Introduction of Cost of Capital

The concept of "cost of capital" is very important in financial management. It is weighted average cost of various sources of finance used by a firm may be in form of debentures, preference share capital, retained earning and equity share capital. A decision to invest in a particular project depend upon the cost of capital of the firm or the cut off rate which is minimum rate of return expected by the investors. When a firm is not able to achieve cut off rate, the market value of share will fall. In fact, cost of capital is minimum rate of return expected by its investors. Every firm have different types of goals or objectives such as profit maximization, cost minimization, wealth maximization and maximum market share. If a firm have main objective is wealth maximization then that firm earn a rate of return more than its cost of capital.

Definition:

Business firms raise the needed fund from internal sources and external sources. Undistributed and retained profit is the main source of internal fund. External fund is raised either by the issue of shares or by issue of debenture (debt) or by both means. The fund collected by any means is not cost free. Interest is to be paid on the fund obtained as debt and dividend is to be paid on the fund collected through the issue of shares. The average cost rate of different sources of fund is called cost of capital .

From the view point of return, cost of capital is the minimum required rate of return to be earned on investment. In other words, the earning rate of a firm which is just sufficient to satisfy the expectation of the contributors of capital is called cost of capital. Shareholders and debenture holders are the contributors of the capital. For example, a firm needs $ 5,00,000 for investing in a new project. The firm can collect $3,00,000 from shares on which it must pay 12% dividend and $ 2,00,000 from debentures on which it must pay 7% interest. If the fund is raised and invested in the project, the firm must earn at least $50,000 which becomes sufficient to pay $36,000

dividend(12% of $3,00,000) and $14000 interest(7% of $2,00,000). The required earning $50,000 is 12% of the total fund raised. This 12% rate of return is called cost of capital.

In this way, cost of capital is only minimum required rate of return to earn on investment and it is not the actual earning rate of the firm. As per above example, if the firm is able to earn only 10%. all the earnings will go in the hands of contributors of capital and nothing will be left in the business. Therefore, any business firm should try to maximize the earning rate by investing in the projects that can provide the rate of return which is more than the cost of capital.

Various Definitions:

Cost of capital is the required return necessary to make a capital budgeting project, such as

building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of

equity. A company uses debt, common equity and preferred equity to fund new projects,

typically in large sums. In the long run, companies typically adhere to target weights for each of

the sources of funding. When a capital budgeting decision is being made, it is important to keep

in mind how the capital structure be affected.

Capital structure is a mix of a company's long-term debt, specific short-term debt, common

equity and preferred equity. The capital structure represents how a firm finances its overall

operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as

common stock, preferred stock or retained earnings. Short-term debt such as working capital

requirements is also considered to be part of the capital structure.

A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and minimizes the firm's cost of capital.

In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt increases. A healthy proportion of equity capital, as opposed to debt capital, in company's capital structure is an indication of financial fitness.

Determining the Cost of Capital :

Personal savings:

Many entrepreneurs use their personal savings as startup capital. It might not seem as if there’s any cost associated with this capital — you’ve earned and saved this money, and now you’re using it to build your own business. But consider that you could spend your hard-earned money on any number of things, not just starting a company. This means there is an opportunity cost involved in using your funds for a startup.

Sometimes, it’s easy to determine opportunity cost — Investopedia gives the example of choosing to buy a stock over a bond. If the stock returns 2 percent annually and the bond yields 6

percent, your opportunity cost in choosing the stock instead of the bond is 4 percent. However, opportunity cost is not so straightforward when starting a business.

If your business is a great success, you will be happy you used your own savings to start it; however, if your business does not pan out, you may regret not using the funds in some other way, for example, by investing in a safe savings account, which would have all but guaranteed some growth. In other words, the cost of using your savings as business capital can’t be determined with absolute certainty, but you should absolutely be aware that there is a cost, and think about whether the odds of business success are high enough to warrant using your own dollars.

