Strictly for the intellectuals..cash flow analysis

Cost of capital is aka hurdle rate. In your example ( if i assume that the cost of equity is 12%), the weighted average cost, of capital is 10.5%

7% is post tax cost of debt. Interest expense is tax deductible expense in pnl. So if gross cost is 10%, the net cost (post tax cost) is 7% ( if tax rate is 30%)

12% is just an assumed cost of equity. Determining the cost of equity is the difficult part unlike debt where the cost is the coupon on debentures or interest rate of loans taken

There are a few methodologies / models generally used to compute this. But as i said this is difficult and different models can throw up very different results.

 

Post tax cost of debt

Borrowing. 100 at 10%
Tax rate. Say 30%

The pnl will look like this

Gross interest expense. 10
PBT. <10>. Loss of 10
Tax benefit. 3. ( tax at 30% on 10)
PAT. <7>

So effective post tax cost of debt is 7%

 

Lost it a little bit...
Now 30 rs was loan borrowed at 10%.. ebita was 30... so interest expense is 10% of 30 which is 3 rs...so profit before tax is rs 27...
Now tax is 30%.. so approx 9 rs... so profit after tax is 18..
Can u continue the explanation with this old example please... u gave a new example so lost it..

 

30 rs is loan .. rate of interest is 10%..(If u are lost please read last 8 to 9 message) .. roce is 30%... so ebita is 30 rs.. now since rate of interest is 10%.. have to pay 10%of 30 rs to bank.. so profit before tax is 30-3=27... now tax is 30%.. so 30% of 27 is 8.1rs let's assume it is 9... so profit AFTER TAX is 27-9= 18...
now since 3rs is paid to the bank. .30% of tax that had to be paid for the 3rs which is paid to the bank is spared... so 30%of 3 rs is 1rs..
So after tax cost of debt will be formulated like (3rs paid to bank minus 1rs of tax saved ) = 2rs on 30 rs of bank loan ... calculated %age wise 2/30*100= 6.7 which is approximately 7%.... tedious but detailed explanation. ...hope all of u got it

 

Tomorrow now..... Brain reaching a shutdown mode now

 

Another simple formula for after/post tax cost of debt is
Interest rate on debt* (100% minus income tax rate)
For most of the companies income tax is around 30%..
Interest rate on debt*(100%-30%).
So for example if interest rate is 20%
20*(100-30)= 20%×70%....

 

I missed adding ROE. I am too lazy to calculate EVA accurately. I prefer to subtract WACC from operating profit then there is the question levering and delivering, so I keep it simple. But I agree, if Eva is calculated accurately, very useful metric.

 

So to summarise EVA
Hurdle rate=Common equity * cost of common equity+EBITA*after tax cost of debt
Here after tax cost of debt is
= %age of interest to debt *(100%-incremental income tax %age)
Now EVA = NOPAT (EBITA-income tax)-(total capital*hurdle rate)

 

The only drawback of this method is that we have to assume a number for cost of equity. ..
So higher a number assumed it will be difficult for the company to maintain standards. .
If we assume a smaller number as cost of equity then may be even a mediocre company might give positive EVA number..
So may be 15 might be a good number to assume to set a good standard to separate those cream company...

 

Like i said there are a couple of generally accepted models which are used by corporate finance / valuation experts. So its not an out of thin air assumed number.

Also cost of equity will more often than not be higher than cost of debt.

 

@ fundamentalist : keen to understand how you arrive at WACC which you then subtract from operating profit. Can you clarify

Thanks

And i dont know how you look at ROE but for me I look at ROE by breaking apart ROE to get a much better understanding about where movements in ROE are coming from.

ROE. =. Net Income / PBT. X. PBT/ Operating income. X. Operating Income/ Total Revenues. X. Total revenues / Total Assets. X. Total Assets. / Shareholders equity

 

What is WACC.. can someone expand it

 

Weighted average cost of capital for me

Wait for fundamentalist to clarify aswell

 

Sorry guys. Just saw this.

Calculating cost of capital is about calculating the cost of equity and the cost of debt, figuring out the proportion of total capital in debt and in equity such that we have a weighted average cost of capital.

This is painful for me now, so I don't do those calculations. But once in a while just for fun I do it.

For some reason ( laziness mostly) I don't use EVA. But I should.

But here is more about WACC for those interested in the theory behind it
DEFINITION of 'Weighted Average Cost Of Capital - WACC'
Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation. A firm’s WACC increases as the beta and rate of return on equity increase, as an increase in WACC denotes a decrease in valuation and an increase in risk.

To calculate WACC, multiply the cost of each capital component by its proportional weight and take the sum of the results. The method for calculating WACC can be expressed in the following formula:



Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Explanation of Formula Elements
Cost of equity (Re) can be a bit tricky to calculate, since share capital does not technically have an explicit value. When companies pay debt, the amount they pay has a predetermined associated interest rate that debt depends on size and duration of the debt, though the value is relatively fixed. On the other hand, unlike debt, equity has no concrete price that the company must pay. Yet, that doesn't mean there is no cost of equity. Since shareholders will expect to receive a certain return on their investment in a company, the equity holders' required rate of return is a cost from the company's perspective, since if the company fails to deliver this expected return, shareholders will simply sell off their shares, which leads to a decrease in share price and in the company’s value. The cost of equity, then, is essentially the amount that a company must spend in order to maintain a share price that will satisfy its investors.

Calculating cost of debt (Rd), on the other hand, is a relatively straightforward process. To determine the cost of debt, use the market rate that a company is currently paying on its debt. If the company is paying a rate other than the market rate, you can estimate an appropriate market rate and substitute it in your calculations instead.

There are tax deductions available on interest paid, which is often to companies’ benefit. Because of this, the net cost of companies’ debt is the amount of interest they are paying, minus the amount they have saved in taxes as a result of their tax-deductible interest payments. This is why the after-tax cost of debt is Rd (1 - corporate tax rate).



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