Cost of Capital

WEIGHTED MARGINAL COST OF CAPITAL
It is the relationship between additional financing and WACC
Determining the weighted average cost of capital Estimate the cost of each source of financing for various levels. Find breaking point. Calculate the WACC for various ranges of total financing between the breaking points. Prepare the weighted marginal cost of capital .
Shiva Industries plans to use equity and debt in the following

proportions :Equity : 40 Debt : 60 Cost of each source of finance for various levels of use :Source of finance range of new financing cost (Rs in million)
0 30 more than 30 0 50 more than 50
(%)
Equity Debt
18 20 10 11
Determination of breaking point and the resulting range of total new financing
Source of
Cost
Capital (1) Equity 18% 20% 10% 11%
Range of new financing (Rs in million) (2) 0 30 above 30 0 50 above 50
breaking point (Rs in million) (3) 30/.4=75 50/.6=83.3 -
Range of total new financing (Rs in million) (4) 0 75 above 75 0 83.3 above 83.3
Debt
Weighted average cost of capital for various ranges of total financing for Shiva industries
Range of Total new financing (Rs in million)
Source of capital (1)
Proportion
Cost%
(2) 0.4 0.6 0.4 0.6 0.4 0.6
(3) 0.18 0.10 0.20 0.10 0.20 0.11
weighted cost % [(2)(3)] (4) .072 .060 .132 .080 .060 .140 .080 .066 .146
Equity Debt Weighted avg cost of capital 75 83.3 Equity Debt Weighted avg cost of capital above 83.3 Equity Debt Weighted avg cost of capital
0 -75
The Weighted Marginal Cost of Capital Range of Total Financing (Rs in million) 0 75 75 83.3 Above 83.3 Weighted Marginal Cost of Capital (%) 13.2 14.0 14.6
DETERMINING THE OPTIMAL CAPITAL BUDGET
To determine the optimal capital budget, we need to compare the expected return on proposed capital expenditure projects with the marginal cost of capital schedule.
Suppose Shiva Industries is developing its capital budget for the forthcoming year. The company s schedule of proposed capital expenditure projects for the coming year is as follows :Projects Amount (Rs. in million) 30 40 25 10 20 Return
A B C D E
18.0% 16.5% 15.3% 13.4% 12.0%
return(%) A 18 B 17 16 15 13.2% 14 13 12 11 10 010 20 30
Determining the optimal capital budgetbudget Investment opportunity curve
C 14.6% 14.0% D
E Marginal cost of capital curve Optimal capital budget
40 50 60 70 80 90 100 110 120 130 140

Amount (in million Rs)
FLOATATION COST AND COST OF CAPITAL

o Approach 1 Revised WACC WACC = 12, Average floatation cost =6 % Revised WACC = WACC /(1-Floatation cost) = 12/(1-.06) = 12.77 %
o Approach 2- Considering floatation cost as part of the project cost Consider a 200million expansion project, floatation cost is 8%. Rs 200 million = (1- .08) * Amount raised Amount raised =Rs.200 million/(1- .08) = Rs. 217.39 million. Floatation costs are Rs. 17.39 million and hence the true cost of the expansion project is Rs. 217.39 million.
FACTORS AFFECTING THE WEIGHTED AVERAGE COST OF CAPITAL

Factors Outside a Firm s Control. Factors Within a Firm s Conrol.
FACTORS OUTSIDE A FIRM S CONTROL:
The level of Interest Rates. Market Risk Premium. Tax rates.
FACTORS WITHIN A FIRM S CONTROL:
Investment Policy. Capital Structure Policy. Dividend Policy.
HOW FINANCIAL INSTITUTIONS CALCULATE COST OF CAPITAL

Financial institutions calculate cost of capital as post tax weighted average cost of the mix of funds employed for the project. Average cost of capital = Total tax liability during the life of the project _______________________________ Total operating profit over the life of the project
The means of financing for a project is given below (rupees @ million) ; equity and cash accruals@15% : preference sharecapital@10% : rupee term loans from institutions@14% : non-convertible debentures@12% : convertible portion of convertible debentures@15% : Non- convertible portion of convertible debentures@10% : Bank borrowing for working capital @ 15% :
Rs.900 Rs.100 Rs.800 Rs.400 Rs.100 Rs.100 Rs.200
The average applicable tax rate for the project is estimated at 25% . Calculate the cost of capital
Cost of capital calculation

Means of financing (A) 1 Equity and cash accruals 2 Preference share capital 3 Rupee term loans @14% 4 non-convertible debentures@12% 5 convertible portion of convertible debentures@15% 6 Non- convertible portion of convertible debentures@10% 7 Bank borrowing for working capital @ 15% Total Amount Cost of (Rs.in millions) funds (B) (C) 900 100 800 400 100 100 200 15% 10% 10.5% 9% 15% 7.5% 11.25% Total cost (post tax) (D) = C x B 135 10 84 36 15 7.5 22.5
2600
310
The average cost of capital (post-tax) is : 310/2600 = 11.92%
THANK YOU

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WEIGHTED MARGINAL COST OF CAPITAL

It is the relationship between additional financing and WACC

Shiva Industries plans to use equity and debt in the following

Capital (1) Equity 18% 20% 10% 11%

Range of new financing (Rs in million) (2) 0 30 above 30 0 50 above 50

breaking point (Rs in million) (3) 30/.4=75 50/.6=83.3 -

Range of Total new financing (Rs in million)

Source of capital (1)

(2) 0.4 0.6 0.4 0.6 0.4 0.6

(3) 0.18 0.10 0.20 0.10 0.20 0.11

DETERMINING THE OPTIMAL CAPITAL BUDGET

18.0% 16.5% 15.3% 13.4% 12.0%

return(%) A 18 B 17 16 15 13.2% 14 13 12 11 10 010 20 30

Determining the optimal capital budgetbudget Investment opportunity curve

E Marginal cost of capital curve Optimal capital budget

40 50 60 70 80 90 100 110 120 130 140

FLOATATION COST AND COST OF CAPITAL

FACTORS AFFECTING THE WEIGHTED AVERAGE COST OF CAPITAL

FACTORS OUTSIDE A FIRM S CONTROL:

The level of Interest Rates. Market Risk Premium. Tax rates.

FACTORS WITHIN A FIRM S CONTROL:

Investment Policy. Capital Structure Policy. Dividend Policy.

HOW FINANCIAL INSTITUTIONS CALCULATE COST OF CAPITAL

Rs.900 Rs.100 Rs.800 Rs.400 Rs.100 Rs.100 Rs.200

Cost of capital calculation

The average cost of capital (post-tax) is : 310/2600 = 11.92%

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