COST OF CAPITAL

Meaning “ The Cost of capital to a firm is the minimum return, which the suppliers of capital require. It is a price of obtaining capital and it is a compensation for time and risk”.

What types of long-term capital do firms use?Long-term debtPreferred stockCommon equity

Capital ComponentsCapital components are sources of

funding that come from investors.Accounts payable, accruals, and deferred

taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.

Project cost & Firm’s cost The project’s cost is the minimum acceptable rate of return on funds committed to the project.

The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects.

It is useful as a standard for:- evaluating investment decision- designing a firm’s debt policy and- appraising the financial performance of top Mgmt.

Significance of Cost of Capital

The Concept of Opportunity Cost of Capital The opportunity cost is the rate of return

foregone on the next best alternative investment opportunity of comparable risk.

Risk Difference:Investors will require different rates

of return on various securities since they have risk different.

Required rate of return

Risk Free Security

Government Bonds

Corporate BondsPreference Shares

Equity Shares

Return

Risk

Computation of Cost of Capital

(A) Specific source of finance(B) Weighted Average cost of capital

(WACC)

(A) Specific source of finance:

1) Cost of Debt: Is the rate of interest payable on debt.

Cost of Debt

(i) Debenture at Par: (before tax)i

Kdb = ---------P

where, Kdb = before cost of debt i = Interest P = Principle

(ii) Debt raised at Premium or Discount:i

Kdb = --------- NP

NP = Net proceeds

Cost of Debt

(iii) After tax cost of debt: i

Kda = ------ (1-t) OR Kda = Kdb(1-t) NP

where, Kda = After tax cost of debt

(iv) Cost of Redeemable debt (at par): The debt is issued and redeemed after a certain period at par during the life time of a firm.

i + (P – NP)/n Kdb = -------------------

(P + NP) / 2 P = proceeds at par NP = Net proceeds

(v) Cost of Redeemable debt (at premium): The debentures are to be redeemed at a premium i.e., the amount more than the face value after the expiry of a certain period.

Cost before Tax:

I + (RV – NP)/n Kdb = -----------------------

(RV + NP) / 2

RV = redeemableNP = Net proceedsn = no. of years debt is redeem Cost of debt after Tax: Kda = Kdb(1-t)

(2) Cost of Preference capital:

A fixed rate of dividend is payable on preference shares. (i) Cost of PC at par: D D = DividendKps = --------- P = PS capital proceeds P

(ii) If PS issued at premium or discount or when cost of floatation cost are incurred: D Kps = -------- NP

(iii) Redeemable PS :

D + (MV – NP)/n Kps = -------------------

(MV + NP) / 2 MV = Maturity Value NP = Net proceeds

(3) Cost of Equity Share Capital: Is the ‘maximum rate of return that the company must earn as equity financed portion of its investments in order to leave unchanged the market price of its stock’

Different methods for cost of equity:

(i) Dividend yield method or dividend/price ratio method:Cost of equity is the ‘discount rate that equates the present value of expected future dividends per share with the Net proceeds (or Current market price) of a share.

D

Ke = --------- NP or MP

NP = Net proceeds per year MP = Market price per share

(ii) Dividend yield plus growth method:

When the dividend of the firm are expected to grow at a constant rate & the dividend pay-out ratio is constant.

D1 Do (1+g)Ke = --------- + G = -------------- + G NP NPD1 = Expected dividend per share

at the end of the year G = Rate of growth in dividends

NP = Net proceeds per share D0 = Previous year’s dividend

In case of cost of existing equity share capital is to be calculated, the NP should be changed with MP (Market Price)

D1Ke = --------- + G MP

MP = Market price (current)

Cost of Equity using Capital Asset Pricing Model (CAPM): The values of an equity share is a function of cash inflows expected by the investors and the risk associated with cash inflows. It is calculated by discounting the future stream of dividends at the required rate of return called ‘the capitalisation rate’.

Required rate of return depends upon the element of risk associated with investment in shares.

CAPM derives the;Relationship between the expected return and risk

of individual securities and portfolios in the marketRisk and Return are the two important

characterstics of every investment.

CAPM …….

- A portfolio risk does not fall below a certain level, irrespective of how wide diversification is, because

Total Risk = Unsystematic + Systematic Risk Risk

Unsystematic (Diversifiable / Business) risk: It arises like (i) a development of a new

product, (ii) emergence of a new competitor. It is also called as business risk

CAPM …….

Systematic risk (Undiversifiable / Market) risk: Risk of a stock represents that portion of its

risk which is attributable to economy-wide factors like growth rate of GDP, interest rate, inflation rate, currency exchange, natural disasters (flood, earth quake) etc.

These market risk affects all firm at a greater degree. Investor cannot avoid the risk arising from them.

CAPM …….

“The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio”

Measurement of Beta requires the recognition of two points;

A rate of return for ‘risk-free’ investment. This rate of risk is given a Beta value of Government Treasury Bills are often sited as ‘risk-free’ investments with a Beta value of zero.

A rate of return for investments carrying the market rate of risks. This rate of risk is given a Beta value of 1.

Risk premium = ßi ( Market return of a diversified portfolio – risk

free return ) OR

ßi (Rm – Rf)Cost of equity, acc. to CAPM will ;

Ke = Rf + ßi (Rm – Rf)Where,

Ke = Cost of equity capital Rf = Risk free rate of return ßi = Beta co-efficient of the firm’s portfolio Rm = Market return of a diversified portfolio

CAPM …….

- The return on risk-free investment (i.e, ß=0) is 6%

- The return on securities carrying ‘market risk’ (i.e., b = 1) is 10% p.a.

- Then the premium for a Beta of 1 is 4% p.a. ( 10% - 6% )

Suppose, - A security with a Beta value of 0.7 would offer

a return of ;= 6% + (0.7 x 4%) = 6% + 2.8% = 8.8% p.a.

Example:

(4) Cost of Retained Earnings: Retained earnings accrue to a firm only because of some sacrifice made by the shareholders in not receiving the dividends out of the available profits. “Cost of retained earnings is the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities”.

DKr = ------ + G

NP Kr = Cost of retained earnings D = Expected dividend NP = Net proceeds of share value G = Rate of growth

To make adjustment in the cost of retained earning for tax and costs of purchasing new securities, the following formulae may be adopted;

(B) Weighted Average Cost of Capital (WACC):

Is the average cost of the costs of various sources of financing. It is also known as composite cost of capital. The weights may be given on the basis of book value or market value weights. Usually market value weights are preferred, because it represent real or true value to the investment.

Kw = Cost of specific X Weight, specific source of finance proportion of finance

Weighted Marginal cost of capital:

Is the cost of additional funds to be raised, called marginal cost of return. It is the weighted average cost of new capital calculated by using the marginal weights.

Steps: 1. Estimate the cost of each source of financing

for various levels of its use through an analysis of current market conditions.

Steps…..

2. Identify the levels of total new financing at which the cost of the new components would change, given the capital structure policy of the firm. These levels, called ‘breaking points’, TFj

BPj = ------- Wj

Where BPj = breaking point on account of financing source j TFj = total new financing from source j at the breaking point Wj = proportion of financing source j in thecapital structure

Steps….

3. Calculate the WACC for various ranges of total financing between the breaking points.

4. Prepare the weighted marginal cost of capital schedule which reflects the WACC for each level of total new financing.

Cost of Capital in practice:

Nature of Industry PracticeElectrical : Profitability based on equity

dividend rate is 10%Tea : Three sources equity,debt & reserves

Ke = last yr. dividend paidKd= different int. ratesKr = taken as 18%

Shipping : Normal Debt-Equity ratio 3:1Ke = 18% Kd = 8% Avg=10.5%

Leasing : Currently Debt – Equity 5:1Pre tax Kd – 18%Pre tax dividend Ke = 40%Avg . 21.7%