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Dilla University

School of business and economicsMBA program

Advanced financial management term paper

Submitted by:

Tesfaye Hailu Id. No. 009/11Esayas Degago 004/11

Submitted to: prof. A.S. KANNAN

June, 2012

Dilla, Ethiopia

Table of Content page

Cost of capital

1. Introduction……………………………………………………………………………………………………………………1

1.1. Definition of cost of capital…………………………………………………………………………………3

1.2. Concept of cost of capital……………………………………………………………………………………4

1.2.1. Characteristics of cost of capital…………………………………………………………………..4

1.3. Significance of cost of capital………………………………………………………………………………5

1.4. Purpose of cost of capital……………………………………………………………………………………6

1.5. Current status of cost of capital……………………………………………………………………….…7

1.6. Determinants of cost of capital………………………………………………………………………..…7

1.7. Factors that affect the composite cost of capital………………………………………………12

1.7.1. Factors the firm cannot control……………………………………………………………..……12

1.7.2. Factors the firm can control…………………………………………………………………..……13

1.8. Adjusting the cost capital for risk………………………………………………………………………14

List of figures

Figure 1. risk and the risk of capital…………………………………………………………………………15

Reference I

Cost of capital1. INTRODUCTION

The management of a company has the paramount responsibility of directing and controlling

the company in the best interest of the owners (shareholders) and the investors. The main

objective of a business firm is to maximize the wealth of its shareholders in the long run. The

management is therefore expected to invest only in those projects which give a return in excess

of cost of funds invested in the projects of the business. This cost of funds committed to the

projects of the business is what is called Cost of Capital. The cost of capital refers to the rate of

return the company has to pay to various suppliers of funds in the company. It can be described

as the minimum rate of return that a firm must earn on its investments so that market value

per share remains unchanged. In other words, it is the minimum required rate of return on the

investment project that keeps the present wealth of shareholders unchanged. There are

variations in the costs of capital due to the fact that different kinds of investment assume

different levels of risk which is compensated for by different levels of return. Because different

sources are opened to a business firm when raising funds, basically equity and debt, the

determination of cost of funds becomes a phenomenon. Cost of capital is also referred to as

cut-off rate, target rate, hurdle rate, minimum required rate of return and standard return. It

consists of risk-free return plus premium for risk associated with the particular business. Risk

premium represents the additional return paid to the providers of capital and debt in regards of

the associated business and financial risks.

The cost of capital is the return that must be provided for the use of an investor’s funds. If the

funds are borrowed, the cost is related to the interest that must be paid on the loan. If the

funds are equity, the cost is the return that investors expect, both from the stock’s price

appreciation and dividends. From the investor’s point of view, the cost of capital is the same as

the required rate of return.

The required rate of return on an investment and its value are intertwined. If you buy a bond,

you expect to receive interest and the repayment of the principal in the future. The price you

pay reflects your required rate of return. What determines your required rate? Your

opportunity cost—the return you could have received on an investment with similar risk.

Suppose that after you buy this bond, market interest rates increase. Your own required rate of

return also rises. When your required rate of return increases, the value of your bond’s future

interest and principal fall since the discount rate—the rate you use to translate future cash

flows into today’s value—increases. The discount rate increases because it is a reflection of

market interest rates. The cost of capital and the required rate of return are marginal concepts.

That is, the cost of capital is the cost associated with raising one more dollar of capital, whereas

the required rate of return is the return expected on one more dollar invested. To make

investment decisions of any kind, we need to know the cost of capital. In economics, you

learned that a firm should produce goods to the point where the firm’s marginal benefit from

producing them equals the marginal cost to produce them. At that level of production, profit is

maximized.

It’s the same in investment and financing decisions: Invest in a project until the marginal cost of

funds to invest is equal to the marginal benefit the project provides. The benefit from an

investment is its return, which we refer to as its internal rate of return (from the investor’s

perspective) or the marginal efficiency of capital (from the firm’s perspective). This means that

managers keep on raising funds to invest in projects until the marginal cost of these funds is

equal to the marginal benefit (which decreases as we take on more and more projects).