Cost of Debt Capital:

The cost of debt capital is relatively easy to determine, although perhaps not as straightforward as it would seem, due to taxes. The basic cost of debt is the interest you’re paying to borrow money from banks or other lending institutions or, if your company has issued bonds, bondholders. However, interest payments on debt financing are generally tax-deductible, so to figure the cost of debt capital, you need to take this into account.

There is a basic formula for determining the cost of debt:

Cost of Debt = Interest Rate(1 – Marginal Tax Rate)

This equation can be refined by taking into account things like a risk premium, which represents the probability of default.

Also consider that some banks or other lenders will ask you to personally guarantee a loan, which means you’re pledging to pay back the loan even if your business cannot. A personal guarantee is unsecured — meaning you are not putting up your personal assets as collateral on the loan — but it does provide the lender with some ground for pursuing legal recourse against you to seize your personal assets if you can’t repay the loan.

Cost of Equity Capital:

It’s more complicated to calculate the cost of equity financing than debt. Some costs are not strictly monetary. By securing equity financing in the form of venture capital, you’re allowing investors to buy into your company, which dilutes your ownership and control over the enterprise. While having savvy investors who can act as advisers can be a great benefit to your company, this has to be weighed against the loss of autonomy that comes with equity financing.

Although you’re not making interest payments to investors, shareholders also expect a return on their money. Because shareholder payouts are dependent on market fluctuations, the equation for figuring the cost of equity is complex and subject to debate even by financial experts. The most widely known formula is the Nobel Prize-winning capital asset pricing model. The CAPM takes into account:

The risk-free rate of return (often the interest rate on U.S. Treasury bills) The “beta,” which is a measure of how much the company’s securities will fluctuate in value

compared to the market as a whole The equity risk premium, or the return expected by investors, considering they are taking a risk

in buying stock – this is calculated by subtracting the risk-free rate from the historical return of the stock marketWhile coming up with a specific figure for the cost of equity can be a complicated process, the general concept to remember is that the costs of equity capital are high relative to debt capital, because investors are taking a bigger risk than lenders in financing your company.

Once you’ve calculated the cost of debt and equity capital, you can figure out the weighted average cost of capital (WACC) for your business as a whole by considering your capital structure. A startup might be entirely funded with personal savings and debt, but some experts say a healthy structure for a mature company would be about 40 percent debt financing to 60 percent equity. In this scenario, the WACC is simply the cost of debt multiplied by 40 percent, added to the cost of equity multiplied by 60 percent.

Although this is a simplified example and in real-world scenarios you may have to consider subtleties like the difference between common and preferred stock, the WACC is essentially just the sum of equity and debt costs. The WACC can also be used to figure the cost of capital you want to raise for a particular project that will be financed through a mixture of debt and equity, allowing you to determine with greater certainty whether you can afford the expansion.

Significant of the Cost of Capital:

Financial experts express conflicting option as to the correct way in which the cost of capital can be measured.Irrespective of the measurement problems,it is a concept of vital importance in the financial decision making.It is useful as a standard for :

Evaluating investment decisions. Designing Firm’s debt policy. Appraising the financial performance of top management.

Designing debt policy:

The debt policy of a firm is significantly influence by the cost consideration. In designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at maximizing the overall cost of capital.

The cost of capital can also be useful in deciding about the methods of financing at a point of time.

Performance appraisal

The cost of capital framework can be used to evaluate the financial performance of top management. Such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected overall cost of capital, and the appraisal of the actual costs incurred by management in raising the required funds.The cost of capital also plays a useful role in dividend decision and investment in current assets.

Investmnet evaluation:

The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. In the net present value (NPV) method, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting its cash flows by the cost of capital.

