Introduction
Introduction
The concept of " cost of capital " is very important in
financial management . 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 .
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 may
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 firmthat 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 a
company's capital structure is an indication of financial
fitness.
Cost of Capital is the expected rate of return that a capital
would earn had it been invested in another project/security of
equivalent risk. I.e. it is the cost of companys funds.If the
project risk is similar to that of companys average risk, then
companys weighted average cost of capital is used for the basis of
evaluation. But if there is a difference in the risk of firm and
risk of division/project, then RISK-ADJUSTED-DISCOUNT-RATE approach
should be adopted. The company must at least earn this rate of
return in order to cover the cost of funds generated forfinancing
the companys securities. The investors would supply further funds
only if they are compensated adequately for the risk taken for
investing in Companys shares and bonds. I.e. the rate of return
must be higher than the cost of capital. The various capital
budgeting decisions are also taken by the firm on the basis of cost
of capital of the projects.
The cost of various capital sources varies from company to
company, and depends on factors such as its operating history,
profitability, credit worthiness, etc. In general,newer enterprises
with limited operating histories will have higher costs of capital
than established companies with a solid track record, since lenders
and investors will demand a higher risk premium for the former.
Every company has to chart out its game plan for financing the
business at an early stage. The cost of capital thus becomes a
critical factor in deciding which financing track to follow debt,
equity or a combination of the two. Early-stage companies seldom
have sizable assets to pledge as collateral for debt financing, so
equity financing becomes the default mode of funding for most of
them
Companies strive to attain the optimal financing mix, based on
the cost of capital for various funding sources. Debt financing has
the advantage of being more tax-efficient than equity financing,
since interest expenses are tax-deductible and dividends on common
shares have to be paid with after-tax dollars. However, too much
debt can result in dangerously high leverage, resulting in higher
interest rates sought by lenders to offset the higher default
risk.
Corporate financial managers need to know the cost of capital in
order: To make well-informed choices about capital structure and
what kinds of new capital to raise,which means that they need to
know the costs of the alternatives. To keep informed about the
expectationsof providers of capital so that theycanact to satisfy
these expectations and encourage investors to keep their capital in
the company. In particular,in making capital investment
decisions,to invest in projects that give the return that
shareholders require, and avoid those that do not. We shall first
consider the costs of the different individual types of capital,
before looking at the cost of the capital structure of the company
as a whole.Significance Of Cost Of CapitalCost of capital is
considered as a standard of comparison for making different
business decisions. Such importance of cost of capital has been
presented below.1. Making Investment Decision
Cost of capital is used as discount factor in determining the
net present value. Similarly, the actual rate of return of a
project is compared with the cost of capital of the firm. Thus, the
cost of capital has a significant role in making investment
decisions.
2. Designing Capital structureThe proportion of debt and equity
is called capital structure. The proportion which can minimize the
cost of capital and maximize the value of the firm is called
optimal capital structure. Cost of capital helps to design the
capital structure considering the cost of each sources of
financing, investor's expectation, effect of tax and potentiality
of growth.
3. Evaluating The PerformanceCost of capital is the benchmark of
evaluating the performance of different departments. The department
is considered the best which can provide the highest positive net
present value to the firm. The activities of different departments
are expanded or dropped out on the basis of their performance.
Formulating Dividend PolicyOut of the total profit of the firm,
a certain portion is paid toshareholders as dividend. However, the
firm can retain all the profit in the business if it has the
opportunity of investing in such projects which can provide higher
rate of return in comparison of cost of capital. On the other hand,
all the profit can be distributed as dividend if the firm has no
opportunity investing the profit.Therefore, cost of capital plays a
key role formulating the dividend policy.
Capital Budgeting DecisionsIt facilitatescapital budgeting
decisions. Any capital expenditure decision depends on the cost of
capital. Selection of the project depends on the present value of
expected returns. If it is equal to or more than the cost of
invetment,it is accepeted otherwise rejected. The expected cash
flow is discounted at he cut off rate which is the cost of capital.
Cost of capital decides the acceptability of investment
propasals.
