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COST OF CAPITAL

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COST OF CAPITAL

A companys cost of capital is the average cost of the various capital components

Average rate of return required by investors who provide capital to the

company Reflects the business risk of existing assets and the capital structure currently employed Also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard return Return that an investor receives from a security is the cost of that security to the company that issues it Cost of capital as an operational criterion is related to the firms objective of wealth maximisation
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COST OF CAPITAL

Cost of capital is used for evaluating investment projects, for determining the capital structure, for assessing leasing proposals, for setting rates that regulated organisations like electric utilities can charge to their customers etc. Important because of its practical utility as an acceptancerejection decision criterion Minimum rate of return that a firm must earn on its investment for

the market value of the firm to remain unchanged

Cost of each source or component of capital is called specific cost of capital

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PROJECTS COST OF CAPITAL

Opportunity cost of capital for a project is the discount rate for discounting its cash flows

Projects cost of capital is the minimum required rate of return on

funds committed to the project, which depends on the riskiness of its cash flows Firm represents the aggregate of investment projects undertaken by it Firms cost of capital can be used to evaluate new investments if two conditions are satisfied:

Risk characterizing the project is not significantly different from

the risk characterizing the existing investments of the firm

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Firm will continue to pursue the same financing policies

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AVERAGE COST OF CAPITAL

Weighted average cost of capital, composite cost of capital, combined cost of capital

Companys cost of capital is the weighted average cost of various

sources of finance used by it viz. equity, preference and debt Suppose that a company uses equity, debt and preference and debt in the following proportions: 50,10 and 40. If the component costs of equity, preference and debt are 16%, 12% and 8% respectively, what will be the weighted average cost of capital?

Consider a firm that employ equity and debt in equal proportions and
whose cost of equity and debt are 14% and 6% respectively. Calculate cost of capital. Further if the firm invests Rs 100 million, say on a project

which earns a rate of return of 12%, what is the return on equity funds
employed in the project?
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EXPLICIT AND IMPLICIT COST OF CAPITAL

Explicit cost of any source of capital is the discount rate that equates the PV of cash inflows that are incremental to the taking of the financing

opportunity with the PV of the incremental cash outflows

Explicit cost is the rate of return of the cash flows of the financing opportunity or the internal rate of return that the firm pays to procure

financing

What is the explicit cost of an interest free loan, a loan bearing interest, sale of an asset, retained earnings?

Opportunity costs are referred to as implicit cost of capital

Implicit costs Rate of return associated with the best investment opportunity for the firm and its shareholders that would be foregone, if the

projects presently under consideration by the firm were accepted

Explicit cost arises when funds are raised, implicit costs arises when funds are used
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COST OF PERPETUAL DEBT

Coupon interest rate or market yield on debt can be said to represent an approximation of the cost of debt Nominal / coupon rate of interest on debt is the before-tax cost of debt Effective cost of debt is the tax-adjusted rate of interest, the before-tax cost of debt should be adjusted for the tax effect ki = I / SV and kd = 1/SV (1-t) Where ki = Before-tax cost of debt kd = After-tax cost of debt I = Annual interest payment SV = Sale proceeds of the bond / debenture T = tax rate

A company has 10% perpetual debt of Rs 1,00,000. The tax rate is 35%. Determine cost of capital (before tax as well as after tax) assuming the debt is issued at (i) par (ii) 10 discount and (iii) 10% premium
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COST OF REDEEMABLE DEBT

Here, account has to be taken, in addition to interest payments, of the repayment of principal

A company issues new 10% debentures of Rs 1000 face value to be redeemed

after 10 years. The debenture is expected to be sold at 5% discount. It will also involve floatation costs of 5% of face value. The companys tax rate is 35%. What would the cost of debt be? Illustrate the computations using (i) trial and error approach and (ii) shortcut method A company issues 11% debentures of Rs 100 for an amount aggregating Rs 1,00,000 at 10% premium, redeemable at par after 5 years. The companys tax

rate is 35%. Determine the cost of debt using the short cut method.

A company has issued 10% debentures aggregating Rs 1,00,000. The floatation cost is 4%. The company has agreed to repay the debentures at par

in 5 equal annual installments starting at the end of year 1. The companys rate
of tax is 35%. Find the cost of debt.
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COST OF EXISTING DEBT

Current cost of existing debt Cost of debt to be approximated by the current market yield of the debt Suppose that a firm has 11% debentures of Rs 1,00,000

(Rs 100 face value) outstanding at 31 December 19X1 to

be matured on December 31, 19X6. If a new issue of debentures could be sold at a net realisable price of Rs 80 in the beginning of 19X2, find the cost of existing debt.