Cost of capital and its importance:

Cost of the capital is the rate of return which is minimum which has to be earned on investments in order to satisfy the investors of various types who are making investments in the company in the form of shares, debentures and loans. It is used in financial investment which refers to the cost of a company's funds or the shareholders return on the company's existing deals. It is the required rate that a company must achieve to cover the cost of generating funds in the market. By seeing this only the investor invests the money in the company if the company is giving the required rate of return. It is a guideline to measure the profitability of different investments.

The importance of cost of capital is that it is used to evaluate new project of company and allows the calculations to be easy so that it has minimum return that investor expect for providing investment to the company. It has such an importance in financial decision making. It actually used in managerial decision making in certain field such as-

Decision on capital budgeting-

It is used to measure the investment proposal to choose a project which satisfies return on investment.

Used in designing corporate financial structure:

- it is used to design the market fluctuations and try to achieve the economical capital structure for firm.

Top management performance-

It evaluates the financial performance of top executives. It involves the comparison of actual profit of the projects and taken projects overall cost. 

Problems in Determination of Cost of Capital

It has already been stated that the cost of capital is one of the most crucial factors in

most financial management decisions. However, the determination of the cost of capital of a firm

is not an easy task. The finance manager is confronted with a large number of problems, both

conceptual and practical, while determining the cost of capital of a firm. These problems can

briefly be summarized as follows:

1. Controversy regarding the dependence of cost of capital upon the method and level of financing:

There is a, major controversy whether or not the cost of capital dependent upon the method and

level of financing by the company. According to the traditional theorists, the cost of capital of a

firm depends upon the method and level of financing. In other words, according to them, a firm

can change its overall cost of capital by changing its debt-equity mix. On the other hand, the

modern theorists such as Modigliani and Miller argue that the firm’s total cost of capital is

independent of the method and level of financing. In other words, the change in the debt-equity

ratio does not affect the total cost of capital. An important assumption underlying MM

approach is that there is perfect capital market. Since perfect capital market does not exist in

practice, hence the approach is not of much practical utility.

2. Computation of cost of equity:

The determination of the cost of equity capital is another problem. In theory, the cost of equity

capital may be defined as the minimum rate of return that accompany must earn on that portion

of its capital employed, which is financed by equity capital so that the market price of the shares

of the company remains unchanged. In other words, it is the rate of return which the equity

shareholders expect from the shares of the company which will maintain the present market price

of the equity shares of the company. This means that determination of the cost of equity capital

will require quantification of the expectations of the equity shareholders. This is a difficult task

because the equity shareholders value the equity shares on the basis of a large number of factors,

financial as well as psychological. Different authorities have tried in different ways to quantify

the expectations of the equity shareholders. Their methods and calculations differ.

3. Computation of cost of retained earnings and depreciation funds:The cost of capital raised through these sources will depend upon the approach adopted

for computing the cost of equity capital. Since there are different views, therefore, a finance

manager has to face difficult task in subscribing and selecting an appropriate approach.

4. Future costs versus historical costs:It is argued that for decision-making purposes, the historical cost is not relevant. The future costs

should be considered. It, therefore, creates another problem whether to consider marginal cost of

capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total funds.

5. Problem of weights:The assignment of weights to each type of funds is a complex issue. The finance manager has to

make a choice between the risk value of each source of funds and the market value of each

source of funds. The results would be different in each case. It is clear from the above discussion

that it is difficult to calculate the cost of capital with precision. It can never be a single given

figure. At the most it can be estimated with a reasonable range of accuracy. Since the  cost of

capital is an important factor affecting managerial decisions, it is imperative for the finance

manager to identify the range within which his cost of capital lies.