Classification of cost of capital
Thecost of capitaldefine as the minimum rate of return a firm
must earn on itsinvestmentin order to satisfy investors and to
maintain its market value. It is the investors required rate of
return.Cost of capitalalso refers to thediscount ratewhich is used
while determining thepresent value of estimated future cash flows
The majorclassification of cost of capitalare:Historical Cost and
future Cost: Historical Cost represents the cost which has already
been incurred for financing a project. It is calculated on the
basis of the past data. Future cost refers to the expected cost of
funds to be raised forfinancing a project. Historical costs help in
predicting the future costs and provide an evaluation of the past
performance when compared with standard costs. Infinancial
decisionsfuture costs are more relevant than historical
costs.Specific Costs and Composite Cost: Specific costs refer to
the cost of a specificsource of capitalsuch asequity
shares,Preference shares,debentures,retained earningsetc. Composite
cost of capital refers to the combined cost of varioussources of
finance. In other words, it is aweighted average cost of capital.
It is also termed as overall costs of capital. While evaluating a
capital expenditure proposal, the composite cost of capital should
be as an acceptance/ rejection criterion. When capital from more
than one source is employed in the business, it is the composite
cost which should be considered for decision-making and not the
specific cost. But where capital from only one source is employed
in the business, the specific cost of those sources of capital
alone must be considered.Average Cost and Marginal Cost:
Averagecost of capitalrefers to theweighted average cost of
capitalcalculated on the basis of cost of each source of capital
and weights are assigned to the ratio of their share to total
capital funds. Marginal cost of capital may be defined as the Cost
of obtaining another dollar of new capital. When a firm raises
additional capital from only one sources (not different sources),
than marginal cost is the specific or explicit cost. Marginal cost
is considered more important incapital budgetingandfinancing
decisions. Marginal cost tends to increase proportionately as the
amount of debt increase.Explicit Cost and Implicit Cost: Explicit
cost refers to the discount rate which equates the present value of
cash outflows or value ofinvestment. Thus, the explicit cost of
capital is the internal rate of return which a firm pays for
procuring the finances. If a firm takes interest free loan, its
explicit cost will be zero percent as no cash outflow in the form
of interest are involved. On the other hand, the implicit cost
represents the rate of return which can be earned by investing the
funds in the alternative investments. In other words, the
opportunity cost of the funds is the implicit cost. Implicit cost
is the rate of return with the best investment opportunity for the
firm and its shareholders that will be forgone if the project
presently under consideration by the firm were accepted. Thus
implicit cost arises only when funds are invested somewhere,
otherwise not. For example, the implicit cost ofretained earningsis
the rate of return which the shareholder could have earn by
investing these funds, if the company would have distributed these
earning to them as dividends. Therefore, explicit cost will arise
only when funds are raised whereas implicit cost arises when they
are used.Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company
hascontrol over:
Capital Structure PolicyAs we have been discussing above, a firm
has control over its capital structure, targeting an optimal
capital structure. As more debt is issued, the cost of debt
increases, and as more equity isissued, the cost of equity
increases.
2. Dividend PolicyGiven that the firm has control over its
payout ratio, the breakpoint of the MCC schedule can be changed.
For example, as the payout ratio of the company increases the
breakpoint between lower-costinternally generated equity and newly
issued equity is lowered.
2. Investment PolicyIt is assumed that, when making investment
decisions, the company is making investments with similar degrees
of risk. If a company changes its investment policy relative to its
risk, both the cost of debt and cost of equity change.
Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company
has no control over:
Level of Interest RatesThe level of interest rates will affect
the cost of debt and, potentially, the cost of equity. For example,
when interest rates increase the cost of debt increases, which
increases the cost ofcapital.
2. Tax Rates:Tax rates affect theafter-tax cost of debt. As
taxrates increase, the cost of debt decreases, decreasing the cost
of capital.
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 financialmanagement 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 in determination of cost
of capital can briefly be summarized as follows:
Controversy regarding the dependence of cost of capital upon the
method and level of financingThere 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 Millerthe
firms total cost of capital argue that 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 ofmuch practical
utility.
2. Computation of cost of equityThe determination of the cost of
equity capital is another problem. In theory, the cost of equity
capitalmay be defined as the minimum rate of return that accompany
must earn on that portion of its capitalemployed, 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.
Computation of cost of retained earnings anddepreciation funds
The cost of capital raised through retained earnings and
depreciation funds 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.
. Future costs versus historical costsIt 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 weightsThe 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
singlegiven 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.COMPONENTS OF COST OF CAPITAL
Proper capital budgeting decisions also require an estimate of
the Cost of Capital. Many other types of decisions, including those
relating to leasing, to bound re- funding, and to working capital
policy also require estimates of the cost of capital. Maximising
the value of a firm requires that the cost of all inputs, including
capital be minimised, and to minimise the cost of capital we must
be able to calculate it.Capital is a necessary factor of
productions, and like any oth- er factor, it has a cost. Capital
can be provided from different source which are as follows:
1. Debt Capital2. Preference Share Capital3. Equity Share
Capital4. Retained Earnings
Cost of Debt
Meaning and definition of Cost of Debt
The effective rate that a company pays on its current debt. This
can be measured in either before- or after-tax returns; however,
because interest expense is deductible, the after-tax cost is
seenmost often. This is one part of the company's capital
structure, which also includes the cost of equity.Investopedia
explains 'Cost Of Debt' A company will use various bonds, loans and
other forms of debt,so this measure is useful for giving an idea as
to the overall rate being paid by the company to use debt
financing. The measure can also give investors an idea as to the
riskiness of the companycompared to others, because riskier
companies generally have a higher cost of debt.To get the after-tax
rate, you simply multiply the before-tax rate by one minus the
marginal tax rate (before-tax rate x (1-marginal tax)). If a
company's only debt were a single bond in which it paid5%, the
before-tax cost of debt would simply be 5%. If, however, the
company's marginal tax rate were 40%, the company's after-tax cost
of debt would be only 3% (5% x (1-40%)).
Cost of debt generally refers to the effective paid by a company
on its debts. The cost of debt can be calculated in either before
or after tax returns. However, the interest expense being
deductible, theafter tax cost is considered very often. Moreover,
the cost of debt is one part of capital structure of the company
and also includes the cost of equity. As explained by Investopedia,
the cost of debt measure is useful for giving an idea about the
overall interest rate being paid for he us of debt financing by the
company since a company uses a variety of bonds, loans, and other
debt forms. Besides, the cost of debt is also helpful in providing
the investors with an idea about the companys riskiness as compared
to that of the others. This is for the reason that companies with a
higher risk involve a higher cost of debt.
How to Calculate the Cost of Debt
Collect information. For personal debt, long term notes are
required along with equity lines of credit, mortgage and credit
cards is required. For corporate debt, bond certificates of the
companyare required.
Compute the weighted average cost of debt on corporate debt or
personal debt. Form a spreadsheet with Column A as Type of Debt,
Column B as Cost of Debt, and Column C as the Amountassociated with
each type of debt. Also, if there are numerous interest rates
consigned to one debt, they should be separated.
3. Create another spreadsheet to estimate the cost of debt for
corporate debt by the use of long term debt.
4. Include a column D to both the spreadsheets as Weight. To
compute the weight, take the total of Column C or the amount of
debts. In column D, to obtainWeight, divide column C by the totalof
Column C thus obtaining the average of each dollar amount. The
weights should figure to 1.00.
Multiply the interest rate (column B) by the weighting (column
D). This would be called Column E (Weighted rate). Add this column
to obtain the WAC of debt.
6. Calculate the after tax rate. Thereafter, take the rate in
Step 5 and multiply it with (1-marginal tax) thus reaching the
after tax cost of debt.
Cost Of Equity
Cost of equity refers to a shareholder's required rate of return
on an equity investment . It is the rate of return that could have
been earned by putting the same money into a different investment
withequal risk. That return is composed of the dividends paid on
the shares and any increase (or decrease) in the market value of
the shares. Cost of Equity is a measure used in analysis and
valuation which tells you the rate of return required by an
investor (including dividends) to incentivize them to take the risk
of investing in the company.If the return offered is too low, then
the cost of equity is said to be too high for the investor and they
will look elsewhere for returns.Generally, it is expected to be
equal to the rate of return that is expected on equity-supplied
capital. The basic formula for calculating the cost of equity
capital involves a few simple figures that are easily extracted
from the financial data relevant to the period cited.In order to
determine the cost of equity capital, it is necessary to know three
specific figures. First, the current market value associated with
the shares must be determined. Second, the dividend growth rate as
it relates to the period under consideration must be calculated.
Last, the number of dividends per share should be identified. Once
these three pieces of information are in hand, it is possible
quickly calculate the current figure.The basic formula begins with
dividing the dividends per share by the current market value. The
resulting number is added to the dividend growth rate. After adding
the two figures, the cost of equity capital as it relates to the
shares is revealed, and can be reported to the shareholders.How it
works/Example:The cost of equity is the rate of return required to
persuade an investor to make a given equity investment . In
general, there are two ways to determine cost of equity.First is
the dividend growth model:Cost of Equity = (Next Year 's Annual
Dividend / Current Stock Price)+ Dividend Growth RateSecond is the
Capital Asset Pricing Model (CAPM) :r a = r f + B a (r m -r f
)where:r f = the rate of return on risk-free securities (typically
Treasuries )B a = the beta of the investment in questionr m = the
market 's overall expected rate of returnWhy it Matters:Cost of
equity is a key component of stock valuation. Because an investor
expects his or her equity investment to grow by at least the cost
of equity, cost of equity can be used as the discount rate used to
calculate an equity investment's fair value . Both cost of equity
calculation methods have advantages and disadvantages.The dividend
growth model is simple and straightforward, but it does not apply
to companies that don't pay dividends, and it assumes that
dividends grow at a constant rate over time. The dividend growth
model also quite sensitive to changes in thedividend growth rate,
and it does not explicitly consider the risk ofthe investment.CAPM
is useful because it explicitly accounts for an investment's
riskiness and can be applied by any company, regardless of its
dividend size or dividend growth rate.However, the components of
CAPM are estimates, and they generally lead to a less concrete
answer than the dividend growth model does. The CAPM method also
implicitly relies on past performance to predict the future.
Cost of Preference Capital
Cost of preference share capital is apparently the dividend
which is committed and paid by the company. This cost is not
relevant for project evaluation because this is not the cost at
which further capital can be obtained. To find out the cost of
acquiring the marginal cost, we will be finding the yield on the
preference share based on the current marketvalue of the preference
share.Preference share is issued at a stated rate of dividend on
the face value of the share. Although the dividend is not mandatory
and it does not create legal obligation like debt, it has
preference of payment over equity for dividend payment and
distribution of assets at the time of liquidation. Therefore,
without paying dividend to preference shares, they cannot pay
anything to equity shares. In that scenario, management normally
tries to pay regular dividend to the preference
shareholders.Broadly, preference shares can be of two types.Cost of
Redeemable Preference Shares:These shares are issued for a
particular period and at the expiry of that period, they are
redeemed and principal is paid back to the preference shareholders.
The characteristics are very similar to debt and therefore the
calculations will be similar too. For finding cost of redeemable
preference shares, following formula can be used.Cost of
PreferenceShare Formula:Here, preference share is traded at say P
with dividend payments D and principal repayment P. The cost of
debt is designated by K . K can be determined by solving above
equation.Cost of Irredeemable Preference Shares:These shares are
issued for the life of the company and are not redeemed. Cost of
irredeemable preference shares can be calculated as follows:Here,
preference share is traded at say P with dividend payments D. The
cost of debt is designated by K . K can be determined by solving
above equation.
Weighted Average Cost of Capital
The weighted average cost of capital (WACC) refers to the rate
that a company is expected to pay on average to all its capital
providers to finance its assets. A company raises capital from
various sources namely: common equity, preferred equity, straight
debt, convertible debt,exchangeable debt, warrants,each category of
capital is proportionately weighted. options, pension liabilities,
executive stock options, governmental subsidies etc. While
calculating WACC, each category of capital is proportionately
weighted.WACC is commonly used by companies internally to arrive
atmeaningful investment decisions. It is often used as a hurdle
rate for capital investment. It also acts as a measure to find the
optimal capital structure for the company and is a key factor in
choosing the mixture of debt and equity used to finance a firm.WACC
is calculated by multiplying the cost of each source of capital for
a projectwhich may include loans, bonds, equity, and preferred
stock by its percentage of the total capital, and then adding
themtogether.In other words, the cost of capital is an opportunity
cost.Formula.
For a company which has two sources of finance, namely equity
and debt, WACC is calculated using the followingformula:Cost of
equity is calculated using different models for example dividend
growth model and capital asset pricing model. Cost of debt is based
on the yield to maturity of the relevantinstruments. If no yield to
maturity can be calculated we can base the estimate on the
instrument's current yield, etc. The weights are based on the
target market values of the relevant components. But if no market
values are available we base the weights on book values.Some small
business firms only use debt financing for their operations. Other
small startups only use equity financing, particularly if they are
funded by equity investors such as venture capitalists . As these
small firms grow, it is likely that they will use a combination of
debt and equity financing. Debt and equity make up the capital
structure of the firm, along with other accounts on the right-hand
side of the firm's balance sheet such as preferred stock. As
business firms grow, they may get financing from debt sources,
common equity (retained earnings or new common stock) sources, and
even preferred stock sources. In order to calculate an accurate
cost of capital for the firm, we must calculate the proportion that
debt and equity is of the business firm's capital structure and
weight the cost of debt and the cost of equity by that percentage
when calculating cost of capital. Then, we sum the weighted costs
of capital to get the weighted average cost of capital.Why it
Matters:It's important for a company to know its weighted average
cost of capital as a way to gauge the expense of funding future
projects.The lower a company's WACC, the cheaper it is for a
company to fund new projects. A company looking to lower its WACC
may decide to increase its use of cheaper financing sources.Uses of
WACC:Weighted average cost of capital is used in discounting cash
flows for calculation of NPV and other valuations for investment
analysis. WACC represents the average risk faced by the
organization. It would require an upward adjustment if it has to be
used to calculate NPV of project which are more risk than the
company's average projects and a downward adjustment in case of
less risky projects.Tricks of the Trade:To accurately calculate
WACC, you need to know the specific ratesof return required for
each source of capital. For example, different sources of finance
may attract different levels of taxation, or interest, which should
be accounted for. A true WACC calculation could therefore be much
more complex than the example provided here.Critics of WACC argue
that financial analysts rely on it too heavily, and that the
algorithm should not be used to assess risky projects, where the
cost of capital will necessarily be higher to reflect the higher
risk.Investors use WACC to help decide whether a company represents
a good investment opportunity. To some extent, WACC represents the
rate at which a company produces value for investorsif a company
produces a return of 20% and has a WACC of 11%, then the company
creates 9% additional value for investors. If the return is lower
than the WACC, the business is unlikely to secure investment.
Although the WACC formula seems simple, different analysts will
often come up with different WACC calculations for the same company
depending on how they interpret the companys debt, market value,
and interest rates.SUMS
Q.1 M/S Chitra Gupta Ltd. Provides you the following specific
cost of capital along with indicated B.V. And M.V. Weights.
Capital TypeCostB.VM.V
Equity shares
15% Prefrence Shares
14% Debentures18%
?
?0.5
0.2
0.30.58
0.17
0.25
Calculate the weighted average cost of capital using book Value
and market Value Weights.
Calculate the weighted average cost of capital if the company
intended to raise the needed funds using 50% long term debt 15%
through equity shares and retained earnings and balance by way of
prefrence shares.
Assume tax at 50%.
Solution:-
Kp = Dividend/ Market price**100
0.03/0.2*100
= 15%
Kd = Interest (1-t)/ Net proceeds*100
0.042 (1.50%)/0.3*100
= 7%
KwBook ValueCost
Equity
Prefrence
Debenture
0.5
0.2
0.318%
15%
7%0.09
0.03
0.021
1.000.141
Kw = 0.141/1.00*100
= 14.1%
At Market Value
KwMarket ValueCostWeight
Equity
Prefrence
Debenture0.58
0.17
0.2518%
15%
7%58
17
2510.44
2.55
1.75
1.0014.74
Jigna Ltd. Issues 10% redeemable debentures of rs. 1,00,000. The
company is in 55% tax bracket. Calculate cost of debt before and
after tax if the debentures are issued at par, at 10% discount and
at 10% premium.
Solution:-
At par
Kd = Interst (1-t)+(Redeemable value-Net proceeds)n/ (
Redeemable value + Net proceeds)n
=10,000(1-55)*100/1,00,000*100
= 4.5%
At Discount
=10,000(1-55)/90,000*100
= 5%
At premium
=10,000(1-55)/1,10,000*100
=4.09%