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COST OF PREFERENCE SHARES

Cost of irredeemable preference shares: kp = Dp / [P0(1-f)]

kp
Where

= Dp (1 + Dt) / [P0(1-f)]
kp Dp = = Cost of preference capital Constant annual dividend payment

P0
f Dt

=
= =

Expected sales price of preference shares

Floatation costs as a percentage of sales price Tax on preference dividend

A company issues 11% irredeemable preference shares of the face value of Rs

100 each. Floatation costs are estimated at 5% of the expected sales price. (a) What is the kp if preference shares are issued at (i) par value (ii) 10% premium and (iii) 5% discount? (b) Also compute kp in these situations assuming 13.125% dividend tax.

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COST OF PREFERENCE SHARES

Explicit cost of redeemable preference shares is

the discount rate which equates the net proceeds

of the sale of preference shares with the present value of future dividends and principal repayments ABC Ltd has issued 11% preference shares of the face value of Rs 100 each to be redeemed after 10 years. Floatation costs are estimated at 5% of the expected sales price. Determine the cost of

preference shares.
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COST OF EQUITY CAPITAL

Equity shares implicitly involve a return in terms of dividends expected by the investors and therefore carry a cost Cost of equity capital is relatively the highest among all sources of funds Equity shares involve the highest degree of financial risk ke may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment project in

order to leave unchanged the market price of shares

Two approaches to calculate the cost of equity capital (i) Dividend approach (ii) Capital asset pricing model approach

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DIVIDEND APPROACH / DIVIDEND VALUATION

MODEL

Cost of equity capital is the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or

the current market price) of a share

Two elements of calculation of ke: Net proceeds from sale of a share / current market price of a share

here adjustments for floatation costs and discount / premium are

necessary and Dividends and capital gains expected on the share here expected

dividend under different growth assumptions to be taken into account

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P0 ke D1 P0 g

= =
= = =

D1 / (ke g) (D1 / P0) + g Expected Dividend per share Net proceeds per share / current market price Growth in expected dividends
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DIVIDEND APPROACH / DIVIDEND VALUATION

MODEL

G = b.r , where b = retention rate and r = rate of return Formula under different growth assumptions of dividends Suppose that dividend per share of a firm is expected to be Re 1 per share next year and is expected to grow at 6% per

year perpetually. Determine the cost of equity capital,

assuming the market price per share is Rs 25.

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DIVIDEND APPROACH / DIVIDEND VALUATION

MODEL

From the under-mentioned facts determine the cost of equity shares of company X:

i.

Current market price of a share = Rs 150

ii.
iii.

Cost of floatation per share on new shares Rs 3

Dividend paid on the outstanding shares over the past five years
Year 1 2 3 4 5 6 Dividend per share (Rs) 10.50 11.02 11.58 12.16 12.76 13.40

iv. v.

Assume a fixed dividend payout ratio. Expected dividend on the new shares at the end of the current year is Rs

14.10 per share.

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CAPITAL ASSET PRICING MODEL (CAPM) APPROACH

Explains the behaviour of security prices and provides a mechanism whereby investors can assess the impact of the proposed security investment on their overall portfolio risk and return Formally describes the risk-return trade-off for securities Basic assumptions of CAPM related to: (1) Efficiency of security markets (2) Investor preferences (risk averse nature of investors) (3) Homogeneous expectations (4) Single time period (5) Risk-free rate Two groups of risks (i) Diversifiable / unsystematic risk and (ii) Non-diversifiable / systematic

Systematic risk is the only relevant risk

Systematic risk can be measured in relation to the risk of a diversified portfolio (market portfolio / market) Non-diversifiable risk of an investment / security / asset is assessed in terms of the beta co-efficient Beta is the measure of the volatility of a securitys return relative to returns of a broad-based market portfolio
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CAPITAL ASSET PRICING MODEL (CAPM) APPROACH

Beta is an index of the degree of responsiveness or co-movement of return on an investment with the market return Beta for the market portfolio as measured by the broad-based market index

equals one

Beta co-efficient of 1 would imply that the risk of the specified security is equal to the market (neutral); less than 1 defensive, more than 1 aggressive; zero co-efficient would imply that there is no market-related risk to the investment; a negative coefficient would indicate a relationship in the opposite direction For a given amount of systematic risk (), SML (Security Market Line) shows the required rate of return

CAPM describes the relationship between the required rate of return, or the cost of
equity capital, and the non-diversifiable or relevant risk of the firm: E(Rj) = Rf + [E(Rm) Rf] j

Where E(Rj) = Expected return on security j Rf = Risk-free rate of interest Rm = Expected return on market portfolio
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j = Undiversifiable risk of security j

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CAPITAL ASSET PRICING MODEL (CAPM) APPROACH

The risk-free rate of return is 8% and the market rate of return is 17%. Betas for four shares P, Q, R, S are respectively 0.60, 1.00, 1.20 and -0.20. What are the required rates of return on these four shares?