The calculation of company´s cost of capital

Cost of debt = risk-free rate + company risk premium Cost of equity (risk-free rate + about 6% equity risk premium)

o The equity risk premium is adjusted with the company´s risk levelo The risk level of a company depends on the business risk (business field) and on

the financial risk (solvency)

A company´s cost of capital is calculated as a weighted average of the above costs of equity and debt.

o The cost of capital is calculated with the target solvency ratio (The cost of capital can not be decreased simply by increasing leverage since increasing leverage increases the risk (and cost) of both equity and debt.)

o Debt cost includes tax shield (1-tax rate) since interest on debt can be deducted from the taxable revenues

EXAMPLE:o Cost of debt: 5,2% + 1% = 6,2% (in the long run)o Cost of equity: 5,2% + 1,2 * 6% = 12,5%o Weighted average cost of capital (WACC): 6,2% * 55% * (1-tax rate) + 12,5% *

45% = 9%

Debt / Cost of Equity

A firm uses Capital for it’s functioning and as we know Capital is a scarce resource, therefore it entails a cost to the firm. Capital can be raised from two sources, Debt and equity. Thus, a firm has two stakeholders that expect returns from the company, Equity holders or the owners and the Debt holders or Creditors.

COST OF DEBIT CAPITAL

Debt holders or Creditors are the ones that provide loan to the company and charge an interest on the same. The rate of interest is called as the cost of debt. However, since a firm gets a tax deduction on the interest expense, cost of debt should be adjusted for the tax shield.

 Cost of Debt Based on:

The cost of debt is usually based on the cost of the company's bonds. Bonds are a company's long-term debt and are little more than the company's long-term loans. The cost of newly issued bonds is the best rate to use if possible when calculating the cost of debt.If a company has no publicly-traded bonds, then the business owner can look at the cost of the debt of other firms in the same industry in order to get an idea of the cost of debt.

Calculate the Cost of Debt Capital:

The cost of debt capital is not simply the cost of the company's bonds. Since the interest on debt is tax-deductible, you must multiply the coupon rate on the company's bonds by (1 - tax rate) to adjust for this as follows:

Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate)

Flotation costs or the costs of underwriting the debt are not considered in the calculation as those costs are negligible when it comes to debt.

Cost of Debit (Before tax and After tax):

Companies use bonds, loans, and other forms of debt for capital; this measure is useful because it indicates the overall rate being used for debt financing. It also gives investors an idea of how risky a company can be; riskier companies generally have a higher cost of debt. To get the after-tax rate, multiply the before-tax rate by 1 minus the marginal tax rate (before-tax rate × (1 - marginal tax)). For example, if a company's only debt was a single bond in which it paid 5%, the before-tax cost of debt would be 5%. If, however, the company's marginal tax rate was 40%, the company's after-tax cost of debt would be only 3% (5% × (1 -40%)).

Cost of debt (before tax):

Cost of debt is what it costs a company to maintain debt. The amount of debt is normally calculated as the after-tax cost of debt because interest on debt is normally tax-deductible. The general formula for after-tax cost of debt then is pretax cost of debt x (100 percent - tax rate). The company will retain the non-taxed portion of the debt while the government taxes the taxable portion of the debt. For example, a company borrows $10,000 at a rate of 8 percent interest. The pre-tax cost of debt is then 8 percent.

Cost of debt (After tax):

After-tax cost of debt means calculating the rate of interest after deducting tax rate from total interest rate. Actually we calculate cost of debt before the tax because interest is our operating charges and it is deducted from our total revenue for tax purpose. So, there is no need to calculate after-tax cost of debt. But some good finance managers recommend calculating after-tax cost of debt because with this, we can estimate our total tax saving, if we get money through debt instead of shares or stock. 

For example ABC Company has issued 10000 shares and debentures with the price of $ 10 each. Cost of debt is 10% and cost of equity share capital is also 10%. Suppose,corporate income tax rate is 25%. After tax cost of debt will be

= 10/100 X 75/100 = 7.5%

But in case cost of equity share capital, we have estimated (not fixed) to pay 10%. By this way, we save 2.5% tax money if we get loan through debenture. This is $ 2500 which we can reinvest in good project. Otherwise, our $ 2500 will go to Govt. account. So, to calculate this rate and on this rate we can estimate our tax saving.