Therefore, you need to know the marginal cost of funds before you can determine how much

to invest in projects in your attempt to maximize shareholder wealth.

When we refer to the cost of capital for a firm, we are usually referring to the cost of financing

its assets. In other words, we mean the cost of capital for all the firm’s projects taken together

and, hence, the cost of capital for the average project risk of the firm.

When we refer to the cost of capital of a project, we are referring to the cost of capital that

reflects the risk of that project. So why determine the cost of capital for the firm as a whole?

For two reasons;

First, the cost of capital for the firm is often used as a starting point (a benchmark) for

determining the cost of capital for a specific project. The firm’s cost of capital is adjusted

upward or downward depending on whether the project’s risk is more than or less than the

firm’s typical project.

Second, many of a firm’s projects have risk similar to the risk of the firm as a whole. So the cost

of capital of the firm is a reasonable approximation for the cost of capital of one of its projects

that are under consideration for investment.

A firm’s cost of capital is the cost of its long-term sources of funds: debt, preferred stock, and

common stock. And the cost of each source reflects the risk of the assets the firm invests in. A

firm that invests in assets having little risk will be able to bear lower costs of capital than a firm

that invests in assets having a high risk.

1.1. Definition of cost of capital:

Cost of capital refers to the opportunity cost of making a specific investment. It is the

rate of return that could have been earned by putting the same money into a different

investment with equal risk. Thus, the cost of capital is the rate of return required to

persuade the investor to make a given investment.

The items on the right side of a firm’s balance sheet—various types of debt, preferred

stock, and common equity—are called capital components. Any increase in total assets

must be financed by an increase in one or more of these capital components.

The cost of capital is the return that must be provided for the use of an investor’s funds.

If the funds are borrowed, the cost is related to the interest that must be paid on the

loan. If the funds are equity, the cost is the return that investors expect, both from the

stock’s price appreciation and dividends. From the investor’s point of view, the cost of

capital is the same as the required rate of return. (Frank j Fabozzi and Pamela p.

Peterson, pp. 322)

1.2. CONCEPT OF COST OF CAPITAL

The term cost of capital refers to the minimum rate of return that a firm must earn on its

investments so as to keep the value of the enterprise in fact. It represents the rate of return

which the firm must pay to the suppliers of capital for use of their funds.

1.2.1. Characteristics of cost of capital:

Cost of Capital is really a rate of return; it is not a cost as such.

A firm’s cost of capital represents minimum rate of return that will result in at

least maintaining (If not increasing) the value of its equity shares.

Cost of Capital as a rate of return is calculated on the basis of actual cost of

different components of capital.

It is usually related to long-term capital funds.

In operational terms, Cost of Capital in terms of rate, of return is used as

discount rate, used to discount the future cash inflows so as to determine

their present value and compare it with investment outlay.

Cost of Capital has three components:

a) Return at Zero Risk Level.

b) Premium for Business Risk

c) Premium for Financial Risk.

a) Return at Zero Risk Level: This refers to the expected rate of return when a project

involves no risk whether business or financial.

Purchasing power risk arises due to changes in purchasing power of money.

Money Rate Risk means the risk of an increase in future interest rates.

Liquidity risk means the ability of a supplier of funds to sell his shares/ debentures

bonds quickly.

1.3. SIGNIFICANCE OF COST OF CAPITALThe determination of the firm’s cost of capital is important because

Cost of capital provides the very basis for financial appraisal of new capital expenditure

proposals and thus serves as acceptance criterion for capital expenditure projects.

Cost of capital helps the managers in determine the optimal capital structure of the

firm.

Cost of capital serves as the basis for evaluating the financial performance of top

management.

Cost of capital also helps in formulating dividend policy and working capital policy

Cost of capital can serve as capitalization rate which can be used to determine

capitalization of a new firm.

In addition to the above significance of cost of capital you will find detail here; Importance of

Cost of Capital in Decision Making The concept of cost of capital is a very important concept in

financial management decision making. The concept is however, a recent development and has

relevance in almost every financial decision making but prior to that development, the problem

was ignored or by-passed.

