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CHAPTER 7 COST OF CAPITAL

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•The cut off rate for determining estimated future cash proceeds of a project and eventually deciding whether the project is worth undertaking or not

•The opportunity cost of an investment• 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. The cost of capital determines how a company can raise money maybe through a stock issue, borrowing, or a mix of the two

DEFINITIONS

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The cost of capital is given as: Kc= (1-δ) Ke+ dKd Where, Kc = Weighted cost of capital for the firm δ = Debt to capital ratio, D / (D + E) Ke = Cost of equityKD = after tax cost of debt D = Market value of the firm's debt, including bank loans and leases E = Market value of all equity (including warrants, options, and the equity portion of convertible securities)

DEFINITIONS

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Basic aspects of the definitionCost of Capital is not a cost as such-it is the rate of return firm needs to earn from its project It is the minimum rate of return- which will at least maintain the market value of sharesIt comprises of three components- The expected normal rate of return at zero-level riskPremium for Finance risk Premium for Business risk (K=ro+ b +f)

DEFINITIONS

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 Significance of the cost of capital:As an Acceptance criterion in Capital Budgeting – the acceptance or rejection of the project is decided by taking into consideration the cost of capitalAs a determinant of capital mix in capital structure decision- the objective of maximizing the value of the firm and minimizing the cost of capital results in optimal capital structureAs a basis for evaluating the financial performance- the profitability is compared to projected overall cost of capital and the actual cost of capital of funds raised to finance the project. As a basis for taking other financial decisions- Like Dividend policy, capitalization of profits, making the rights issue, working capital

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 Classification of cost:Historical and future cost: HC are Book cost related to past. Future cost is related to the future. Specific and composite cost: SC refers to cost of a specific source of capital, composite cost is combined cost of various sources of capital. Explicit cost and implicit cost: EC is the discount rate which equates the PV of cash. Implicit cost is also known as opportunity cost, it is the cost foregone in order to take up a particular project. Average cost and marginal cost: AC is the combined cost of various sources of capital; MC is the average cost of capital which has to be incurred to obtain additional funds required by the firm.

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 Problems in determination of COC:Conceptual controversies regarding the relationship between the cost of capital and the capital structure: few are of the opinion that a firm can minimize the WACC and increase the value of the firm by debt financing. Others believe that the cost of capital is unaffected by the changes in the capital structure.Problems with regard to considering the various costsProblems in computing the cost of equity: it is a difficult task to calculate the expected rate of return on equity.Problems in computing cost of retained earnings:

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COST OF EQUITYDividend Price Approach: Cost of equity capital is computed by dividing the current dividend by average market price per share. This dividend price ratio expresses the cost of equity capital in relation to what yield the company should pay to attract investors.

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COST OF EQUITYEarning/ Price Approach: The advocates of this approach co-relate the earnings of the company with the market price of its share. Accordingly, the cost of ordinary share capital would be based upon the expected rate of earnings of a company.

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COST OF EQUITYDividend Price + Growth Approach: Earnings and dividends do not remain constant and the price of equity shares is also directly influenced by the growth rate in dividends. Where earnings, dividends and equity share price all grow at the same rate, the cost of equity capital may be computed as follows:Ke = (D/P) + G Where, D = Current dividend per share P = Market price per share G = Annual growth rate of earnings of dividend. 

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COST OF EQUITYEarnings Price + Growth Approach: This approach is an improvement over the earlier methods. But even this method assumes that dividend will increase at the same rate as earnings, and the equity share price is the regulator of this growth as deemed by the investorKe = (E/P) + G Where, E = Current earnings per share P = Market share price G = Annual growth rate of earnings 

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COST OF EQUITY Realized Yield Approach: According to this approach, the average rate of return Realized in the past few years are historically regarded as ‘expected return’ in the future. The yield of equity for the year is:  

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COST OF EQUITY Capital Asset Pricing Model Approach (CAPM): the cost of equity capital can be calculated under this approach as: Ke = Fro + b (Mr. − Fro) Where, Ke = Cost of equity capital For = Rate of return on security b = Beta coefficient Mr. = Rate of return on market portfolio 

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The following consideration should be kept in mind while maximising the value of the firm in achieving the goal of the optimal capital structure:

If ROI > the fixed cost of funds, the company should prefer to raise the funds having a fixed cost, such as, debentures, Loans and PSC. It will increase EPS and MV of the firm. If debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax. It should also avoid undue financial risk attached with the use of increased debt financing The Capital structure should be flexible 

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Factors affecting capital structure

INTERNAL Financial leverage Risk Growth and stability Retaining control Cost of capital Cash flows Flexibility Purpose of finance Asset structure 

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EXTERNALSize of the company Nature of the industry Investors Cost of inflation Legal requirements Period of finance Level of interest rate Level of business activity Availability of funds Taxation policy Level of stock prices Conditions of the capital market  

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Factors influencing the dividend decisionStability of earnings Financing policy of the firm Liquidity of funds Dividend policy of competitive firmsPast dividend rates Debt obligation Ability to borrow Growth needs of the company Profit rates Legal requirements Policy of controlCorporate taxation policy Tax position of shareholders Effect of trade policyAttitude of the investor group