COST OF EQUITY SHARE CAPITAL

Cost of equity share capital is that part of cost of capital   which is payable to equity shareholder. Every shareholder gets shares for getting return on it. So, for company point of view, it will be cost and company must earn more than cost of equity capital in order to leave unaffected the market value of its shares. 

Calculate Cost Of Equity Capital:

1. Dividend yield method or Dividend Price ratio method:

According to dividend   yield method or dividend price ratio method, “Cost of equity capital is minimum rate which will be equal to the present value of future dividend per share with current price of a share. 

Cost of equity = Dividend per equity share/ Market price or net proceed of per share Ke = DPS/ MPPS or NPPS

A company issues 1000 shares of Rs. 100 each at a premium of 10%. The company has been paying 20% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs. 160?

Solution: 

Ke= DPS/MPPS or NPPS

= 20/110 X 100

= 18.18%

If the market price of equity share is Rs. 160.

=20/160 X 100 = 12.5%

At increasing of market price, value of cost of equity capital   will decrease. 

2. Dividend yield plus growth in dividend method:

Dividend yield plus growth in dividend method is based on the assumption that company is growing and its shares market value is also increasing. In that situation, shareholders want more than simple dividend, so company can provide some more profit according to growth. So, we will add it in previous calculated cost of equity capital.

Cost of Equity Capital = DPS/ MPPS or NPPS + Rate of growth in dividends Ke = DPS/ MPPS or NPPS + G%

A company plans to issue 1000 new equity shares of Rs. 100 each at par. The floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares.

= 10/100-5 + 5% = 15.53%

If the current market price of equity share is Rs. 150, calculate the cost of existing equity share capital.

=10/150 +5% = 11.67%

3. Earning yield method:

According to this method, cost of equity capital is minimum rate which we have to earn on market price of a share. Its formula is 

Ke = Earning per share / Net proceed or Market price per share

Ke = EPS/ MPPS or NPPS

A firm is considering an expenditure of Rs. 60 lakhs for expanding its operations. The relevant information is as follows:

Number of existing equity shares = 10 LakhsMarket value of existing share= Rs. 60 Net Earning = Rs. 90 Lakh

Compute the cost of existing equity share capital and of new equity capital assuming that new shares will be issued at a price of Rs. 52 per share and the costs of new issue will be Rs. 2 per share. 

Earning per share = earning / total number of shares = 90/10 = Rs. 9Ke = 9/60 X 100Ke = 15%

Cost of new equity capital

Ke = 9/52-2 X 100 = 18%

4. Realized yield method:

One of major limitation of dividend yield method or earning yield method that both methods are based on estimation of future dividend or earning. There are large numbers of factors which are uncontrollable and uncertain. And if any financial risk will happen, we cannot use it in future

planning or we also can not take any decision related to estimation of return on investment. So, realized yield method is best method for calculating the cost of equity share capital. This method is based on actual earning earned on all amount of investment. After this, we try to know, how much money is financed from equity share capital and reserve amount of past profits and after this we calculate cost of equity share capital.

Ke = Actual earning per Share / Market price per share X 100

COST OF PREFERENCE SHARE CAPITAL

Cost of preference share capital is that part of cost of capital in which we calculate the amount which is payable to preference shareholders in the form of dividend with fixed rate. Even, dividend to preference shareholder is on the desire of board of directors of company and preference shareholder can not pressurize for paying dividend but it doesn’t mean that calculation of cost of pref. share capital is not necessary because, if we don’t pay the dividend to pref. shareholders, it will affect on capability to receive funds from this source. 

