Scribd
Upload
105 views9 pages

Major Assignment 11150

The document discusses several capital budgeting techniques and financial metrics used to evaluate investments and assess business performance, including: 1) Cost of debt - the average interest rate a company pays on all its debts. It is used to analyze capital structure and is part of calculating the weighted average cost of capital (WACC). 2) Preferred stock - a form of equity that provides dividend payments but no voting rights. Its cost is calculated as the annual dividend divided by the stock price. 3) Cost of equity - the rate of return required by equity investors. It can be calculated using the dividend capitalization model or discounted dividend model. 4) Economic value added (EVA) - compares net operating

Uploaded by

M ASIF
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
105 views9 pages

Major Assignment 11150

The document discusses several capital budgeting techniques and financial metrics used to evaluate investments and assess business performance, including: 1) Cost of debt - the average interest rate a company pays on all its debts. It is used to analyze capital structure and is part of calculating the weighted average cost of capital (WACC). 2) Preferred stock - a form of equity that provides dividend payments but no voting rights. Its cost is calculated as the annual dividend divided by the stock price. 3) Cost of equity - the rate of return required by equity investors. It can be calculated using the dividend capitalization model or discounted dividend model. 4) Economic value added (EVA) - compares net operating

Uploaded by

M ASIF
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 9

MUHAMMAD ASIF ID NO 1115

MAJOR ASSIGNMENT

1: The Cost of Debt (And How to Calculate It):

The cost of debt is the average interest rate your company pays across
all of its debts: loans, bonds, credit card interest, etc.

Cost of debt is an advanced corporate finance metric that outside


investors, investment bankers and lenders use to analyze a
company’s capital structure, which tells them whether or not it’s too
risky to invest in.

Calculating cost of debt (along with cost of equity) is an important part


of calculating a company’s weighted average cost of capital (WACC),
which measures how well a company has to perform to satisfy all its
stakeholders (i.e. lenders and investors).

But you don’t have to be a hedge fund manager or bank to calculate


your company’s cost of debt. Businesses calculate their cost of debt to
gain insight into how much of a burden their debts is putting on their
business and whether or not it’s safe to take on any more.

How to calculate cost of debt

To calculate your business’ total cost of debt—also sometimes called


your business’ effective interest rate—you need to do three things:
1. First, calculate the total interest expense for the year. If your
business produces financial statements, you can usually find this
figure on your income statement. (If you compile these quarterly,
add up total interest payments for all four quarters.)
2. Total up all of your debts. You can usually find these under the
liabilities section of your company’s balance sheet.
3. Divide the first figure (total interest) by the second (total debt) to
get your cost of debt.

Calculating cost of debt: an example:

4. Let’s say your business has two main sources of debt: a $200,000
small business loan from a big bank with a 6% interest rate, and a
$100,000 loan from billionaire investor Marc Cuban with an
interest rate of 4% (he liked your pitch on Shark Tank).
5. The total annual interest for those two loans will be $12,000 (6% x
$200,000) plus $4,000 (4% x $100,000), or $16,000 total. The total
amount of debt is $300,000. So the cost of debt is:
6. $16,000 / $300,000 = 5.3%
7. The effective pre-tax interest rate your business is paying to
service all its debts is 5.3%.

2: What is Preferred Stock?

Preferred stock is a form of equity that may be used to fund expansion


projects or developments that firms seek to engage in. Like other equity
capital, selling preferred stock enables companies to raise funds.
Preferred stock has the benefit of not diluting the ownership stake of
common shareholders, as preferred shares do not hold the same voting
rights that common shares do.

Preferred stock lies in between common equity and debt instruments,


in terms of flexibility. It shares most of the characteristics that equity
has and is commonly known as equity. However, preferred stock also
shares a few characteristics of bonds, such as having a par value.
Common equity does not have a par value.

The cost of preferred stock formula:

Rp = D (dividend)/ P0 (price)

For example:

A company has preferred stock that has an annual dividend of $3. If the
current share price is $25, what is the cost of preferred stock?

Rp = D / P0

Rp = 3 / 25 = 12%

It is the job of a company’s management to analyze the costs of all


financing options and pick the best one. Since preferred shareholders
are entitled to dividends each year, management must include this in
the price of raising capital with preferred stock.

For investors, the cost of preferred stock, once it has been issued, will
vary like any other stock price. That means it will be subject to supply
and demand forces in the market. In theory, preferred stock may be
seen as more valuable than common stock, as it has a greater likelihood
of paying a dividend and offers a greater amount of security if the
company folds.
3: cost of equity (Discount dividend model):

Cost of Equity is the rate of return a company pays out to equity


investors. A firm uses cost of equity to assess the relative attractiveness
of investments, including both internal projects and external acquisition
opportunities. Companies typically use a combination of equity and
debt financing, with equity capital being more expensive.

Dividend capitalization model:

XYZ Co. is currently being traded at $5 per share and just announced a
dividend of $0.50 per share, which will be paid out next year. Using
historical information, an analyst estimated the dividend growth rate of
XYZ Co. to be 2%. What is the cost of equity?