The progressive management always takes notice of the cost of capital while taking a financial

decision. The concept is quite relevant in the following managerial decisions.

(1) Capital Budgeting Decision. Cost of capital may be used as the measuring road for adopting

an investment proposal. The firm, naturally, will choose the project which gives a satisfactory

return on investment which would in no case be less than the cost of capital incurred for its

financing. In various methods of capital budgeting, cost of capital is the key factor in deciding

the project out of various proposals pending before the management. It measures the financial

performance and determines the acceptability of all investment opportunities.

(2) Designing the Corporate Financial Structure. The cost of capital is significant in designing

the firm's capital structure. The cost of capital is influenced by the chances in capital structure.

A capable financial executive always keeps an eye on capital market fluctuations and tries to

achieve the sound and economical capital structure for the firm. He may try to substitute the

various methods of finance in an attempt to minimise the cost of capital so as to increase the

market price and the earning per share.

(3) Deciding about the Method of Financing. A capable financial executive must have knowledge of the

fluctuations in the capital market and should analyze the rate of interest on loans and normal dividend

rates in the market from time to time. Whenever company requires additional finance, he may have a

better choice of the source of finance which bears the minimum cost of capital. Although cost of capital

is an important factor in such decisions, but equally important are the considerations of relating control

and of avoiding risk.

(4) Performance of Top Management. The cost of capital can be used to evaluate the financial

performance of the top executives. Evaluation of the financial performance will involve a comparison of

actual profitability’s of the projects and taken with the projected overall cost of capital and an appraisal

of the actual cost incurred in raising the required funds.

(5) Other Areas. The concept of cost of capital is also important in many others areas of decision

making, such as dividend decisions, working capital policy etc.

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1.4. Purpose of cost of capital

The cost of capital is also used for at least three other purposes: (1) It is a key input used to

calculate a firm’s or division’s economic value added (EVA). (2) Managers estimate and use the

cost of capital when deciding if they should lease or purchase assets. And (3), the cost of capital

is important in the regulation of monopoly services provided by electric, gas, and telephone

companies. These firms are natural monopolies in the sense that one firm can supply service at

a lower cost than could two or more firms. Since it has a monopoly, your electric or telephone

company could, if it were unregulated, exploit you. Therefore, regulators (1) determine the cost

of the capital investors have provided to the utility and (2) then set rates designed to permit the

company to earn its cost of capital, no more and no less (Bringham & Houston pp 456).

1.5. Current status of cost of capital

In recent decades, theoretical breakthroughs in such areas as portfolio diversification, market

efficiency, and asset pricing have converged into compelling recommendations about the cost

of capital to a corporation. By the early 1990s, a consensus had emerged prompting such

descriptions as “traditional...textbook...appropriate,” “theoretically correct,” and “a useful rule

of thumb and a good vehicle.” Beneath this general agreement about cost of capital theory lies

considerable ambiguity and confusion over how the theory can best be applied.

The issues at stake are sufficiently important that differing choices on a few key elements can

lead to wide disparities in estimated capital cost. The cost of capital is central to modern

finance touching on investment and divestment decisions, measures of economic profit,

performance appraisal, and incentive systems. Each year in the US, corporations undertake

more than $500 billion in capital spending. Since a difference of a few percent in capital costs

can mean a swing in billions of expenditures, how firms estimate the cost is no trivial matter.

1.6. DETERMINING THE COSTS OF EACH CAPITAL COMPONENT

The cost of capital is the marginal cost of raising additional funds. This cost is important in our investment decision-making because we ultimately want to compare the cost of funds with the benefits from investing these funds.

Cost of Capital is the cost an organization pays to raise funds (e.g., through bank loans or issuing

bonds), expressed as an annual percentage.

Cost of Borrowing simply refers to the total amount paid by a debtor to secure a loan

and use funds, including financing costs, account maintenance, loan origination, and other

loan-related expenses. A cost of borrowing sum will most likely be expressed in currency

units (e.g. $, £, ¥ or €).

