Lecture No.

3 – Cost of Capital & Capital Structure

(Associated with capital budgeting/cash flow estimation).

Concepts of cost of capital

A firm raises funds from various sources, which are called the components of capital.
Different sources of fund or the components of capital have different costs. For example, the cost
of raising funds through issuing equity shares is different from that of raising funds through issuing
preference shares. The cost of each source is the specific cost of that source, the average of which
gives the overall cost for acquir-ing capital. The firm invests the funds in various assets. So, it
should earn returns that are higher than the cost of raising the funds. In this sense the minimum
returns a firm earns must be equal to the cost of rais-ing the fund. So, the cost of capital may be
viewed from two viewpoints—acquisition of funds and application of funds. From the viewpoint
of acquisition of funds, it is the borrowing rate that a firm will try to minimize. On the other hand,
from the viewpoint of application of funds, it is the required rate of return that a firm tries to
achieve. The cost of capital is the average rate of return required by the investors who provide
long-term funds. In other words, cost of capital refers to the minimum rate of return a firm must
earn on its investment so that the market value of company’s equity shareholders does not fall.

“The cost of funds used for financing a business. Cost of capital depends on the mode of
financing used – it refers to the cost of equity if the business is financed solely through equity, or
to the cost of debt if it is financed solely through debt. Many companies use a “combination” of
debt and equity to finance their businesses, and for such companies, their overall cost of capital
is derived from a weighted average of all capital sources, widely known as the weighted average
cost of capital (WACC)”.

“Since the cost of capital represents a hurdle rate that a company must overcome before
it can generate value, it is extensively used in the capital budgeting process to determine whether
the company should proceed with a project”.

• When we study finance, we consider Balance sheet (Financing & Investing)

• Financing
▪ Capital Structure
▪ Cost of capital
• Money is required by the organization to invest in Fixed and Long-Term Assets.
▪ Sources: Available, from where we can get finance.
• Capital is the Amount of money an organization need – for Investment Purposes.
▪ Where company acquire this money?
▪ Equity Financing (External source of funds)
▪ Debt Financing (External source of funds)
Sources
Debt Finance Equity Finance
Definition Money raised by the company in theIn finance, Equity refers to the Net
form of borrowed capital is known as
Worth of the company. It is the
Debt. It represents that the company
source of permanent capital. It is
owes money towards another person the owner’s funds which are
or entity. They are the cheapest source
divided into some shares. By
of finance as their cost of capital is
investing in equity, an investor gets
lower than the cost of equity and an equal portion of ownership in
preference shares. Funds raised the company, in which he has
through debt financing are to be repaid
invested his money. The
after the expiry of the specific term.
investment in equity costs higher
than investing in debt.
Meaning Funds owed by the company towards Funds raised by the company by
another party is known as Debt. issuing shares is known as Equity.
What is it? Loan Funds Own Funds

Reflects Obligation Ownership

Term Short-term/ specific Long-term/ Independent period of

time
Holder’s status Lenders Proprietors

Risk Less High

Types Term loan, Debentures, Bonds etc. Shares and Stocks.

Return Interest Dividend

Return’s nature Fixed and regular Variable and irregular

Collateral Essential to secure loans, but funds Not required

can be raised otherwise also.
Contract Source of contract between owner’s Source of contract between the
and the company debtors and the company
Short term bond – Commercial paper
Long terms bond – Corporate bond
Holders ▪ They have % age of nominal amount; ▪ They are secured
▪ They get annual interest; 1st right ▪ They can resale their shares
▪ They are secured against the assets of
the company
Wants ▪ Return on investment ▪ Return on investment
▪ % --debt: interest ▪ % -- on shares: dividend
▪ For company it’s a cost of debt kd ▪ For company it’s a cost of equity
ke
Numerical
Calculate Ke; Kd and WACC (weighted average cost of capital).
Market value of share 12
Share Capital 100,000 @10 (no of share x par 10,00,000
value)
Share Premium (capital reserve) 100,000 @ 2 200,000
- profit earned by the company not
from the normal operations.
Retained earnings (Revenue -- 300,000
reserve) - profit earned by the
company from the normal
operations; can be paid as dividend
in future.
Equity: has three components i.e.
Share capital: 10,00,000
Share premium: 200,000
Retained earnings: 500,000
Total: 15,00,000
8 % Bonds 500,000
Total: 20,00,000
Requirements:
▪ 10 % dividend? 0.10
▪ 5 % growth on equity? 0.05
▪ Tax rate 40% = 0.40
▪ Cost of capital (what company must earned for the shareholders to meet their
expectations) ?
Formula: WACC: (We x Ke) + (Wd x Kd) (1-tax rate)
WACC: cost of equity ( includes dividend gain and capital gain) + cost of debt after tax:
since, debt financing provide tax shield.

Calculation:
1. Cost of Equity = Dividend gain + capital gain i.e. 100,000+75,000= 175,000
a. Dividend gain
10,00,000 x 10/100 = 100,000
b. Capital gain or 5 % growth on equity
15,00,000 x 5/100 = 75,000
Ke: 175,000/15,00,000 x 100 = 11.6%
2. Cost of debt i.e. already given in the table: 0.08 or 8%
Thus:
WACC = (0.75 x 0.116) + (0.25 x 0.08) (1 - 0.40)
WACC = 9.9 % or almost 10 % return
According to WACC: the management must earn 200,000 for its stakeholders
i.e. shareholder and debt holder.
CAPITAL STRUCTURE
• HOW MUCH EQUITY AND LIABILITY SIDE OF THE BALANCE SHEET IS STRUCTURED.
• HOW MUCH IS DEBT FINANCING AND HOW MUCH IS EQUITY FINANCING
NOTE:
• SHARE HOLDER PREFER HIGH DEBT TO EQUITY RATION
• MANAGEMENT PREFER IRONY.
QUESTIONS
• HOW DIFFERENCE IN THE CAPITAL STRUCTURE IMPACT THE…
• HOW DO THEY SIGNAL?
A B C D
EQUITY 1000*10 10,000 8000 6000 4000
8 % BOND -- 2000 4000 6000
CAPITAL 10,000 10,000 10,000 10,000
EMPLLOYED
EBIT 4000 4000 4000 4000
INTEREST -- -160 -320 -480
EBT 4000 3840 3680 3520
TAX 40% -1600 -1536 -1472 -1408
NPAT: PART OF PROFIT 2400 2304 2208 2112
SHAREHOLDER HAS THE
RIGHT.
EPS= NPAT/NO OF SHARE
2.4 2.88 3.68 5.28
ROE= 24% 28.8% 36.8% 52.8%
NPAT/EQUITY*100