of Capital

...With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery. Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey conducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and 90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk. But that is where the consensus ends. The AFP asked its global membership, comprising about 15,000 top financial officers, what assumptions they use in their financial...

Words: 1057 - Pages: 5