(^74) Financial Management
where NPo = the market price of the equity share less flotation costs incurred
in issuing new shares.
ii) Capital asset pricing model: As discussed in the last chapter the expected cost
of equity share is dependent on the risk profile of the share versus the market as
a whole.
ks = kf + b(km - kf)
where ks = the cost of equity share
kf = the risk-free rate
b = beta, measure of the stock's systematic risk
km = the expected rate of return on the market
iii) Risk-Premium Approach: All these models are very useful for companies that
have their shares listed in the market or about to get them listed. What about the
companies that are privately owned. The best way to do it for these companies is
to find the general risk premium and take the company specific cost of debt
(which is supposed to include the risk premium of the company) and then add the
two to find out the equity cost of the company.
ks = kd + RPs
where ks = cost of equity share
kd = cost of debt
RPs = risk-premium of equity share
- Determining capital structure mix
- The individual costs of capital will be different for each source of capital in the
firm's capital structure. If the company uses debt to the level of fifty percent of
its investment, then the cost of debt should get 50% weightage in the capital
structure.
To use the cost of capital in investment analyses, we must compute a weighted or
overall cost of capital. - Level of financing and the weighted average cost of capital
The weighted marginal cost of capital specifies the composite cost for each
additional rupee of financing. The firm should continue to invest up to the point
where the marginal internal rate of return earned on a new investment (IRR)
equals the marginal cost of new capital.
Effect of additional financing on the cost of capital would be threefold.