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Unit 3 Cost of Capital

The document discusses various topics related to cost of capital including: 1) Cost of capital refers to the minimum rate of return expected by providers of capital. It is a weighted average of the cost of debt and equity. 2) Cost of debt includes the cost of perpetual/irredeemable debt, redeemable debentures, and preferential shares. 3) Cost of equity can be calculated using methods like the dividend method, constant growth model, earnings model, and capital asset pricing model (CAPM).

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0% found this document useful (0 votes)
82 views41 pages

Unit 3 Cost of Capital

The document discusses various topics related to cost of capital including: 1) Cost of capital refers to the minimum rate of return expected by providers of capital. It is a weighted average of the cost of debt and equity. 2) Cost of debt includes the cost of perpetual/irredeemable debt, redeemable debentures, and preferential shares. 3) Cost of equity can be calculated using methods like the dividend method, constant growth model, earnings model, and capital asset pricing model (CAPM).

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Vïñü MN
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Cost of capital

y S
d d
R e
Mr. Karthik Reddy S
h i k
rt
M.Com, UGC-KSET, MBA, MPhil.

Asst. Professor, Dept. of MBA, SVCE


Bengaluru Ka
o f.
P r
1
COST OF CAPITAL

Firm's cost of capital can be defined as the rate


y S
of return that could be earned in the capital
market on securities of equivalent risk.
d d
R e
h i k
In general, the higher the riskiness of the firm's
activities, the higher is its cost of capital, since
rt
investors typically require compensation for
Ka
greater risk. For a firm financed by debt and
f.
equity, the cost of capital will be a weighted
o
r
average of its cost of capital from both sources.
P
In short it refers to Minimum Rate of Return
expected by providers of capital. 2
TYPES OF COST

Marginal Cost: A marginal cost is the additional cost


S
incurred for producing one more unit. It refers to the
y
d d
change in the total cost, resulting from the change in
production per unit of output. It is also called as
incremental or differential cost R e
i k
Marginal cost is the newth
a r
the firm incurs if it were
or the incremental cost that
to raise capital now, or in the
near future.
f . K
r o
SpecificPor Component Cost: It is the combined
cost of capital or an average costs of different sources
of funds. 3
Explicit cost:
An explicit cost is the discount rate which
y
equates the present value of cash inflowsS
with the present value of the cash d d
R e
outflows. It is the internal rate of return on
cash flows.
h i k
Implicit cost: rt
Ka
f.
It is opportunity cost which is given up in
o
r
order to pursue a particular action.
P
4
COST OF DEBT CAPITAL

Cost of Debenture
y S
d
debenture to the lenders of a company.d
The required rate of return on investment in

R e
Debenture is an acknowledgment of debt. A
i k
debenture could be redeemable or irredeemable.
h
rt
Redeemable Debenture is one which has to be
a
repaid during the life time of co.,
K
f.
Irredeemable Debenture is one which will be
o
P r
repaid during liquidation of co.,
Debenture carries a fixed rate of Interest and it
is tax deductible expenses.
5
Cost of Perpetual / Irredeemable Debt

y S
d d
R e
h i k
rt
Ka
o f.
P r
6
Cost of Redeemable Debenture

y S
d d
R e
h i k
rt
Ka
of.
P r
7
DEBENTURE COST OF CAPITAL :

capital in the following situations:


y S
Assuming the corporate tax rate of 35%, compute the after tax cost of

d d
(i)Perpetual 15% Debentures of Rs.1, 000, sold at a premium of 10% with
no flotation costs.
R e
i k
(ii) 10-year 14% Debentures of Rs. 2,000, redeemable at par, with 5%
flotation costs.
h
rt
Ka
o f.
P r
8
y S
d d
R e
h i k
rt
Ka
of.
P r
9
Cost of Preferential Capital
The required rate of return on investment
in preference shares to the preference
shareholders of the company.
y S
d d
R e
Preference shares are those which have
i k
preferential right over equity in terms of
h
rt
dividend payment and claim on asset.
Ka
of.
A preference shares may be redeemable
P r
or irredeemable. Preference shares carry
a fixed rate of dividend and are not tax
deductible. 10
Cost of Irredeemable/ Perpetual Preference
Share

y S
d d
R e
h i k
rt
Ka
of.
P r
11
Cost of Redeemable Preference Share

y S
d d
R e
h i k
rt
Ka
of.
P r
12
Cost of Equity Capital

The required rate of return on the y S


d d
investment in the equity shares to the
R
equity shareholders of the co. e
h i k
rt
a
It is also known as equity capitalization
K
o f.
rate. The following are the methods of
computing cost of equity.
P r
13
Cost of Equity Capital : methods

1.Dividend Method (No growth model) y S


2.Constant growth model (Gordone d d
model)

k R
3.Earnings Model
h i
rt
K a
4.Capital Asset Pricing Model.

