Chapter 5 - Cost of Capital SML 401 Btech (1)

7/30/2019 Chapter 5 - Cost of Capital SML 401 Btech (1)

1/52

Cost of Capital Minimum rate of return which a company is expected

to earn from a proposed project so as to make noreduction in the earning per share to equityshareholders and its market price.

In economic terms there are two approaches to define

CoC:1. It is the borrowing rate of the firm, at which it canacquire funds to finance the proposed project

2. It is the lending rate which the firm could have

earned if the firm would have invested elsewhereCoC is a combined cost of each type of source

by which a firm raises funds.


2/52

CoCAlso referred to as cut-off rate, target rate,

hurdle rate, minimum required rate of return,standard return, etc.

Assumption: that the firms business andfinancial risks are unaffected by the acceptance

and financing of projects.Business risk is the risk to the firm of being

unable to cover fixed operating costs. Measuredby: (EBIT/EBIT)/ (Sales/Sales)

Financial risk is the risk of being unable tocover required financial obligations such asinterest, preference dividends. Measured by:(EPS/EPS)/ (EBIT/EBIT)


3/52

Importance of CoC

Capital Budgeting Decisions

Designing the Corporate Financial Structure

Deciding about the method of financing in lieu withcapital market fluctuations

Performance of top management

Other areas eg., dividend policy, working capital


4/52

Measuring CoCA realistic measure of CoC should have the following

qualities of capital expenditure decisions:1. It must account for the general uncertainty of

expected future returns from investment proposals.2. It must allow for the various degrees of uncertainty of

expected future returns associated with different usesof funds.

3.It must allow for the effects of uncertainty associatedwith an incremental investment and the uncertaintyof returns from the entire asset portfolio of the firm.

4. It must account for a variety of financing meansavailable to a firm.

5. It must allow for the differential effects of financingcombination on the amount and quality of residualnet benefits accruing to shareholders.

6. It must reflect the changes in the capital market.


5/52

Basic costs of capital

1. Cost of Equity Capital: the cost of obtaining fundsthrough the sale of common stock.

2. Cost of Preference Shares3. Cost of Debt

4. Cost of Retained Earnings


6/52

Cost of Equity Capital

Ke is defined as the minimum rate of return that a firmmust earn on the equity-financed portion of aninvestment project in order to leave unchanged themarket price of the shares.

It is the rate at which investors discount the expecteddividends of the firm to determine its share value.

The two approaches to measure ke are i. Dividendvaluation approach and ii. Capital asset pricingmodel.


7/52

Cost of EquityMost difficult and controversial cost to work out.

Conceptually, the cost of equity ke may be defined asthe minimum rate of return that a firm must earn onthe equity financed portion of an investment project inorder to leave unchanged the market price of theshares.

The cost of equity capital is higher than that ofpreference and debt because of greater uncertainty ofreceiving dividends and repayment of principal at theend.


8/52

2 approaches to measure Ke 1. Dividend approach dividend valuation model:

assumes that the value of a share equals thepresent value of all future dividends that it is

expected to provide over an indefinite period. Ke accordingly is defined as the discount rate that

equates the present value of all expected futuredividends per share with the net proceeds of thesale (or the current market price) of a share.


9/52

FormulaN

Po(1-f)= D1/(1+ke)

+ D2/(1+ke)2

+.+

n=1

N

= D1(1+g)n-1/(1+ke)nn=1

Po(1-f) = D1/(keg) or

Ke = (D1/Po) + g; where

D1 = expected dividend per sharePo = net proceeds per share/current market price

g = growth in expected dividends


10/52

Assumptions of the Dividend

Approach The market value of shares depends upon the

expected dividends.

Investors can formulate subjective probabilitydistribution of dividends per share expected to bepaid in various future periods. The initial dividendis greater than 0.

Dividend payout ratio is constant. Investors can accurately measure the riskiness of

the firm so as to agree on the rate at which todiscount the dividends.


