Cost of Capital

In this chapter… Cost of debt, preference and equity

capital… Cost of retained earnings… Weighted average cost of capital… Marginal cost of capital…

Cost of Capital… Cost of capital is the minimum required rate

of return needed to justify the use of capital. Investor view point = Opportunity cost Firm’s view point = Minimum rate Capital Expenditure view point = Cut of rate

The measurement of the scarifies made by investor in order to capital formation.

Investor’s point of view….

Firm’s point of view… It is the minimum required rate of return

needed to justify the use of capital.

Capital expenditure point of view…

The cost of capital is the minimum required rate of return or the hurdle rate or target rate or cut off rate or any discounting rate used to value cash flows.

The risk less cost of the particular type of financing (rj)

The business risk premium (b); and The financial risk premium (f). Symbolically:

Ko = rj + b+ f

Basic Aspects of Cost of Capital…

Designing optimal capital structure. Investment (capital budgeting) Evaluation. Financial Performance Appraisal.

Importance of Cost of Capital…

Marginal cost Average cost Historic cost/Book cost Future cost Specific cost Opportunity cost Explicit cost Implicit cost

Classification of Cost…

Marginal Cost… Marginal cost of the capital is the additional

cost incurred to obtain additional funds required by a firm.

It refers to change in the total cost of capital resulting from the use of additional funds.

It is very important concept in investment decisions.

Average Cost/ Overall Cost… It is the average cost of various specific

costs of the different components of capital structure at a given time and this is used as the acceptance criteria for investment proposal.

Historic Cost/ Book Cost… As per this, book values, as maintained in

the books of accounts, that are readily available.

It acts as guide for future cost estimation.

Future Cost… It is the cost of capital that is expected to

raise finds to finance a capital budget or investment proposal.

Specific Cost… It is the cost associated with particular

source of finance.

Spot Costs… The costs that are prevailing in the market

at a certain time.

Opportunity Cost… It is the benefit that the shareholder forgoes

by not putting investments elsewhere as they have been retained by the management.

Explicit Costs… It is the discount rate that equates the

present value of the cash inflows that are incremental to the taking of the financing opportunity with present value of its incremental cash outflows.

It is also called as IRR.

Implicit Costs… It is the opportunity cost which is given up

in order to pursue a particular action.

Computation of cost of Capital (WACC) WACC: An weighted average cost of each of the

source of funds employed by the firm Steps involved in computation of WACC:

Determination of the source of funds to be raised and their individual share in the total capitalization of the firm,

Computation of cost of specific source of funds, Assignment of weight to specific source of funds, Multiply the cost of each source by the appropriate assigned

weights, and Add individual source weight cost to get cost of capital.

Cost of Equity… Cost of Retained Earnings. Cost of Issue of Equity shares.

Cost of Retained Earnings (Kre)… Kre = Ke [(1 – Ti) / (1 – Tb)] Where;

Ke = Cost of Equity Ke = D / P or (E/P) + g Ti = Marginal Tax rate applicable to the

individuals concerned. Tb = cost of purchase of new securities. D = expected dividend per share. NP = net proceeds of equity share g = growth rate (%)

Cost of Equity… Dividend capitalization approach (D/P) Earnings capitalization approach (E/P) (D/P) + g Approach Bond yield plus risk premium approach CAPM Approach

Dividend capitalization approach (D/P)

According to this approach, the cost equity capital is calculated on the basis of required rate of return in terms of the future dividends to be paid on the shares.

It means investor arrives at a market price of a share by capitalizing dividends at a normal rate of return.

Dividend capitalization approach (D/P) The cost of equity capital can be measured

with following formula: Ke = D/ CMP or NP Where;

Ke = Cost of Equity. CMP = Current Market Price Per Share. D = Dividends Per Share. NP = Net Proceeds Per Share.

Limitations of Dividend capitalization approach (D/P)

It does not consider future earnings. It ignores the earnings on retained

earnings. It ignores the fact that market price rise

may be due to retained earnings and not on account of high dividends.

It does take into account the capital gains.

Earnings capitalization approach (E/P) According to this approach, the cost of equity (Ke)

is the discount rate that equates the present value of expected future EPS with the net proceeds or current market price of share.

This approach is employed under the conditions that; Constant EPS over the future period. There should be either 100% retention ratio or 100%

dividend pay out ratio. Company satisfies the requirements with equity shares

and does not employ debt.