When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Cost of borrowing may include, for instance, interest payments, plus (in some cases) loan

origination fees, loan account maintenance fees, borrower insurance fees, and still other

fees.

Cost of Debt is the overall average rate an organization pays on all its debts, typically

consisting primarily of bonds and bank loans. Cost of debt is expressed as an annual

percentage. Cost of debt is calculated:

The cost of debt is the cost associated with raising one more dollar by issuing debt.

Suppose you borrow one dollar and promise to repay it in one year, plus pay 10 cents to

compensate the lender for the use of her money.

After tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate)

Methods of estimating cost of debt

There are several ways we could estimate the cost of raising an additional dollar of new

debt. We could look at:

1. Yields on recent debt offerings with similar risk.

2. Yields on recent debt offerings made by Du Pont.

3. Yields on outstanding debt of Du Pont.

The Cost of Preferred Stock

The cost of preferred stock is the cost associated with raising one more dollar of capital

by issuing shares of preferred stock. Preferred stock may or may not have a maturity.

Preferred stock without a maturity date is called perpetual preferred stock. The

determination of the cost of preferred equity becomes much more complex for dividend

rates that are not fixed or nearly constant. If the dividend rate is adjusted frequently,

the preferred shares will trade around their par value and the required rate of return

(and hence the cost of capital) will fluctuate as market rates on preferred shares

fluctuate.

The required rate of return on debt is the yield demanded by investors to compensate

them for the time value of money and the risk they bear in lending their money. The

cost of debt to the firm differs from this required rate of return due to:

1. Flotation costs, and

2. The tax benefit from the deductibility of interest expense.

The cost after flotation costs is called the all-in-cost of debt.

The Cost of Common Stock

The cost of common stock is the cost of raising one more dollar of common equity

capital, either internally (from earnings retained in the firm) or externally (by issuing

new shares of common stock). There are costs associated with both internally and

externally generated capital. How can internally generated capital—retained earnings—

have a cost? As a firm generates internal funds, some portion is used to pay off creditors

and preferred shareholders. The remainders are funds owned by the common

shareholders.

Retained funds are not a free source of capital. The cost of internal equity funds is the

opportunity cost of funds of the firm’s shareholders. This opportunity cost is what

shareholders could earn on these funds for the same level of risk. The cost of issuing

common stock is difficult to estimate because of the nature of the cash flow streams to

common shareholders. The change in the price of shares is also difficult to estimate; the

price of the stock at any future point in time is influenced by investors’ expectations of

cash flows further into the future beyond that point. Nevertheless, two methods are

commonly used to estimate the cost of common stock:

1. the dividend valuation model and

2. The capital asset pricing model.

Each method relies on different assumptions regarding the cost of equity; each

produces different estimates of the cost of common equity.

The DVM deals with the expected dividend yield and is based on an assumption that

dividends grow at some constant rate into the future. The CAPM assumes that investors

hold diversified portfolios, so they require compensation for the time value of money

and the market risk they bear by owning the stock

The required rate of return on common stock is more difficult to estimate than the cost

of debt or preferred stock because of the nature of the return on stock: Dividends are

not guaranteed nor fixed in amount, and part of the return is from the change in the

value of the stock. .

Cost of Equity (COE) is a part of a company's capital structure. COE measures the

returns demanded by stock market investors who will bear the risks of ownership. COE is

usually expressed as an annual percentage.

A high cost of equity indicates that the market views the company's future as risky, thus

requiring greater return rates to attract investments. A lower cost of equity indicates just

the opposite. Not surprisingly, cost of equity is a central concern to potential investors

applying the capital asset pricing model (CAPM), who are attempting to balance

expected rewards against the risks of buying and holding the company's stock.

The two most familiar approaches to estimating cost of equity are illustrated here:

Dividend Capitalization Model Approach:

Cost of equity = (Next year's dividend per share + Equity appreciation per share) / (Current market value of stock) + Dividend growth

Capital Asset Pricing Model (CAPM) Approach

Cost of equity = (Market risk premium) x (Equity beta) + Risk-less rate

Cost of Funds: refers to the interest cost that financial institutions pay for the use of

money, usually expressed as per annum percentage.

