Cost Capital

CHAPTER 13

CONTENTS Introduction Opportunity Cost of Capital WACC – Preview Cost of Debt

Cost of Redeemable Debt Cost of Perpetual Debt Post Tax Cost of Debt

Cost of Preferred Capital

Cost of Capital

2

Chapter 13

CONTENTS Cost of Equity

Dividend capitalization Approach Earning Based Approach CAPM Based Approach Cost of External Equity

Assigning Weights Marginal Cost of Capital WACC as Discount Rate & Risk Pure Play Approach-

Unlevering & Relevering Beta Factors Affecting Cost of Capital

Cost of Capital

3

Chapter 13

Cost of CapitalIntroduction

Cost of capital is an extremely important input requirement for capital budgeting decision.

Without knowing the cost of capital no firm can evaluate the desirability of the implementation of new projects.

Cost of capital serves as a benchmark for evaluation.

Cost of Capital

4

Chapter 13

Opportunity Cost Of Capital

The basic determinant of cost of capital is the expectations of the suppliers of capital.

The expectations of the suppliers of capital are dependent upon the returns that could be available to them by investing in the alternatives.

The returns provided by the next best alternative investment is called opportunity cost of capital. This could serve as basis for cost of capital.

Cost of Capital

5

Chapter 13

WACC Besides opportunity cost the cost of capital must also

consider1. Business risk 2. Financial risk

There are predominantly two suppliers of capital1. Debt 2. Equity

WACC is a composite figure reflecting cost of each component multiplied by the weight of each component.

WACC = we x re + wp x rp + wd x rd

we = Proportions of equity re = Cost of equitywp = Proportion of pref capital rp = Cost of preference capitalwd = Proportion of Debt rd = Cost of debt

Cost of Capital

6

Chapter 13

Cost Of Perpetual Debt

Cost of debt is determined by equating the cash flows of the instrument to its market price.

Cost of perpetual debt, rd is

Most debts are repayable in the specified time interval. Is debt perpetual?

Where a firm decides to maintain a fixed component of debt by replacing one debt with another, it becomes the case of perpetual debt.

Chapter 13Cost of Capital

7

ot

ddt

o PC=ror r

C=P

Cost Of Debt

3d

3d

2dd )r1(

105)r1(6.0x11

)r1(6.0x11

r16.0x1195


8

Cost of redeemable debt is determined by equating the cash flows of the instrument to its market price.

Cost of redeemable debt is

Post tax cost of debt = rd (1-T)

For a bond paying 11% coupon annually and redeemable after three years at Rs 105 that sells for Rs 95 the cost of debt is 10.12% given by

∑N

1tN

dt

d

to )r(1

R)r(1

CP

Cost Of Debt

ISSUE EXPENSES To mobilise debt one has to incur

floatation cost which increases the cost of debt

WHICH DEBTS TO CONSIDER While computing the cost of debt the

claims of the suppliers of long-term debt are only considered.

Cost of Capital

9

Chapter 13

Cost Of Preference Capital

Preference capital is in between pure debt and equity that explicitly states a fixed dividend.

The dividend has claim prior to that of equity holders.

But unlike interest on the debt the dividend on preference capital is not tax deductible.

Cost of preference capital, rp is determined by equating its cash flows to market price. No adjustment for tax is required.

Cost of Capital

10

N

1t N

pt

p

to )r(1

R)r(1

DP

Chapter 13

Cost Of Equity Capital

Cost of equity capital is most difficult to determine because It is not directly observable There is no legal binding to pay any

compensation, and It is not explicitly mentioned.

Does this mean that cost of equity is zero?

Cost of Capital

11

Chapter 13

Types Of Equity Capital

Equity capital is classified as1) Internal: the profits that are not distributed but

retained by the firm in funding the growth, is referred as internal equity, and

2) External: equity capital raised afresh to fund, is called external equity

And external equity may have cost differential on account of

Floatation cost associated with raising fresh equity, Inability to deploy external equity instantaneously, Underpricing of fresh issue.

Cost of Capital

12

Chapter 13

ApproachesCost Of Equity

Cost of equity is determined by Dividend capitalization approach CAPM based approach.

Both approaches are driven by market conditions and measure the cost of equity in an indirect manner.

The price to be used in any of the model is the market determined.

Cost of Capital

13

Chapter 13

Dividend Capitalization

Approach Dividend capitalization approach determines the

cost of equity by equating the stream of expected dividends to its market price.

For constant dividend cost of equity is equal to dividend yield.

For constant growth of dividend at ‘g’

Cost of Capital

14

Yield DividendPDr or ; r

DP Then

D......DDD . i.e constant is dividend if

...................)r(1

D)r(1

D)r(1

D)r(1

DP

0e

e0

321

4e

43

e

32

e

2e

10

g+PD=r or ; g-r

D=P then

...................)r+(1g)+(1D+

)r+(1g)+(1D+

)r+(1g)+(1D+)r+(1

D=P

01

ee

0

4e

31

3e

21

2e

1e

10

Chapter 13

Cost Of Equity PE Approach

01

ee1

0

e1

e1

0

PE=r or r

E=P k;=b whenAnd

bxk-rb)-x(1E= g-r

D=P


15

Earnings based approach, as manifested by Dividend capitalization Approach equates the value as

Under the special case when the firm uses the earnings at the same rate as expected by shareholders earnings based approach measures the cost of equity as

bxk-rb)-x(1E= g-r

D=P e1

e1

0

Cost Of EquityCAPM Approach

CAPM based determination of cost of equity considers the risk characteristics that dividend capitalization approach ignores.