11/52

Note 1: if the growth rate is not uniform, then,

Po(1-f)or Po=D1/(1+ke)+ D1(1+g1)/(1+ke)2 + D1(1+g1)(1+g2)/(1+ke)3 .+

Note 2: if we limit the dividend payment upto N years,then,

Po(1-f)or Po=D1/(1+ke)+ D1(1+g)/(1+ke)2++ D1(1+g)N-1/(1+ke)N +.+ PN/(1+ke)N

Where, PN is the share value at the end of the Nth year.

Example: Expected dividend is Rs.2 in 1st year. Growth rateexpected 4% in perpetuity. Floatation cost is 2%. What isthe cost of equity? Assume market price of share is Rs. 20.

So, 20(1-0.02)=2/ke-0.04

ke=0.04+2/20(1-0.02)=14.20%

If there are no floatation costs, then,

ke=g+D1/P0=0.04+2/20=14%


12/52

The Fincon Ltd. is planning an equity issue in Jan 1998.it has an EPS of Rs.25 and declared a dividend of Rs.15per share in the current year. Its present P/E ratio is 8.

It wants to price the issue at market price andfloatation costs are expected to be 10% of the issueprice. Determine required rate of return for equityshares before issue and after the issue. How will

dividend tax under the Indian Income Tax Act affectyour calculations?

Cost of present equity:

Ke=[EPS/P0(1-f)]=[D1/Po(1-f)]+g=reciprocal of P/E

multipleg=%Retimes[EPS/Po(1-f)]

Ke=1/8=.125=12.5% OR Ke=15/200+25/200(1-

15/25)=.125=12.5%


13/52

Cost of equity for new issue:

Ke=15/200(1-0.10)+[25/200(1-0.10)](1-15/25)=15/180+(25/180)(0.40)=.1388=13.9%

Under new tax laws:

Po=D1/(Ke-g) OR Ke=D1/P0+g

But 10% tax is paid by company out of profits. Thus,

retained earnings or g alone is affected. Thus, revisedformula for g is:

g=EPS/P0[1-DPS(1+dt)/EPS] or g=[EPS-DPS(1+dt)]/P0

where, dt is dividend tax

For existing issue, Ke=D1/P0+[EPS-DPS(1+dt)]/P0

Ke=15/200+[25-15(1+0.1)]/200=15/200+[25-16.5]/200=15/200+8.5/200=.1175=11.75%


14/52

For further issue of equity, Ke=D1/P0(1-f)+[EPS-DPS(1+dt)]/P0(1-f)

Ke=15/200(1-0.1)+8.5/200(1-0.1)=15/180+8.5/200=23.5/180=0.13055=13.1%

The new tax laws would result in:

a. Lower cost of equity

b. Perhaps it would promote investment also.


15/52

Example: suppose current dividend (D0)=Rs. 2

Current share price P0=Rs.100

Company growth rate: upto 5th year 10%

6-10th year=8%

11th year & beyond=6%

Then, P0

5

= 2*1.10(1.1)n-1/(1+ke)n+n=1

10

D6(1.08)n-1/(1+ke)n+n=6

D6(1.06)n-1/(1+ke)n

+n=11


16/52

2. Capital Asset Pricing Model

approach The CAPM explains the behavior of security prices

and provides a mechanism whereby investorscould assess the impact of proposed security

investment on their overall portfolio risk andreturn. In other words, it formally describes therisk-return trade-off for securities.

The basic assumption of CAPM are related to

A. the efficiency of the market, and

B. investor preferences.


17/52


18/52

B. Investors preference assumption is that all investorsprefer the security that provides the highest return fora given level of risk or the lowest risk for a given level

of return. That is, investors are risk averse.


19/52

Risk to which security investment is exposed to

are of 2 types: Diversifiable/unsystematic risk: is the portion of

the securitys risk that is attributable to firm-specificrandom causes; can be eliminated through

diversification. Eg., management capabilities anddecisions, strikes, unique government regulations,availability of raw materials, competition.


20/52

Systematic/Non-diversifiable risk: is the

relevant portion of a securitys risk that isattributable to market factors that affect all firms;cannot be eliminated through diversification. Eg.,interest rate changes, inflation or purchasing power

change, changes in investor expectations about theoverall performance of the economy and politicalchanges.