A Cost of Funds Index (COFI): refers to an established Cost of Funds rate for a

region. In the United States, for instance, a regional COFI might be set by a Federal Home

Loan Bank.

Weighted Average Cost of Capital (WACC)

is the arithmetic average (mean) capital cost, where the contribution of each capital source is

weighted by the proportion of total funding it provides. WACC is usually expressed as an annual

percentage.

A firm's cost of capital from various sources usually differs somewhat between the different sources of capital used. Cost of capital may differ, that is, for funds raised with bank loans, sale of bonds, or equity financing. In order to find the appropriate cost of capital for the firm as a whole, weighted average cost of capital (WACC) is calculated. WACC is not the same thing as cost of debt, because WACC can include sources of equity funding as well as debt financing. Like cost of debt, however, the WACC calculation is usually shown on an after-tax basis when funding costs are tax deductible.

Calculating WACC is a matter of summing the capital cost components, where each is multiplied

by its proportional weight. . For example, in simplest terms:

WACC = (Proportion of total funding that is equity funding) x (Cost of equity)

+ (Proportion of total funding that is debt funding) x (Cost of Debt)

x (1 – Corporate tax rate)

Steps in calculating cost of capital

The cost of capital is determined in three steps:

(1) Determine what proportions of each source of capital we intend to use;

(2) Calculate the cost of each source of capital; and

(3) Put the cost and the proportions together to determine the weighted average cost

of capital.

1.7. FACTORS THAT Affect THE COMPOSITE COST OF CAPITAL

The cost of capital is affected by a number of factors. Some are beyond a firm’s control, but

others are influenced by its financing and investment decisions.

1.7.1. FACTORS THE FIRM CANNOT CONTROL

The two most important factors that are beyond a firm’s direct control are the level of interest

rates and tax rates.

The Level of Interest Rates

If interest rates in the economy rise, the cost of debt increases because firms will have to pay

bondholders more to obtain debt capital. Also, recall from our discussion of the CAPM that

higher interest rates increase the costs of common and preferred equity capital. During the last

decade, inflation, and consequently, interest rates in the United States declined significantly.

This reduced the cost of capital for all firms, encouraging additional investment. Our lower

interest rates also enabled U.S. firms to compete more effectively with German and Japanese

firms, which in the past had enjoyed lower costs of capital than U.S. firms.

Tax Rates

Tax rates, which are largely beyond the control of an individual firm (although firms can and do

lobby for more favorable tax treatment), have an important effect on the cost of capital. Tax

rates are used in the calculation of the component cost of debt. In addition, there are other less

apparent ways in which tax policy affects the cost of capital. For example, lowering the capital

gains tax rate relative to the rate on ordinary income makes stocks more attractive, and that

reduces the cost of equity.

1.7.2. FACTORS THE FIRM CAN CONTROL

A firm can directly affect its cost of capital through its capital structure policy, its dividend

policy, and its investment (capital budgeting) policy.

Capital structure policy

Until now we have assumed that a firm has a given target capital structure, and we used

weights based on that target structure to calculate the WACC. However, a firm can change its

capital structure, and such a change can affect its cost of capital.

The after-tax cost of debt is lower than the cost of equity. Specifically, if the firm decides to use

more debt and less common equity, this change in the weights in the WACC equation will tend

to lower the WACC. However, an increase in the use of debt will increase the riskiness of both

the debt and the equity, and these increases in component costs will tend to offset the effects

of the change in the weights.

Dividend policy

As we indicated earlier, firms can obtain new equity either through retained earnings or by

issuing new common stock, but because of flotation costs, new common stock is more

expensive than retained earnings. For this reason, firms issue new common stock only after

they have invested all of their retained earnings. Since retained earnings is income that has not

been paid out as dividends, it follows that dividend policy can affect the cost of capital because

it affects the level of retained earnings

Investment policy

When we estimate the cost of capital, we use as the starting point the required rates of return

on the firm’s outstanding stock and bonds. Those cost rates reflect the riskiness of the firm’s

existing assets. Therefore, we have implicitly been assuming that new capital will be invested in

assets of the same type and with the same degree of risk as is embedded in the existing assets.

