Page 81 - DMGT409Basic Financial Management

Basic Financial Management

Notes Cost of Equity

I estimated the cost of equity, using the Capital Asset Pricing Model (CAPM). Other
methods such as the Dividend Discount Model (DDM) and the Earnings capitalization
Ratio can be used to estimate the cost of equity. However, in my opinion, the CAPM is the
superior method.
My estimate of Nike’s cost of equity is 10.5 per cent I used the current yield on 20-year
Treasury bonds as my risk-free rate, and the compound average premium of the market
over Treasury bonds (5.9 per cent) as my risk premium. For beta, I took the average of
Nike’s beta from 1996 to the present.
Putting it all Together
After inputting all my assumptions into the WACC formula, my estimate of Nike’s cost of
capital is 8.4 per cent.
WACC = K (1 – t) * D/(D + E) + K * E/(D + E)
d c
= 2.7% * 27.0% + 20.5% * 73.0%

= 8.4%
4.5 Summary

The cost of capital is viewed as one of the corner stones in the theory of fi nancial
management.

Cost of capital is the weight average cost of various sources of finance used by the fi rm.
It comprises the risk less cost of the particular type of fi nancing (r ), the business risk
j

premium, (b) and the financial risk premium (f). Symbolically (K ) = r + b + f.
j
o
The cost of capital is useful in designing optimal capital structure, investment evaluation,

and financial performance appraisal.

The financial manager has to compute the specific cost of each type of funds needed in the

capitalisation of a company. Company may resort to different financial sources (equity
share, preference share, debentures, retained earning, public deposits.
Retained earnings are one of the internal sources to raise equity fi nance. Corporate
executives and some analysts too normally consider the retained earnings as cost free, but
it is not so. They involve opportunity.

Cost of equity capital, is the minimum rate of return that a firm must earn on the equity
financed portions of an investment project in order to leave unchanged the market price of

the shares. There are six approaches available to compute K .
e
Cost of preference share capital (K ) is a function of the dividend expected by the investors.
p

K is having some conceptual difficulty. There are different types of preference shares. But
p
computation of K is only done for the redeemable and irredeemable shares.
p
Computation of Cost of capital/of WACC involves five steps: (1) Determination of the

type of funds to be raised and their individual share in the total capitalisation of the fi rm,
(2) Computation of the cost of each type of funds, (3) Assigning weights to specifi c costs,
(4) Multiplying the cost of the source by the (appropriate) assigned weights, and
(5) Dividing the total weighted cost by the total weights to get over all cost of capital.

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