Bba 4 fm u 3 cost of capital

UNIT-3The Cost of CapitalCourse: BBA-4Subject: FM

*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Chapter ObjectivesExplain the general concept of opportunity cost of capital.Distinguish between the project cost of capital and the firms cost of capital.Learn about the methods of calculating component cost of capital and the weighted average cost of capital.Understand the concept and calculation of the marginal cost of capital.Recognise the need for calculating cost of capital for divisions.Understand the methodology of determining the divisional beta and divisional cost of capital.Illustrate the cost of capital calculation for a real company.

Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.

*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.IntroductionThe 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. The firms cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Significance of the Cost of CapitalEvaluating investment decisions,Designing a firms debt policy, andAppraising the financial performance of top management.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.The Concept of the Opportunity Cost of CapitalThe opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.General Formula for the Opportunity Cost of CapitalOpportunity cost of capital is given by the following formula:

where Io is the capital supplied by investors in period 0 (it represents a net cash inflow to the firm), Ct are returns expected by investors (they represent cash outflows to the firm) and k is the required rate of return or the cost of capital.The opportunity cost of retained earnings is the rate of return, which the ordinary shareholders would have earned on these funds if they had been distributed as dividends to them.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Weighted Average Cost of Capital Vs. Specific Costs of CapitalThe cost of capital of each source of capital is known as component, or specific, cost of capital. The overall cost is also called the weighted average cost of capital (WACC).Relevant cost in the investment decisions is the future cost or the marginal cost. Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now, or in the near future. The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Cost of DebtDebt Issued at Par

Debt Issued at Discount or Premium

Tax adjustment


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Cost of Preference CapitalIrredeemable Preference Share

Redeemable Preference Share


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Cost of Equity CapitalIs Equity Capital Free of Cost? No, it has an opportunity cost.Cost of Internal Equity: The DividendGrowth ModelNormal growth

Supernormal growth

Zero-growth


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Cost of Equity CapitalCost of External Equity: The DividendGrowth Model

EarningsPrice Ratio and the Cost of Equity


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.The Capital Asset Pricing Model (CAPM)As per the CAPM, the required rate of return on equity is given by the following relationship:

Equation requires the following three parameters to estimate a firms cost of equity:The risk-free rate (Rf) The market risk premium (Rm Rf)The beta of the firms share ()


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Cost of Equity: CAPM Vs. DividendGrowth ModelThe dividend-growth approach has limited application in practice It assumes that the dividend per share will grow at a constant rate, g, forever. The expected dividend growth rate, g, should be less than the cost of equity, ke, to arrive at the simple growth formula.The dividendgrowth approach also fails to deal with risk directly.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Cost of Equity: CAPM Vs. DividendGrowth ModelCAPM has a wider application although it is based on restrictive assumptions:The only condition for its use is that the companys share is quoted on the stock exchange. All variables in the CAPM are market determined and except the company specific share price data, they are common to all companies.The value of beta is determined in an objective manner by using sound statistical methods. One practical problem with the use of beta, however, is that it does not probably remain stable over time.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.The Weighted Average Cost of CapitalThe following steps are involved for calculating the firms WACC:Calculate the cost of specific sources of fundsMultiply the cost of each source by its proportion in the capital structure.Add the weighted component costs to get the WACC.

WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firms target capital structure.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Book Value Versus Market Value WeightsManagers prefer the book value weights for calculating WACC:Firms in practice set their target capital structure in terms of book values.The book value information can be easily derived from the published sources.The book value debtequity ratios are analysed by investors to evaluate the risk of the firms in practice.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Book Value Versus Market Value WeightsThe use of the book-value weights can be seriously questioned on theoretical grounds:First, the component costs are opportunity rates and are determined in the capital markets. The weights should also be market-determined. Second, the book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Book Value Versus Market Value WeightsMarket-value weights are theoretically superior to book-value weights:They reflect economic values and are not influenced by accounting policies.They are also consistent with the market-determined component costs. The difficulty in using market-value weights:The market prices of securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Flotation Costs, Cost of Capital and Investment AnalysisA new issue of debt or shares will invariably involve flotation costs in the form of legal fees, administrative expenses, brokerage or underwriting commission. One approach is to adjust the flotation costs in the calculation of the cost of capital. This is not a correct procedure. Flotation costs are not annual costs; they are one-time costs incurred when the investment project is undertaken and financed. If the cost of capital is adjusted for the flotation costs and used as the discount rate, the effect of the flotation costs will be compounded over the life of the project. The correct procedure is to adjust the investment projects cash flows for the flotation costs and use the weighted average cost of capital, unadjusted for the flotation costs, as the discount rate.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Divisional and Project Cost of CapitalA most commonly suggested method for calculating the required rate of return for a division (or project) is the pure-play technique.The basic idea is to use the beta of the comparable firms, called pure-play firms, in the same industry or line of business as a proxy for the beta of the division or the project.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.Divisional and Project Cost of CapitalThe pure-play approach for calculating the divisional cost of capital involves the following steps:Identify comparable firms.Estimate equity betas for comparable firms.Estimate asset betas for comparable firms.Calculate the divisions beta.Calculate the divisions all-equity cost of capital.Calculate the divisions equity cost of capital.Calculate the divisions cost of capital.


*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.The Cost of Capital for ProjectsA simple practical approach to incorporate risk differences in projects is to adjust the firms WACC (upwards or downwards), and use the adjusted WACC to evaluate the investment project.Companies in practice may develop policy guidelines for incorporating the project risk differences. One approach is to divide projects into broad risk classes, and use different discount rates based on the decision-makers experience.


The Cost of Capital for ProjectsFor example, projects may be classified as:Low risk projects

discount rate < the firms WACC Medium risk projects

discount rate = the firms WACCHigh risk projects

discount rate > the firms WACC*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.


Sourse :- Book : - Financial Management (Ninth Edition) Author I M Panday Vikas Publication

*Financial Management, Ninth Edition I M PandeyVikas Publishing House Pvt. Ltd.


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Bba 4 fm u 3 cost of capital