Determinants of cost of equity under CAPM based approach include three parameters; the risk free rate, rf

the market return, rm and

β, as measure of risk

Cost of Capital

16

Chapter 13

Cost Of EquityCAPM Approach

β,the primary determinant of risk governs the cost of equity.

re = rf + β x (rm – rf)

Cost of Capital

17

Cost of Equity re

rm

Risk Premium(rm-rf)β

rf

β = 1 Risk, β

Chapter 13

Cost of EquityDDM Vs CAPM

Approach CAPM based determination of cost of equity

is regarded superior as it relies on the market information and

incorporates risk

it need not know the dividend policy.

Dividend capitalization approach does not consider risk of the dividend

has assumption of constant pay-out ratio.

Cost of Capital

18

Chapter 13

Cost Of Internal And External

Equity There are three major differences in the

INTERNAL and EXTERNAL equity Existence of flotation cost Under utilisation of external equity Under pricing of fresh capital

If floatation cost is 5% of the issue price and cost of internal equity determined either through DDM or CAP-M is 16% then the cost of fresh equity shall be 16.84% (16/0.95).

Cost of Capital

19

g+PD

f)-(11=f)-(1

equity internal of Cost= equity external for r 01

e

Chapter 13

Assigning Weights

After cost of each component is determined they need to be multiplied by the respective proportions to arrive at WACC.

The proportions may be based on

1) marginal

2) book value or

3) market value

The weights based on the target capital structure are most appropriate though the current capital structure may not conform.

Cost of Capital

20

Chapter 13

Book Value Vs Market Value

The weights for computation of WACC can either be based on

book values or market values

Though book value weights appear convenient and practical it lacks conviction ignoring current trends.

Use of market value based weights is technically superior reflecting the current expectations of investors.

Cost of Capital

21

Chapter 13

Marginal Cost Of Capital

WACC as discount rate, implies that acceptance of projects do not alter the existing capital structure.

When project is large compared to the existing operations, the capital structure as well as the cost of each component would more likely increase.

Lenders tend to raise cost with the quantum, so could be the case with equity suppliers.

In such cases WACC is inappropriate as hurdle rate. Marginal (incremental) cost of capital is more appropriate.

Cost of Capital

22

Chapter 13

Optimal Capital Budget

In practice Marginal Cost of Capital must be used in determination of the optimal capital budget.

Marginal cost of capital governs the value addition.

Incremental benefits must exceed incremental cost.

The capital expenditure level at which incremental benefits are equal to the incremental cost is “Optimal capital budget”.

Cost of Capital

23

Chapter 13

WACC And Risk The discount rate for the project must be appropriate

to its risk.

In most cases WACC adequately represents the risk since most projects selected by the firms belong to the line of activity.

Where project has substantially different risk profile blind use of WACC as discount rate may cause

1. erroneous acceptance of riskier project due to lower discount rate or

2. erroneous rejection of less risky project due to higher discount rate.

Cost of Capital

24

Chapter 13

Pure Play ApproachAdjusting For Risk

Risk-adjusted WACC must be used as discount rate for the cash flow.

Most popular method to incorporate such risk is called a pure-play approach,

identifying a firm that most resembles the risk profile of the new project.

beta of the firm is adjusted for its leverage to find an all equity beta, called unlevering and then

re-adjusting for the proposed capital structure of the project, called relevering.

The value of β so arrived is used in calculating the WACC.

Cost of Capital

25

Chapter 13


Cost of Capital

26

Chapter 13

Equity of ValueMarket EDebt of ValueMarket Dbeta observed thefirm; leveredfor equity of Betaβdebt of Betaβ firm unlevered theof Betaβ

Where

.ED

EβED

Dββ

L

du

Ldu

ET)-D(1Eβ

ET)-D(1T)-D(1ββ Ldu

D/E} x T)-(1+{1β=β or

E+T)-(1 x DEβ=β

Lu

Lu


While using beta of the pure play firm it must be unlevered for the financial leverage to reflect only the business risk and then re-levered for the proposed capital structure of the project.

Assume that observed beta of Pure-play firm is 1.2. Besides reflecting the business risk the observed beta also represents the financial risk. This has to be unlevered i.e. converted into β of equity as if it were all equity financed.

If the debt equity ratio based on market values is 1:5 and its marginal tax rate is 30% the beta of pure play firm is

Cost of Capital

27

Chapter 13

0526.15/17.01

20.1D/E} x T)-(1{1

ββor

ET)-(1 x D

Eββ

Lu

Lu

x

Re-Levering This now needs to be relevered with the proposed

financing pattern of the project. This can be done by incorporating debt equity ratio (D*/E*) and tax rate (T*) of the proposed project.

If new project is proposed with debt equity ratio of 2:5 and with tax rate of 35% the beta of the project is


28

1.32620.65x2/5)1.0526(1}/ED x )T-(1{1ββ ***U

*L

WACC After incorporating the business risk and leverage in its beta,

the cost of equity may be calculated using CAP-Mre = rf + β x (rm – rf)

Using the risk free return rf of 6% and market return of rm of

16% the cost of equity is 19.262%.re = rf + β x (rm – rf) = 6 + 1.3262 x (16 – 6) = 19.262%

Finding WACC, the discount rate; The WACC is given by WACC = we x re + wd x rd

The cost of equity is arrived at by using 19.262%. Assuming the pre-tax cost of debt at 8%, WACC for with debt at 40% of equity (debt equity ratio at 2:5) would be 5/7 x 19.26% + 2/7 x 8% x (1 – 35%) = 15.244%


29

Documents

Cost Capital