Cost of Capital

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Copyright by R. S. Pradhan All rights reserved.

WELCOME TO

CHAPTER 8:THE COST OF CAPITAL


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CHAPTER 8: THE COST OF CAPITAL

It is the minimum rate of return requiredfroman investment to maintain or increase the value

of the firm in the market place.

It is not really a costas such, it is a required

return on new capital projects. It is a hurdle rateor cutoff pointfor new proposals.

Which of the following projects be chosen?

Project A - 30%

Project B - 28%Project C - 26%

Project D - 24%

Project E - 22%


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If COC is 25 percent, choose projects A,B & C. Even if the project is financed by debt or equity alone,

the cost of capital should be calculated as weightedaverage or composite costof the various types ofcapital.

The weighted average approach assumes that thedebt has one cost, preferred stock has another, &common stock a third, and, therefore, the overallrequired returnis weighted averageof the individual

components of capital structure.Cost of Capital Components:1. Debt2. Preferred3. Common Equity

4. WACCBefore-tax or after-tax capital costs? Most firms incorporate tax effects in the cost of

capital. Therefore, focus is on after-tax costs. Only cost of debt is affected.

Dividends are not tax deductible.


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Should we focus on historical (embedded) costs

or new (marginal) costs?

The cost of capital is used primarily to makedecisions which involve raising and investingnew capital. So, the firm should focus on

marginal costs.Component Cost of Debt

Interest is tax deductible, so

kd = kb (1 - T) = 10% (1 - 0.40) = 6%.Flotation costs are small & ignored.


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Whats the cost of preferred stock? Vps=Rs.113;

10% dividend; Par=Rs.100; Floatation cost=Rs.2.

0.09 = 9%111

10 Rs.113 - Rs.2(Rs.100)0.1 xps

Vps

Dkps

Flotation costs for preferred are significant, soare reflected. Use net price.

Preferred dividends are not tax deductible, so

no tax adjustment.


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Two ways of raising common equity?

Retained earnings (cost of RE). External equity (cost of ext. equity)Why is there a cost for retained earnings? It is an opportunity cost of retained earnings.

Investors could invest in their own profitableopportunities, & earn a return.

Three ways to determine cost of equity, ke1. CAPM: ke= kRF+ (kM- kRF) = kRF+ (RPM)

RP = risk premium2. DCF: ke= (D1/P0)+ g3. Own-Bond-Yield-Plus-Risk Premium:

ke= kd+ RP

Cost of common stock


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1. CAPM approach, ke?Given: kRF=4%, KM=11.5%, =1.2Ke = kRF + (kM - kRF )

= 4%+ (11.5% - 4%)1.2 = 13%2. DCF approach, ke?Given: D0= Rs.10; g = 5%, P0= Rs.150

D1 D0 (1+g) Rs.10(1.05)

Ke= ------ + g =------------- + g =------------------- + 0.05P0 P0 Rs.150=0.07+0.05 = 0.12 = 12%

3.Own-bond-yield-plus-risk-premium approach,Ke?(Given: kd=6%, RP=5%.)ke= kd+ RP= 6.0% + 5.0% = 11.0%- This RP is not the same as RP of CAPM.- Produces one more estimate of ke. Usefulcheck.

Average = (13%+12%+11%)/3 =12%


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Assume target or optimal capital structure is 30percent debt, 10percent preferred stock, & 60

percent equity. kd= 6%, kps=9%, ke=12%. Whatsthe WACC? Tax =40%.

WACC = wdkd+ wpskps+ wceke

= 0.3(6%) + 0.1(9%) + 0.6(12%)

= 1.8% + 0.9% + 7.2% = 9.9%.Calculation of WACCCapital Prop./Weight AT Cost Wtd. CostDebt 0.3 0.06 0.018Pref. 0.1 0.09 0.009Equity 0.6 0.12 0.072

Total 1.0 0.099WACC = 9.9%.


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Some additional considerations

Cost of debt is constant up to a certain

limit, after which, it increases at an increasing

rate with the increase in leverage. Tax=50%.

(D/TA,%) (kb) kd= kb(1T) kd10% 10% 5%

20% 10% 5%

30% 10.8% 5.4%

35% 11% 5.5%

40% 13% 6.5%

50% 16% 8% Leverage (TD/TA)


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Optimal or target capital structureS.no. Cap.str. % total Cost, % WACC1. Debt 10 5 0.5

Equity 90 12.3 11.1/11.62. Debt 20 5 1.0

Equity 80 12.75 10.2/11.23. Debt 30 5.4 1.6

Equity 70 13.29 9.3/10.9

4. Debt 35 5.5 1.9Equity 65 13.5 8.3/10.25. Debt 40 6.5 2.6

Equity 60 15.51 9.3/11.96. Debt 50 8.0 4.0

Equity 50 18.0 9.0/13.0

Keincreases curvilinearly because:Smaller the size of common stock issue, higherwould be floatation cost.

Increase in debt means increase in equity

capitalization rate.


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A f te r ta x c os t o f ca p i ta l , %

3 5 %

1 0 .7 %

L e v e r ag e ( D e bt/T A , % )

k e

k O

k d

Optimal capital structure is given bythe lowest point in Kocurve.


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Marginal cost of capital

The moment there is a change incomponent cost of capital, WACC will change.

The new WACC is known as MCC.Suppose:Earnings avail. to stockholders: Rs. 59mLess dividends paid 27mRetained earnings 32m Now suppose the firm wants to undertake a

project costing Rs.45.7m.

What would be WACC? How big is the project we can undertake withcurrent RE?

Assume optimal or target capital structure is29% debt, 1% preferred stock, & 70% equity.


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If kb=11%, T=46%, kps=11%, kd= kb(1-T) = 0.11(1-.46) =5.94%,

Div.Yld. Or D1/Po=10%, Po= Rs. 100, g=5%. ke=D1/Po+g=10%+5%=10/100+5%=15%.Alsoknown as cost of RE or internal equity.

Capital Target cap str. ATCost Wtd. costDebt 0.29 Rs.13.2m 5.94 1.72Preferred 0.01 Rs. 0.5m 11.00 0.11Common 0.70 Rs. 32.0m 15.00 10.50

1.00 Rs. 45.7m 12.33% Retained earnings are just enough to provide

equity portion of capital. There is no need to go for external financing.

Hence WACC = 12.33% If the project cost is less or morethan

Rs.45.7m, what would be the MCC?


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If the cost of the project is Rs.100m instead ofRs.45.7m, retained earnings are not enough. Thefirm needs to go for external equity, and needs to

incur floatation cost. If float. cost is 10%, ke=10/90+5% =16.11%. Also

known as cost of external equity.Capital Target cap str. ATCost Wtd. costDebt 0.29 Rs. 29m 5.94 1.72Preferred 0.01 Rs. 1m 11.00 0.11Ret. earn. 0.32 Rs. 32m 15.00 4.8Ext. eq. 0.38 Rs. 38m 16.11 6.12

1.00 Rs.100m 12.75%

Retained earnings are not enough to provideequity portion of capital. There is a need to go for external financing. Break has occurred in MCC schedule. New cost of

capital is known as MCC.

Hence WACC or MCC would increase to 12.75%.


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Now suppose, after undertaking Rs. 45.7m orRs.100m project, there is another projectcosting Rs.100m. What would be the MCC?

The retained earnings are already exhausted.We need to go for external equity to provide

equity portion of capital there by incurringfloatation cost.

It will increase cost of equity.

Increase in cost of equity will increase WACC.Thus we say that there is an increase in MCC,i.e., Cost above break.


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Suppose,

Capital Target cap str. ATCost Wtd. costDebt 0.29 Rs. 29m 5.94 1.72

Preferred 0.01 Rs. 1m 11.00 0.11

Common 0.70 Rs. 70m 16.11 11.28

1.0 Rs. 100m 13.11%

There is a need to go for external financing.Hence WACC = 13.11%.

The break would occur whenever there is achange in component cost of capital.


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Break in MCC Retained earnings

Or = ------------------------------New capital Percent equity

Rs. 32 million

=---------------------- = Rs. 45.7 million0.70

Cost below break = 12.33% Cost above break = 13.11%


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Factors affecting WACCControllable & uncontrollable: Level of interest rates.If rises, WACC

increases.

Tax rates:If tax rate increases, WACC

decreases.

Capital structure policy: more debt meanslower WACC.

Dividend policy: If dividend increases, WACCincreases due to external equity.

Investment policy: If the firm undertakes morerisky project, WACC would increase.


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Some problem areas in COC

Privately owned firms Small businesses

Measurement problems

Costs of capital for projects of differing risks

Capital structure weightsSolve problems: Chap.8

Self-test problems: SP 1,2,4 (Correction:

Change D1=Rs.16.05 instead of Rs. 20), 7 & 9.

Problems:P1, 7, & 9.

Home assignment: P12 & 13 (Correction:

Change net price of external equity from Rs. 96 to

Rs.180).

QUIZ *** Thanking you ***

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Cost of Capital