Cost of Pref. Share Capital’s formula:

Cost of Pref. Share capital (Kp) = amount of preference dividend/ Preference share capital Kp = D/P

If we have obtained this preference share capital after some adjustments like premium or discount or pay some cost of floatation, at that time, it is our duty to deduct discount andcost of floatation or add premium in par value of pref. share capital. In adjustment case cost of pref. share capital will change and we can calculate it with following way:-

Kp = D/ NP

D = Annual pref. dividend, 

NP = Net proceed = Par value of Pref. share capital – discount – cost of floatation

Or NP = Par value of pref. share capital + Premium

There will no adjustment of  tax  rates because, dividend on pref. share capital is payable on net profit after tax adjustment, so need not to do adjustment of tax for comparing it with cost of debt or cost of equity share capital .Some, time we issue redeemable preference shares whose amount is payable after some time. At the time of maturity, we need to calculate cost of pref. share capital with following formula 

Cost of redeemable pref. share capital =

D = Annual dividend 

MV = Maturity value of pref. shares

NP = Net proceeds of pref. shares

N= number of years 

This formula is little different from cost of non redeemable pref. share capital because, we have to add, the benefit which we have given to pref. share capital at the time of maturity. 

Suppose, we have to pay Rs. 10, 00,000 but at the time of issue of pref. share, we had paid Rs. 2 per issue of pref. share. So, net proceed is Rs. 9,80,000 but if this amount is payable after 10 years at 10% premium, this will also benefit to pref. share capital and total cost of pref. share capital will increase. Rate of dividend is 10%.

Cost of pref. share capital

= D + (MV – NP )/n / ½(MV +NP) X 100

= 100,000 + ( 10,50,000- 9,80,000 )/ ½ ( 10,50,000 + 9,80,000) x 100

= 100,000 + 7,000/ 10, 15,000 X 100

= 10.54%

If we compare it with simple cost of pref. share capital with following wayKp = D/P X 100 = 100000 / 10, 00,000 X 100 = 10% it is same as dividend rate but Kpr is more than Kp. So, Kpr will give you correct result.

Cost Of Retained Earning

Retained earnings are the profits generated by a company that are not distributed as dividends to the shareholders. The retained earnings are the sum of profits that have been retained by a company since its inception. They are reduced by the losses. Retained earnings are also known as accumulated surplus, accumulated profits, accumulated earnings, undivided profits and earned surplus.When a company makes profits, the board of directors has two choices. It can either distribute these profits as cash dividends or it can retain these profits and reinvest them for future growth. A company may retain its profits in a reserve to serve some specific objectives. For example, a company may retain its profits to create a reserve for paying off a debt or for purchasing an expensive capital asset.It is important to note that the retained earnings do no represent surplus cash left after payment of dividends. Instead, the retained earnings show how the company has treated its profits. They represent the amount of profits a company has reinvested since it was incorporated. The reinvestments are either purchases of new assets or reductions in liabilities.

Retained earnings represent the dividend policy of a company because they reflect a decision of a company to either reinvest the profits or to distribute profits. Therefore, most analyses try to evaluate which action created or would create higher value for the shareholders. This evaluation can be done by comparing the retained earnings per share to earnings per share, or by comparing the amount of capital retained to the changes in the share price.

Retained earnings are affected by the nature of industry and the age of company. Capital intensive industries and growing companies tend to retain more of their earnings because they need assets to operate. Older companies may have significantly larger amounts of retained earnings than identical younger companies because retained earnings represent profits retained since the inception of a company.

The cost of existing common stock, or retained earnings, is one of four possible direct sources of capital for the business firm. the others are debt capital, preferred stock, and new common stock. The weighted average cost of these sources of capital make up the weighted average cost of capital for the company with only a few exceptions. The calculations for debt capital and the cost of new common stock are relatively straightforward. Only the cost of retained earnings is a bit more complex.

Cost of retained earnings (ks) is the return stockholders require on the company's common stock.

There are three methods one can use to derive the cost of retained earnings:

Capital-asset-pricing-model (CAPM) approach Bond-yield-plus-premium approach Discounted cash flow approach

CAPM Approach:

To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).

The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.

Example: CAPM approachFor Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained earnings for Newco using the CAPM approach?