This assumption is generally correct, as most firms do invest in assets similar to those they

currently operate. However, it would be incorrect if the firm dramatically changed its

investment policy. For example, if a firm invests in an entirely new line of business, its marginal

cost of capital should reflect the riskiness of that new business. To illustrate, ITT Corporation

recently sold off its finance company and purchased Caesar’s World, a casino gambling firm.

This dramatic shift in corporate focus almost certainly affected ITT’s cost of capital. Likewise,

Disney’s purchase of the ABC television network changed the nature and risk of the company in

a way that might also influence its cost of capital. The effect of investment decisions on capital

costs is discussed in detail in the next section

1.8. ADJUSTING THE COST OF CAPITAL FOR RISK

As noted above, the cost of capital is a key element in the capital budgeting process. As you will

see in the next two chapters, a project should be accepted if and only if its estimated return

exceeds its cost of capital. For this reason, the cost of capital is sometimes referred to as a

“hurdle rate”—project returns must “jump the hurdle” to be accepted.

As we saw in Chapter 6, investors require higher returns for riskier investments. Consequently,

a company that is raising capital to take on risky projects will have a higher cost of capital than

a company that is investing in safer projects. Figure 1 illustrates the trade-off between risk and

the cost of capital. Firm L is a low-risk business and has a WACC of 8 percent, whereas Firm H is

exposed to high risks and has a WACC of 12 percent. Thus, Firm H will accept a typical project

only if its expected return is above 12 percent. The corresponding hurdle rate for Firm L’s

typical project is only 8 percent. It is important to remember that the cost of capital values at

points L and H in Figure 1 represent the overall, or composite, WACCs for the two firms, and,

thus, only represent the hurdle rate of a “typical” project for each firm. Different projects

generally have different risks. Indeed, the hurdle rate for each project should reflect the risk of

the project itself, not the risks associated with the firm’s average project as reflected in its

composite WACC. For example, assume that Firms L and H are both considering Project A. This

project has more risk than a typical Firm L project, but less risk than a typical Firm H project. As

shown in Figure 1, Project A has a 10.5 percent expected return. At first, we might be tempted

to conclude that Firm L should accept Project A because its 10.5 percent return is above Firm L’s

8 percent WACC, while Firm H should turn down the project because its return is less than H’s

12 percent WACC. However, this would be wrong. The relevant hurdle rate is the project’s

WACC, which is 10 percent, as read from the WACC line in Figure 1. Since the project’s return

exceeds its 10 percent cost, both firms should accept Project A.

Figure 1. risk and the cost of capital

Rate of return (%) Acceptance region WACC

12 ………………………………………..……………………..

10.5 …………………………….…… A rejection region 10.0 ………………………………….. 9.5 …………………………………..B 8.0 ………………… L

risk 0 risk Low risk average risk high

Next, consider Project B. It has the same risk as Project A, but its expected return is 9.5 percent

versus its 10 percent hurdle rate. Both firms should reject Project B. However, if they based

their decisions on their overall WACCs rather than on the project-specific cost of capital, Firm L

would accept Project B because its return is above L’s 8 percent WACC. However, if Firm L’s

managers accept Project B, they would reduce their shareholders’ wealth, because the project’s

return is not high enough to justify its risk. Applying a specific hurdle rate to each project

insures that every project is evaluated properly (Bringham & Houston pp. 475)

References

Bringham and Houston, fundamental of financial management 12th edition 2009, south

western.

Frank j. Fabozzi and Pamela p. Peterson , financial amanegement and analysis 2nd edition.

2003 john wiley and sons, inc. new jersey

James c. Van Horne, John M. Wachowicz, fundamentals of financial management 13rd

prentice hall, 2009 london

Jonathan reuvid the corporate finance handbook 3rd edition royal and sun alliance 2002

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