Cost of equity capital Ke = Rf + [Km Rf] j

As an investment manager, you are given the following information
Year-end Dividends market (Rs) price(Rs) 2 2 2 140 50 60 135 1,005

Investment in equity shares of A Cement Ltd Steel Ltd Liquor Ltd B Government of India Bonds Risk-free return, 8%

Initial price(Rs) 25 35 45 1,000

Beta risk factor 0.80 0.70 0.50 0.99

You are required to calculate (i) Expected rate of returns of market portfolio and (i) Expected returns in each security, using CAPM.
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RETAINED EARNINGS

Do not involve any formal arrangement to become a source of funds The firm is implicitly required to earn on the retained earnings at least equal to the rate that would have been earned by the shareholders if they were distributed to them Opportunity cost in terms of dividends foregone by / withheld from the equity shareholders Alternative use of retained earnings is based on the external yield criterion Opportunity cost of retained earnings is the rate of return that could be earned by investing the funds in another enterprise by the firm Cost of retained earnings kr would approximately be equal to ke, but kr

would be lower than the former due to differences in flotation costs and
due to dividend payment tax
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WEIGHTED AVERAGE COST OF CAPITAL

WACC wd kd wp k p we ke

Computation of the WACC involves the following steps: Assigning weights to specific costs

Multiplying the cost of each of the sources by the appropriate weights Dividing the total weighted cost by the total weights

Assignment of weights:

Book value weights

Market value weights

Book value weights

One potential source of these weights is the firms balance sheet, since

it lists the total amount of long-term debt, preferred equity, and common

equity

We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

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WACC w k w
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WEIGHTED AVERAGE COST OF CAPITAL

Source Long-term Debt Preferred Equity Common Equity Grand Totals

Market Value Weights

The problem with book-value weights is that the book values are historical, not current, values The market recalculates the values of each type of capital on a

continuous basis. Therefore, market values are more appropriate

Calculation of market-value weights is very similar to the calculation of the book-value weights

The main difference is that we need to first calculate the total market
value (price times quantity) of each type of capital

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WACC w k w
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Total Book Value $400,000 $100,000 $500,000 $1,000,000

% of Total 40% 10% 50% 100%

WEIGHTED AVERAGE COST OF CAPITAL

Source Debt Preferred Common Totals

Price per Unit $ 905 $ 100 $ 70

Example

A firms after-tax cost of capital of the specific sources is as follows: Cost of debt

Cost of preference shares (including dividend tax) Cost of equity funds

The following is the capital structure:

Source Debt Equity capital

Preference Capital

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Calculate the weighted average cost of capital using book value and market value weights.22

WACC w k w
8% 14% 17%
Market Value Amount (Rs) (Rs) 300,000 200,000 500,000 270,000 230,000 750,000 1,000,000 1,250,000

Total Market Value 400 $362,000 1,000 $100,000 10,000 $700,000 $1,162,000

Units

% of Total 31.15% 8.61% 60.24% 100.00%

WEIGHTED MARGINAL COST OF CAPITAL

Generally, WACC tends to rise as the firm seeks more and more capital Supply schedule of capital is typically upward sloping debt) issued by the firm

Marginal cost is the new or incremental cost of new capital (equity and

WMCC WAC of the new capital given the firms target capital structure Illustration

The firm discussed above wishes to raise Rs 5,00,000 for expansion of its plant. It estimates that Rs 1,00,000 will be available as retained earnings and the balance of the additional funds will be raised as follows: Long-term debt Rs 3,00,000 Rs 1,00,000

Preference shares

Using marginal weights, compute the WACC.

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WACC w k w
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WEIGHTED MARGINAL COST OF CAPITAL

Based on its discussions with merchant bankers and lenders Shiva usage as follows:
Sources of Finance

Electronics estimates the cost of its sources of finance for various levels of
Range of New Financing (Rs in Lakhs)

Equity

Debt (post-tax cost)

Preference

The company is considering expanding its operations and needs Rs 500

lakhs for the same. Its capital structure is in proportions of equity 40%,
of Rs 600 lakhs, what will be the WMCC of the new financing?
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preference 10% and debt 50%. If the company actually invested an amount

WACC w k w
Cost (%)

0-150

14 15 16 8 9

150-400

400 and above 0-100

100-350 0-20

350 and above 20 and above

10 15 16

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