Answer:ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%

Bond-Yield-Plus-Premium ApproachThis is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the

interest rate of the firm's long-term debt and add a risk premium (typically three to five percentage points)

ks = long-term bond yield + risk premiumExample The interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of retained earnings for Newco using the bond-yield-plus-premium approach?

Answer: ks = 7% + 4% = 11%c)Discounted Cash Flow Approach

Also known as the "dividend yield plus growth approach". Using the dividend-growth model, you can rearrange the terms as follows to determine ks.

ks = D1 + g;

P0

where:D1 = next year's dividendg = firm's constant growth rateP0 = price

g = (retention rate)(ROE) = (1-payout rate)(ROE)

Example:

Assume Newco's stock is selling for $40; its expected return on equity (ROE) is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. What is the cost of retained earnings for Newco using the discounted cash flow approach?

Answer: g must first be calculated: g = (1-0.3)(0.10) = 7.0%ks = 2/40 + 0.07 = 0.12 or 12%

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is a common topic in the financial management examination. This rate, also called the discount rate, is used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset. Previous examinations have revealed that many students fail to understand how to calculate or understand .

WACC is calculated as follows:

WACC = E/V x Re + D/V x Rd x (1-tax rate)

WACC is the proportional average of each category of capital inside a firm common shares, preferred shares, bonds and any other long-term debt

where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D = firm value

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

The rate used to discount future unlevered free cash flows (UFCFs) and the terminal value (TV) to their present values should reflect the blended after-tax returns expected by the various providers of capital. The discount rate is a weighted-average of the returns expected by the different classes of capital providers (holders of different types of equity and debt), and must reflect the long-term targeted capital structure as opposed to the current capital structure. While a separate discount rate can be developed for each projection interval to reflect the changing capital structure, the discount rate is usually assumed to remain constant throughout the projection period.

In situations where projections are judged to be aggressive, it may be appropriate to use a higher discount rate than if the projections are deemed to be more reasonable. While choosing the discount rate is a matter of judgment, it is common practice to use the weighted-average cost of capital (WACC) as a starting point.

Considerations in Calculating WACC:

The following are important considerations when calculating WACC:

WACC must comprise a weighted-average of the marginal costs of all sources of capital (debt, equity, etc.) since UFCF represents cash available to all providers of capital.

WACC must be computed after corporate taxes, since UFCFs are computed after-tax.

WACC must use nominal rates of return built up from real rates and expected inflation, because the expected UFCFs are expressed in nominal terms.

WACC must be adjusted for the systematic risk borne by each provider of capital, since each expects a return that compensates for the risk assumed.

While calculating the weighted-average of the returns expected by various providers of capital, market value weights for each financing element (equity, debt, etc.) must be used, because market values reflect the true economic claim of each type of financing outstanding whereas book values may not.

Long-term WACCs should incorporate assumptions regarding long-term debt rates, not just current debt rates.

Predicted Beta:

Equity betas can be obtained from the Barra Book. These betas will be levered and either historical or predicted. The historical beta is based on actual trading data for the period examined (often 2 years), while the predicted beta statistically adjusts the historical beta to reflect an expectation that an individual company's beta will revert toward the mean over time. For example, if a company's historical beta is less than 1.00, then the predicted beta will be greater than the historical beta but less than 1.00. Similarly, if the historical beta is greater than 1.00, the predicted beta will be less than the historical beta but greater than 1.00. It is generally advisable to use predicted beta.

Betas of comparable companies are used to estimate re of private companies, or where the shares of the company being valued do not have a long enough trading history to provide a good estimate of the beta.

Predicted beta may be calculated using one of two methods:

(A) Using the company's beta:

1. De-lever the beta using the following formula:

Unlevered β =Levered β

1 + [(D/E) × (1−t) + P/E]

2. Where:

E = Market value of existing equity

D = Market value of existing debt

P = Market value of existing preferred stock

3. Re-lever the unlevered β with the targeted capital structure (typically reflecting an average capital structure for the industry, not the capital structure for the individual company) using the formula:

Levered β = Unlevered β × [1 + [(D/E) × (1−t) + P/E]]

4. Where:

Levered β = β used in CAPM formula for re

E = Market value of targeted equity

D = Market value of targeted debt

P = Market value of targeted preferred stock

(B) Using betas of comparable companies:

1. De-lever the comparable companies' betas using the formula stated above. Use each comparable company's existing capital structure to de-lever its beta.