Since diversifiable risks can be eliminated through

diversification, investors should be concerned withonly non-diversifiable risks.


21/52


22/52

Formula ke = rf + (km rf);

Where,ke = cost of equity capital;

rf = the rate of return required on a risk freeasset/security/investment

km = required rate of return on the market portfolioof assets that can be viewed as the average rate ofreturn on all assets

= the beta coefficient.

for market portfolios is 1, while it is 0 for risk-freeinvestments.


23/52

rf

ke

rm

1


24/52

Difference b/w CAPM and Dividend Valuation

method

Valuation model does not consider the risk as reflectedin beta.

CAPM model suffers from the problem of collection ofdata.

Beta measures only systematic risk.

Example: =1.4, rf=8%, km=12%

ke=8%+1.4(12%-8%)=8%+1.4*4%=13.6%


25/52

Note: CAPM approach is theoretically sound but haslimitations:

1. It does not incorporate floatation costs.

2. Difficult to get values.

3. Poorly diversified investors would be concerned withnot only systematic but total risk.

So, dividend approach is better.


26/52

Cost of Preference Capital They are a hybrid security between debt and equity.

The shareholders are paid a dividend yearly. Though,this payment is not tax-deductible but the company isrequired to make payments; since, if it does not pay, itcant pay dividends to the equity holders. Also,

preference dividend, if unpaid, gets accumulated overyears. Preference shares may beredeemable/irredeemable. (now irredeemable

preference shares are not allowed. Have to be redeemedin maximum 10 years)

Cost of preference share capital is the annualpreference share dividend divided by the net proceedsfrom the sale of preference shares.

Perpetual security (irredeemable)

Cost of redeemable preference share


27/52

Cost of Preference Shares

The preference shareholders carry a prior right toreceive dividends over the equity shareholders.

Moreover, preference shares are usually cumulativewhich means that preference dividend will keep gettingaccumulated unless it is paid.

Further, non-payment of preference dividend mayentitle their holders to participate in the managementof the firm as voting rights are conferred on them insuch cases.

Above all, the firm may encounter difficulty in raising

further equity capital mainly because the non-paymentof preference dividend adversely affects the prospects ofordinary shareholders.


28/52

A. Irredeemable (perpetual)

kp=dp/P0(1-f); where,dp=constant annual dividend,

P0=expected sales price of preference share

f= floatation costs

Example: a 12% irredeemable preference share of face value ofRs.100, f=5%. What is kp if preference share issued at i. par,ii.10% premium, iii. 10% discount

i. At par, kp=12/100(1-0.05)=12/95=12.63%

ii. At 10% premium, kp=12/110(1-0.05)=11.48%

iii. At 10% discount, kp=12/90(1-0.05)=14.03%


29/52

B. Redeemable preference shares

N

Po(1-f)= dp/(1+kp)n+PN/(1+kp)N ;n=1

Example: 14% preference dividend on face value of

Rs.100 to be redeemed after 10 years. Floatation cost is5%. Kp?

N

100(1-0.05)= 14/(1+kp)n+100/(1+kp)10 ;n=1

By trial and error kp=15% approximately.


30/52

Cost of Debt

Debt is the cheapest form of long-term debt fromthe companys point of view as:

Its the safest form of investment from the point ofview of creditors because they are the firstclaimants on the companys assets at the time of itsliquidation. Likewise they are the first to be paidtheir interest. Another, more important reason for

debt having the lowest cost if the tax-deductibilityof interest payments.


31/52

Cost of Debt

It is the interest rate which equates the present valueof the expected future receipts with the cost of theproject. The present value of tax-adjusted interest

costs plus repayments of the principal is equated withthe amount received at the time the loan isconsummated.


32/52

Cost of Debt

Cost of debt is the after-tax cost of long-termfunds through borrowing.

Net cash proceeds are the funds actually receivedfrom the sale of security.

Flotation cost is the total cost of issuing andselling securities.