Earnings capitalization approach (E/P) Formula is ;

where:; Ke = Cost of Equity. E = Earning Per Share CMP = Current Market Price Per Share. NP = Net Proceeds Per Share

NPCMP

EKe /

Limitations of Earnings capitalization approach (E/P) All earnings are not distributed to the equity

shareholders as dividend. EPS may not be constant. Share Price also does not remain constant.

Dividend Capitalization + Growth Rate Approach… This approach considers not only DPS but also growth in

dividends for computing Ke. Cost of Capital under constant Growth Rate Perpetually:

Cost of Capital Under Variable Growth Rate:gr : Do (1+r)n = Dn

Where: gr = growth rate in dividends.(1+r)n= PVF for ‘n’ year.Do = First Year Dividend Payment.Dn = Last Year Dividend Payment.

gCMPNP

DKe

/

Bond Yield + Risk Premium Approach…[BYRP]

According to this approach the rate of return required by the equity shareholder of a company is equal to yield on long term bonds and risk premium.

Ke = Yield on long - term Bonds + Risk Premium

Capital Asset Pricing Model Approach [ CAPM]

This model was developed by William Sharpe.

CAPM explains the relationship between the required rate of return and the non diversifiable or relevant risk, of the firm as reflected in its index of non diversifiable risk that is beta.

Capital Asset Pricing Model Approach [ CAPM] Ke = Rf + ( Rmf – Rf ) B Where;

Ke = Cost of Equity Capital. Rf = Rate of Return Required on a Risk Free

Security (%) B = Beta co efficient. Rmf = required rate of return on the market

portfolio of assets, that can be viewed as the average rate of return on all assets.

Assumptions of CAPM… Perfect capital market: All investors have

same information about securities. There are no restrictions on buying and selling. Securities of completely divisible. There are no transaction costs. There are no taxes. Competitive market – no single investor can

affect market price significantly.

Assumptions of CAPM… Investors Preference: Investors are risk

avers. Investors have homogeneous expectations

regarding the expected returns, variances and correlation of returns among all securities.

Investors seek to maximize the expected utility of their portfolios over a single period planning horizon.

Cost of Preference Shares… Cost of Irredeemable Preference Share. Cost of Redeemable Preference Share.

Cost of Irredeemable Preference Share… Without Tax:

Where: Kp = Cost of Preference Share. D = Dividend Per Share. CMP = Current Market Price per Share. NP = Net Proceeds.

Kp =D

CMP or NP

Cost of Irredeemable Preference Share… With Tax:

Where: Dt = tax on preference dividend.

Kp =D (1 + Dt)

CMP or NP

Cost of Redeemable Preference Share…

2/)(

/)(

NPRV

NpiprdfDK mp

Where:

D = Dividend per Share. f = Flotation Cost (Rs.)

d = Discount on issue of Preference Share (Rs.)

pr = Premium on Redemption of Preference Share (Rs.)

pi = Premium on Issue of Preference Share (Rs.)

Nm = Term of Preference Shares

RV = Redeemable Value of Preference Share

NP = Net Proceeds Realized

Cost of Debt… Cost of Irredeemable Debt. Cost of Redeemable Debt.

Cost of Irredeemable Debt… Pre – tax Cost:

Where; Kd = Cost of debenture. I = Interest. P = Principle Amount or Face Value.

Kd =I

P or NP

Cost of Irredeemable Debt… Post – tax Cost:

Where; Kd = Cost of debenture. I = Interest. t = Tax rate. P = Principle Amount or Face Value.

Kd =I (1-t)

P or NP

Cost of Redeemable Debt…

2/)(

/)()1(

NPRV

NpiprdftIKd m

Where; Kd = Cost of Debt. t = Tax Rate f = Flotation Cost (Rs.) d = Discount pr = Premium on Redemption pi = Premium on Issue Nm = Maturity Period of Debt. RV = Redeemable Value NP = Net Proceeds

Types of WACC… Book Values Weights. Capital Structure Weights. Market Value Weights.

Marginal Cost of Capital… When the company may rise additional

fund for expansion, a financial manager may be required to calculate the cost of additional funds to be raised., which is called as a marginal cost of capital.

Factors affecting WACC… Controllable/ Internal Factors. Uncontrollable/ External Factors.

Controllable factors… Capital structure policy. Dividend policy. Investment policy.

Uncontrollable factors… Tax rates. Level of interest rates. Market risk premium.