D1 = $0.50

P0 = $5

g = 2%

Re = ($0.50/$5) + 2%

Re = 12%

The cost of equity for XYZ Co. is 12%.

4: Economic Value Added (EVA):

Economic value added (EVA) is an internal management performance


measure that compares net operating profit to total cost of
capital. Stern Stewart & Co. is credited with devising this trademarked
concept.

Economic value added (EVA) is also referred to as economic profit.


The formula for EVA is:
EVA = Net Operating Profit after Tax - (Capital Invested x WACC)
As shown in the formula, there are three components necessary to
solve EVA: net operating profit after tax (NOPAT), invested capital, and
the weighted average cost of capital (WACC) operating profit
after taxes (NOPAT) can be calculated, but can usually be easily found
on the corporation's income statement.
The next component, capital invested, is the amount of money used
to fund a particular project. We will also need to calculate the
weighted-average cost of capital (WACC) if the information is not
provided.
The idea behind multiplying WACC and capital investment is to assess a
charge for using the invested capital. This charge is the amount that
investors as a group need to make their investment worthwhile.

Let's take a look at an example:


Assume that Company XYZ has the following components to use in the
EVA formula:
NOPAT =$3,380,000
Capital Investment=$1,300,000
WACC = .056 or 5.60%
EVA = $3,380,000 - ($1,300,000 x .056) = $3,307,200
The positive number tells us that Company XYZ more than covered its
cost of capital. A negative number indicates that the project did not
make enough profit to cover the cost of doing business.

5: Market Value Added (MVA):

Market value added, on the other hand, is merely the difference


between the current value of the company on the market and the initial
contributions made by its investors. Contrary to what many assume,
MVA is not a performance indicator. Instead, it is a metric used to
measure wealth. Essentially, it is used to determine exactly how much
value the firm has accumulated over time. If a company has been
performing well, it means that it has been retaining earnings. The
earnings boost the book value of the company’s stocks, encouraging
investors to increase the prices of their shares in anticipation of future
earnings. The whole process causes the company’s market value to
soar.

MVA Formula:

Although one may encounter different formula for computing MVA, the
simplest one is: MVA = Market Value of Shares – Book Value of
Shareholders’ Equity To find the market value of shares, simply multiply
the outstanding shares by the current market price per share. If a
company offers owns preferred and ordinary shares, then the two are
summed together to find the total market value.

EXAMPLE:
As an example, consider Company XYZ whose shareholders’ equity
amounts to $750,000. The company owns 5,000 preferred shares and
100,000 common shares outstanding.

The present market value for the common shares is $12.50 per share
and $100 per share for the preferred shares.

Market Value of Common Shares = 100,000 * $12.50 = $1,250,000

Market Value of Preferred Shares = 5,000 * $100 = $500,000

Total Market Value of Shares = $1,250,000 + $500,000 = $1,750,000

Using the figures obtained above:

Market Value Added = $1,750,000 – 750,000 = $1,000,000

6: Improvement in EVA theory:

There are two major ways a company can improve its economic value
added (EVA): increase revenues or decrease capital costs. Revenue can
be increased by raising prices or selling additional goods and services.
Capital costs can be minimized in several ways, including increasing
economies of scale. It is also possible for a firm to offset capital costs by
choosing investments that earn more than their associated capital
charges.

In the EVA formula, a firm's revenue is expressed as being equal to net


operating profits after tax (NOPAT). Capital costs are traditionally
estimated using a weighted average cost of capital (WACC or $WACC).
EVA, also known as economic profit, is the result of subtracting all net
capital charges from NOPAT. It is one of the most popular profitability
metrics used by companies and fundamental analysts.
If a company wants to improve its EVA by adding to its revenues, it
must ensure the marginal revenue gain is larger than the accompanying
marginal costs, including taxes. This makes sense – you would not
spend $150 to earn $100 in revenue. Since revenue generation is
usually uncertain, it is often easier for a company to reduce its net
capital costs.

Net capital costs can be lowered by reducing operating expenses,


increasing marginal productivity or both. A company might renegotiate
with its creditor to acquire a lower interest rate on debt or call
in preferred shares and reissue them at a lower rate.

Economic value added is sometimes also referred to as shareholder


value added (SVA), although some companies might make different
adjustments in their NOPAT and cost of capital calculations. These are
not the same as cash value added (CVA), which is a metric used by
value investors to see how well a company can generate cash flow.

7: capital budgeting technique:

Capital budgeting is the process a business undertakes to evaluate


potential major projects or investments. Construction of a new plant or
a big investment in an outside venture are examples of projects that
would require capital budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective


project's lifetime cash inflows and outflows to determine whether the
potential returns that would be generated meet a sufficient target
benchmark. The capital budgeting process is also known as investment
appraisal.

KEY TAKEAWAYS

 Capital budgeting is used by companies to evaluate major projects


and investments, such as new plants or equipment. 
 The process involves analyzing a project’s cash inflows and
outflows to determine whether the expected return meets a set
benchmark.  
 The major methods of capital budgeting include discounted cash
flow, payback, and throughput analyses.

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy