COST OF CAPITAL
COST OF CAPITALCONCEPTCost of capital is the minimum required
rate of return, a project must earn in order to cover the cost of
raising funds being used by the firm in financing of the
proposal.It is the minimum return which the firm must earn on the
proposals in order to break-even in order to satisfy the
expectations of its investors.In other words, cost of capital is
the rate of return, a firm must earn in order to attract the
supplier of funds to make available the funds to the
firm.Importance and SignificanceThe importance and significance can
be stated in terms of the contribution it makes towards the
achievement of the objective of the maximisation of the wealth of
the shareholders.It means that if the firms return is more than the
cost of capital, then the investor is receiving the rate of return
from the firm and vice-versa.Moreover, when the cost of capital is
used as a discount rate in capital budgeting it helps in accepting
only those proposals whose rate of return is more than the cost of
capital and hence results in increasing the value of the
firm.Factors affecting cost of capitalRisk free interest rate : the
risk free interest rate is the interest rate on risk-free and
default-free securities. It consists of 2 components:Real interest
ratePurchasing power risk premium2. Business Risk : it is the risk
associated with the firms promise to pay interest and dividends to
its investors. 3. Financial Risk : the likelihood that the firm is
not being able to meet its fixed financial charges4. Other
consideration: the investors may like to add a premium with
reference to other factors such as liquidity or marketability of
the investment. therefore, K = If + b + fTherefore, the cost of
capital of the firm may also be defined as the opportunity cost of
the supplier of funds(investors).Relationship between risk and
required rate of returnIt is based on the premise that the
investors must be compensated for undertaking the additional risk
otherwise, they will not supply the funds.Diagram: Measurement of
cost of capitalIt refers to the process of determining the cost of
funds to the firm.If this decision is taken wrongly, it will affect
the liquidity as well as the profitability of the firm.Assumptions
to be undertaken: The business risk of the firm is unaffected by
the proposal being evaluated at the cost of capital that means the
degree of responsiveness of the EBIT to sales revenue is
constantFinancial risk of the firm remains unchanged whether a
proposal is accepted or not
Costs of Bonds and DebenturesIt depends on:Current level of
interest rateDefault risk of the firmTax advantages associated with
the debtTherefore, it is defined as the returns expected by
potential investors of the firmDebt is of 2 typesPerpetual
debtRedeemable debt
Cost of perpetual debtKi = I/B0Ki = cost of capital after debtI
= annual interest payableB0 = net proceeds = FV + Pm D F(on face
value or issue price whichever is higher)Tax adjustment = ki (1 t)
cost of capital of redeemable debtKd = I(1 t) +(RV B0)/N / (RV +
B0)/2Ques. ABC Ltd. Issues 15% debentures of face value of Rs.100
each, redeemable at the end of 7 years. The debentures are issued
at a discount of 5% and the floatation cost is estimated to be 1%.
Find out the cost of capital of debentures given that the firm has
50% tax rate.Intrinsic value of the bondIt is the real worth of the
bond calculated as: = (coupon rate/ desired rate) * 100
Ques. A 10% Rs.100 debenture which will mature after 5 years is
available in the market for Rs.90. X expects a rate of return of
12% from his investments. Should he buy this debenture from the
market?Cost of Preference CapitalIt can be of 2 types:Redeemable
Irredeemable Cost of Redeemable Preference shares = PD(1 + t) + (Pn
Po)/N (Pn + Po)/2cost of Irredeemable Preference shares Kp = PD(1 +
t)/Po ; Po = net proceeds on issue of preference sharesQues. A Ltd.
issues 15% preference shares of the face value of Rs.100 each at a
floatation cost of 4%. Find out the cost of capital of preference
share if The preference shares are irredeemableThe preference
shares are redeemable after 10 years at a premium of 10%Cost of
equity capitalDepends on the type of growth in dividendsZero growth
in dividendsConstant growth in dividendsZero growth in dividends:Ke
= D1/P0D1 = expected dividend after year 1Po = current market
price
Constant growth in dividendsPo = Do(1+g)/ ke-gg = growth in
dividends