f .
r o
P
14
y S
d d
R e
h i k
rt
Ka
of.
P r
15
y S
d d
R e
h i k
rt
a
The shares of a company are selling at Rs 40 per share and it had paid a
K
f.
dividend of Rs. 4 per share last year. The investor’s market expects a

o
P r
growth rate of 5 percent per year.
1.Compute the company’s equity cost of capital.
2.If the anticipated growth rate is 7 percent per annum, calculate the indicated
market price per share.
16
y S
d d
R e
h i k
t
Well do company ltd, is currently earning 15 percent operating profit
r
a
on its share capital of Rs 20 Lakh [FV of Rs 200 per share]. It is
K
f.
interested to go for expansion for which the company requires an

o
P r
additional share capital of Rs 10 lakh. Company is raising this amount
by the issue of equity shares at 10 percent premium and the expected
floatation cost is 5%. Calculate the cost of equity

17
CAPITAL ASSET PRICING MODEL (CAPM)
CAPM is the model that provides a frame work to
determine the required rate of return on an asset
y S
and indicates the relationship between the return
and risk of an asset. d d
R e
i k
The required rate of return specified by CAPM
h
t
helps in valuing an asset.
r
a
CAPM envisages the relationship between risk and
K
f.
the expected return on the risky securities. It
o
r
provides a frame work to price individual securities
P
and determine the required rate of return for
individual securities.
18
y S
d d
Where,
R e
Rf = Risk Free rate. Ie yield on government securities as risk free rate

h i k
Rm-Rf = Market Risk premium. Ie the difference between the market return
and the risk free rate
rt
Ka
f.
Bj = Beta of the firms share. Ie Beta is the systematic risk of an ordinary
share in relation to the market
r o
P
Beta is the measure of a security’s future risk. But investors do not have
future Data to estimate beta, hence historical data is used to estimate the
value of beta.
19
The Capital Asset Pricing Model
(CAPM)
S
• As per the CAPM, the required rate of return on
y
d
equity is given by the following relationship:
d
R e
i k
• Equation requires the following three
ht
parameters to estimate a firm’s cost of equity:
r
– The risk-free rate (R
– The market risk K
fa)

– The beta of f
. premium (R – R )
m f

r o the firm’s share (β)

P
20
COST OF RETAINED EARNINGS:

y S
It is the internal generation of funds, it represents the
investment of existing shareholders and may be used
d d
for further investments. The cost of retained may be
R e
calculated in the same way as that of equity capital.

h i k
rt
Ka
o f.
P r
21
WACC

y S
Weighted Average cost of Capital refers
to the average cost of various sources of
d d
R e
finance including equity, preference and
debenture or debt capital. It is also know
h i k
as overall cost of capital.
rt
K a
f
The overall . cost of capital is a weighted
averagero of the individual required rates of
P
return ( costs)
22
The Weighted Average Cost of Capital

• The following steps are involved for y S


calculating the firm’s WACC: d d
R e
– Calculate the cost of specific sources of funds
i k
– Multiply the cost of each source by its proportion
h
t
in the capital structure.
r
a
– Add the weighted component costs to get the
K
WACC.
o f.
P r
23
BOOK VALUE / MARKET VALUE WEIGHTS

Managers prefer the book value weights y S


for calculating WACC: d d
R e
– Firms in practice set their target capital structure
in terms of book values.
h i k
t
– The book value information can be easily derived
r
a
from the published sources.
K
f.
– The book value debt—equity ratios are analysed
o
P r
by investors to evaluate the risk of the firms in
practice.

24
• The use of the book-value weights can be
seriously questioned on theoretical
y S
grounds:
d d
e
– First, the component costs are opportunity rates
R
h i k
and are determined in the capital markets. The
weights should also be market-determined.
rt
Ka
– Second, the book-value weights are based on
arbitrary accounting policies that are used to
o f.
calculate retained earnings and value of assets.
r
Thus, they do not reflect economic values.
P
25
• Market-value weights are theoretically superior
to book-value weights:
y S
– They reflect economic values and are not influenced by
accounting policies.
d d
component costs.
R e
– They are also consistent with the market-determined

i k
• The difficulty in using market-value weights:
h
r t
– The market prices of securities fluctuate widely and
frequently.
K
– A market value baseda target capital structure means that
f
the amounts of. debt and equity are continuously adjusted

r o
as the value of the firm changes.
P
26
y S
d d
R e
h i k
rt
Ka
of.
P r
27
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d d
R e
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rt
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of.
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of.
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of.
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d d
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of.
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31
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d d
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rt
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of.
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d d
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of.
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d d
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rt
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of.
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d d
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rt
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of.
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d d
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rt
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of.
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d d
R e
h i k
rt
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of.
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38
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d d
R e
h i k
rt
Ka
of.
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39
y S
d d
R e
h i k
rt
Ka
of.
P r
40
y S
d d
R e
h i k
rt
Ka
of.
P r
Thank You,
Karthik Reddy S

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