2. Calculate the average unlevered beta of the comparable companies.

3. Re-lever the average unlevered beta using the formula above. Use the company's targeted capital structure to re-lever the average unlevered beta.

Relationship between Risk and Cost of Capital

It’s no secret that risk and return are related.  But how should we measure risk? For decades, the finance community has been equating risk with volatility (often calculated and presented in the form of standard deviation).Others, however, have argued that volatility isn’t necessarily the best measure of risk. They argue that cost of capital is a better measure of risk–a primary reason being cost of capital’s direct link to expected return.

Cost of Capital: Bond ReturnsTo illustrate the link between cost of capital and expected returns, consider the bond market. The interest rate a company offers on its bonds is both the company’s cost of capital and the bond buyers’ expected return.

And the worse a company’s credit rating, the higher the interest rate it will have to offer on a series of bonds in order to get investors to buy them. End result:

Higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Stocks vs. Bonds:

The same relationship exists when comparing stock returns to bond returns. Capital raised by issuing bonds comes at a lower cost to the company than capital raised by issuing stock. Why? Because investors demand greater expected returns from stocks than they do from bonds in order to compensate for the uncertainty of payoff.

Higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Small-Cap and Value Stocks:

The link between risk, cost of capital, and expected returns also explains why small-cap stocks and value stocks have historically earned higher returns than their large-cap and growth counterparts.Start-up companies involve more risk than large, well-established companies. So it makes sense that a small-cap company has to offer investors a proportionally greater share in the company’s profits in order to raise a given amount of capital.

Higher risk = higher cost of capital = higher expected returns.

The same thing occurs with value companies as compared to growth companies. If the expected returns were the same, why would you ever invest in a poorly-run company in a declining industry? You wouldn’t. And neither would anybody else. To attract capital, value companies have to offer more attractive expected returns than growth companies.

Higher risk = higher cost of capital = higher expected returns.

Cost Components of a Company’s Capital Structure:

The capital structure of many companies includes two or more components, each of which has its own cost of capital. Such companies may be said to have a complex capital structure. The major components commonly found are

Debt Preferred stock Common stock or partnership interests

Similarly, a project being considered in a capital budgeting decision may be financed by multiple components of capital.In a complex capital structure, each of these general components may have subcomponents, and each subcomponent may have a different cost of capital. In addition, there may be hybrid or special securities, such as convertible debt or preferred stock, warrants, options, or leases.

References:

http://www.wikidsystems.com/WiKIDBlog/determining-cost-of-capital

http://professional-edu.blogspot.com/2010/02/145-significant-of-cost-of-capital.html

Article Source: http://EzineArticles.com/4711774

http://careerride.com/fa-cost-of-capital-explained.aspx

http://www.mbaknol.com/financial-management/problems-in-determination-of-cost-of-capital/

http://www.svtuition.org/2010/04/cost-of-equity-share-capital.html

http://shobnasingh29.xomba.com/busniess_concept_cost_equity_share_capital

http://www.svtuition.org/2010/04/cost-of-pref-share-capital.html

http://www.svtuition.org/2012/01/after-tax-cost-of-debt-definition.html

http://bizfinance.about.com/od/cost-of-capital/qt/calculate-the-cost-debt-capital.htm

http://www.investorwords.com/1155/cost_of_debt_capital.html

http://bizfinance.about.com/od/cost-of-capital/qt/calculate-the-cost-debt-capital.htm

http://wiki.fool.com/How_to_Calculate_Before_Tax_Cost_of_Debt