Cost of perpetual/irredeemable debt

Cost of redeemable debt

Cost of Perpetual/Irredeemable debt


33/52

Cost of Perpetual/Irredeemable debt

The nominal cost of debt is the periodical interest paid on it. The

interest rate/market yield is said to be cost of debt.Suppose a bond is issued to procure perpetual debt. Then,

ki=I/SV; where I is annual interest payment (coupon payment); SVis sale proceeds of bond/debenture.

kd=I(1-T)/SV; where T is tax rate.Example: A 12% perpetual debt of nominal value of Rs.100000. Tax

rate is 50%. Cost of debt when issued at i. Par, ii. At discount of5% and iii. premium of 10%.

i. At par ki=12000/100000=12%kd=12%(1-0.5)=6%

ii. At discount of 5%, that is value received is 95,000.ki=12000/95000=12.63%

kd=12.63%(1-0.5)=6.32%


34/52

iii. At a premium of 10%, that is value received is110,000.

ki=12000/110,000=10.91%kd=10.91%(1-0.5)=5.45%

So here (ii) 6.32% is highest cost followed by (i) 6%or (iii) 5.45%.


35/52

Cost of Redeemable debt

To find the cost, initial net proceeds are to be equatedwith net outflows.

Co= In/(1+kd)n+PN/(1+kd)N ; if principal payment is maden=1 at the end of Nth year

Or,

Co= In+PN/(1+kd)n ; if payment of principal is done in

n=1 installments

E l % d b f R (f l ) b


36/52

Example: 15% debentures of Rs.1000 (face value) to beredeemed after 10 years. Net proceeds are after 5%floatation costs and 5% discount. The tax rate is 50%.

What is the cost of debt?Year Cashflows

0 1000-5%of 1000(floatation)-5%ofdiscount

=900

1-10 Rs. 15% of 1000(1-0.5)=Rs.75

10 Rs. 1000 (repayment)10

So, 900= = 75/(1+kd)n+1000/(1+kd)10n=1

By trial and error; kd =9% approx.

Note: ki route is preferred over kd route.

Example: of redemption on yearly basis (coupon


37/52

Example: of redemption on yearly basis (couponrate=15%). The par value of debenture is Rs.100000. thefloatation cost is 10%. Principal to be paid back in 5equal installments at the year end. Tax rate is 50%.

Net proceeds=100000-10%=90000

Outflows: Net coupon Principal Total

Yr 1 15000(1-0.5)=7500 20000 27500

Yr 2 80000*.15(1-0.5)=6000 20000 26000Yr 3 60000*.15(1-0.5)=4500 20000 24500

Yr 4 40000*.15(1-0.5)=3000 20000 23000

Yr 5 20000*.15(1-0.5)=1500 20000 21500So, 90000=27500/(1+kd)+26000/(1+kd)2 +24500/(1+kd)3

+23000/(1+kd)4 +21500/(1+kd)5

By trial and error, kd=12% approx


38/52

Cost of Retained Earnings May be defined as the opportunity cost in terms of

dividends foregone by/withheld from the equityshareholders.

Cost of retained earnings is the same as the cost of anequivalent fully subscribed issue of additional shares,

which is measured by the cost of equity capital. Retained earnings are dividends withheld, that is, if

were in the hands of the investors (shareholders) theycould have earned on these by investing somewhereelse. The assumption is that the firm is earning atleast equal to ke on these retained earnings. So thecost kr is approximately equal to ke (a little less thanke because of floatation costs are not there, kr


39/52

Weighted Average Cost of Capital

(WACC)

This gives us the overall cost of capital. Weight ageis given to the cost of each source of funds byassessing the relative proportion of each source offund to the total, and is ascertained by using thebook value or the market value of each type ofcapital. The cost of capital of the market value is

usually higher than it would be if the book value isused.


40/52

Steps in Calculation of WACC

(Ko)Assigning weights to specific costs.

Multiplying the cost of each sources by the appropriateweights.

Dividing the total weighted cost by the total weights.


41/52

Weighting can be using marginal or historicalweights

Why marginal weights? Because it is the new capital

being raised for new investment that is important sothe weighted cost of new capital is of relevance. Else,projects with costs higher than managerial costs maybe accepted, giving negative results and vice-versa.

But the problem is that if we go by marginal weighting,we may resort to too much borrowing and accept manyprojects because of lower cost at the moment. But, at alater date, company may have the problem of raising

more finance. Marginal weights ignore long term view.

