Cost of equity DCF Model
Dukane Electric Company
Computation of Cost of Capital
Brajesh Kumar (MP12015)Santosh K Singh (MP12063)Rakesh Agarwal
(MP12054)Amit Bharti (MP12005)George Verghese (MP12021)Case Study
OverviewDEC was a company engaged in public distribution of
electricity with $172M sales in last fiscal year.It planned for a
major construction programme to expand customer base.Construction
budget estimated at over $500 M with approximately 60% finance from
internal resources. New capital investment requires the company to
earn a reasonable rate of return for its capital providers.The
above return must be decent enough to cover the cost of capital,
also known as WACC.Challenges ahead for WACC Inflation, increasing
wage cost and higher operating cost.Shareholders expectation
Comparable earning, capital attraction and maintain credit
standing.Case Study Overview contdComputation of WACC has many
inferences like using of different model for cost of equity and
application of different weights (market or book or target).What is
the most appropriate method to compute WACC.
Why the WACCMeasures the returns demanded by all providers of
capitalInvestments must offer this return to be worth using the
capital providers moneyAs an opportunity costThe rate of return
investors could earn elsewhere on projects with the same risk and
capital structureMethods for WACC ComputationCost of
EquityDiscounted Cash Flow Method (DCF)Capital Assets Pricing Model
(CAPM)Weighted Average Cost of Capital (WACC) using Book Value as
weightMarket Value as weightTarget Value as weightDecide : Most
Appropriate Method (MAM) for WACC
Cost of Equity DCF MethodD1 = Do X (1+g) = 1.14 X 1.08 = 1.23Po
= 16.125
Cost of Equity (Ke) = [D1 / Po] + g = 1.23/16.125 + 0.08 =
15.61%
Rm = Return on market portfolio = 13%Rf = Risk-free rate of
return = 7.50%Beta = 0.90Cost of Equity (Ke) = Rf + (Rm-Rf) X Beta
= 7.50 + (13-7.50) X 0.90 = 12.45%Cost of Equity CAPM
MethodCalculation of Different Weights
Component-wise Cost of CapitalCost of Preference Share (Kp) =
Div. / Market Price (net of floatation cost) = 2 / 20 X 100 =
10%
Cost of Equity (Ke)15.61 % (DCF Model) 12.45 % (CAPM Model)
Pretax Cost of Debt (Kd)= 8%WACC Computation (Book Value, Market
Value & Target Value)
MV Weight Vs BV WeightProvides better yardstick of investors
expectations.Based on market sentiments and not affected by
accounting entries in the books.Provides fair estimate of cost of
capital in relation to listed corporations.Difficult to compute
since market value is based on estimates and subject to different
individual inferences.
Most Appropriate MethodWe recommend WACC (TARGET WEIGHT) for the
following reasons
More dynamic compared to Market Weight and reciprocates the
investor expectations in current market scenario after raising the
new capital.
Target weights are management internal commitment which they
need to achieve in the long run.
Target weight attempts to incorporate the risk profile of the
firm in the industry, which in turn affects the WACC of the
firm.