Thus, the fact that todays financing affects tomorrowscosts, is not considered in using marginal weights.


42/52

Historical weights take a long term view and try toraise financing also in the proportion of existing

capital structure considered superior.Historical weights can be divided into book value

weights and market value weights.

Calculations based on the book value weights are moreeasy operationally while those based on market valuesare more sound theoretically since the sale price ofsecurities is going to be more close to the marketvalue. But the problem is how to choose the marketvalue because they fluctuate widely sometimes andalmost everyday their values are different.

Example: capital structure (book value based)


43/52

Example: capital structure (book value based)

Debt 30% (Rs.6000) cost kd=8%

Preference shares 30% (Rs.6000) cost kp=13%

Equity 40% (Rs.8000) cost k=14%

Ko=WACC=wiki=30%*8%+30%*13%+40%*14%

=2.4%+3.9%+5.6%=11.9%

Note: ko calculated on the basis of market value is likely to begreater than the one calculated on the basis of book value

since market values of equity and preference shares isusually higher than book value and hence their weight ismore with respect to debt. For example, in the aboveexample, market values are:


44/52

Debt 25% (Rs.60000) cost kd=8%

Preference shares 29.17% (Rs.70000) cost kp=13%

Equity 45.83% (Rs.110000) cost k=14%Total=240000

Ko=WACC=wiki=0.25*0.08+0.2917*0.13+0.4583*0.14=0.0200+0.03

792+0.06416=0.122082=12.21%


45/52

Market Value vs. Book Value

Weights MV sometimes preferred to BV for the MV

represents the true expectations of the investors.However, it suffers from the following

limitations:1. MV undergoes frequent fluctuations and have to

be normalized;

2. The use of MV tends to cause a shift towardslarger amounts of equity funds, particularly

when additional financing is undertaken.


46/52

MV more appealing than BV as: Market values of securities closely approximate the

actual amount to be received from their sale

Costs of specific sources of finance which constitutethe capital structure of the firm are calculated usingprevalent market prices.


47/52

Advantages of BV weights1. The capital structure targets are usually fixed interms of book value.

2. It is easy to know the book value.3. Investors are interested in knowing the debt-

equity ratio on the basis of book values.

4. It is easier to evaluate the performance of a

management in procuring funds by comparingon the basis of book values.


48/52

Relevant costs closely related to

CoC1. Marginal cost of capital: average cost of new or

incremental funds raised by the firm. MC tens toincrease proportionately as the amount of debtincreases.

2. Explicit cost and implicit cost:a. Explicit cost: of any source of finance is thediscount rate that equates the present value of thecash inflows that are incremental to the taking ofthe financial opportunity with the present value of

the incremental cash outflows. The explicit cost ofa debt would be 0 if it is interest free. The explicitcost of a gift would be 100%.

b Implicit cost is the opportunit cost It is the


49/52

b. Implicit cost: is the opportunity cost. It is therate of return associated with the bestinvestment opportunity for the firm and its

shareholders that will be foregone if the projectpresently under consideration by the firm wereaccepted. It is not concerned with anyparticular source of finance.

The explicit cost include only the CoC to be paidand ignores the other factors such as riskinvolved, flexibility and leverage characteristics

which are adversely affected with an increase indebt contents in its capital structure and thesechanges imply additional but hidden costs.


50/52

3. Future cost and Historical costWe always consider the projects expected internal rate

of return and compare it with the expected (future)cost of capital while making capital expenditure

decision. Historical costs (past costs) help inpredicting the future costs and provide an evaluationof the past performance


51/52

4. Specific cost and

Inclusive/Combined/Composite CoC

a. Specific CoC is associated with a specificcomponent of capital structure.

b. Inclusive CoC is an aggregate of the CoC from allsources. In other words, it is WACC.


52/52

5. Spot costs and Normalized costsa. Spot costs represent those costs prevailing in the

market at a certain time.

b. Normalized cost indicate an estimate of cost by someaveraging process from which cyclical element isremoved.

Documents

Chapter 5 - Cost of Capital SML 401 Btech (1)