Cost_of_Capital.pdf

8/17/2019 Cost_of_Capital.pdf

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Chapter - 6

The Cost of Capital

Sitaram Dhakal , Kathm andu Col lege of Management[KCM]


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Capital

• Investment supplied by the investors to the corporation.

• Fund raised by corporation from the investors.• Sources of capital are debt, equity, preferred stock and

retained earnings.

• Job of financial manager is to raise fund for a corporation,

maximize the wealth of corporation, meet the interest ofinvestors who supplied capital in the corporation.

• Corporation pays cost of debt to the debtors ( in the form ofcoupon), cost of equity to the equity holders ( in the form of

dividend and capital gain) cost of preferred stock ( in the formof fixed dividend) and cost of retained earning ( in the firm ofgrowth dividend and capital gain)


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Capital Structure• Capital structure is the mix of the long term sources of funds

used by the firm.

• The primary objective of capital structure decision is tomaximize the market value of the firm through appropriatemix of long term sources of the funds.

• For example:

• The above example is and specimen of capital structure

showing the mix of 40% debt, 10% preferred stock and 30%retained earning and the rest i.e. 20 % is common stock.

Source s of Capital Amount [Rs] Proportion

DebtPreferred stock

Retained EarningCommon StockTotal capital

Rs. 400,000Rs. 100,000

Rs. 300,000Rs. 200,000Rs. 1,000,000

40%10%

30%20%100%


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Cost of capital• Minimum return that must be generated by a corporation from

the use of fund supplied by investors in each source of

capital.• Opportunity cost of capital is given by the following formula:

where I o

is the capital supplied by investors in period 0 (itrepresents a net cash inflow to the firm), C

t are returns

expected by investors (they represent cash outflows to thefirm) and k is the required rate of return or the cost of capital.

• The opportunity cost of retained earnings is the rate of return,which the ordinary shareholders would have earned on thesefunds if they had been distributed as dividends to them.


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Cost of Capital• The project’s cost of capital is the minimum

required rate of return on funds committed tothe project, which depends on the riskiness of its cash flows.

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

• WACC= (Kd) (1-t) (Wd) + (Wps) (Kps) + (Wr ) (Kr )+ (We) (Ke)


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Significance Merits/Use/Adv./Importance

• Investment decisions,

• Finance Decision

• Dividend Decision• Appraising the financial performance of

top management.


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Demerits/ Disadv. /Limitation

• Constant Business Risk

• Constant Financial Risk

• Constant tax rate• Constant dividend Policy


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Cost of Component Capital

• Components are:

oDebts i.e. bonds, debentures etc.

oPreferred Stocks

oEquity capital & Retained earnings


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Bonds /Debt/Debenture: A long term security or long-term promissory note, promising to

pay interest and principal, on specific date, to the holders of thebond.

Issuer pays a fixed interest payment each period until the bondmatures. This payment is known as the coupon. At maturity, the

borrower pays back the bondholder the bond’s face value(principal).

Against Future receipts investors pay certain value at present.

For e.g. “Rs. 1,000 par, 8%, 5-year annual coupon bonds areissued by NIC ASIA at Rs. 950.”


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Features of Bonds

Par Value

Maturity

Coupon Payments

Call Provision

Indenture

Trustee


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Par Value

• The stated face value of the bond, which ispaid at maturity.

• Called maturity value or face value orprincipal.

• Rs. 1,000 per bond, although multiple of Rs.1,000 is also used.

• It is used to calculate the annul coupon

payments.


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Maturity

• The specified date on which the principal

amount (par value) is repaid.

• It includes original maturity and remaining

maturity.

• Remaining years to maturity will be declined

year to year.

• Remaining years to maturity is effective to

calculate value of bond and rate of return.


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Coupon Payments

• A fixed amount of interest paid at the endof each period (year or six month).

• Coupon payment is divided by the par

value is the coupon interest rate.

• For e.g. Rs. 1,000 par, 10% bond has

Rs. 100 coupon payments and 10 %coupon rate.


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Call Provision

The right to call the bonds prior to maturity to an issuer to protectfrom interest rate risk.

Call period and call price can be used to calculate the value of the bond and return of the bond.

Call price is par value plus call premium.

Call period is always less than remaining years to maturity.


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Indenture

• A legal document or contract that contains

terms and conditions of bond issue.

• Includes details of debt issue, description of

property pledged (if any), the methods of

principal repayment, restrictions (or

covenants’) placed on the firm by the lenders,

rights and responsibilities of both borrowerand lender.


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Cost of Debt

• For Perpetual Bond

• For Pure Discount Bond


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Bond with maturity for annual coupon

Here, Kd can be calculated using trial and error approach


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Bond with Maturity and semi annual Coupon

Here, Semi-kd can be calculated using trial and error approach


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Callable Bond: Yield to call is the cost of debt

To calculated YTC, yield to call, call period & call price can be used,


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Tax adjustment for cost of Debt is made bycalculating cost of debt,

Note - If flotation cost are given than it isreduced to find net proceeds, NP, of the bond

After tax cost of debt

E l 1


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Example - 1Calculate the after tax cost of debt of the following assuming 35percent tax bracket:

a.Rs. 1000 par, 10-year perpetual bond selling at Rs. 1250.

b.Rs. 1000 par, 10-year zero coupon bond selling at Rs. 350.

c.Rs. 1000 par, 10%, 10-year annual coupon bond selling at Rs.950.

d.Rs. 1000 par, 9%, 12-year semi-annual coupon bond selling atRs. 1050.

e.Rs. 1000 par, 12%, 15-year annual coupon bond selling at Rs.1090. The bond has call provision to make a call at the end of 5

year at 10 percent premium.

f.Rs. 1000 par, 9%, 12-year semi-annual coupon bond selling atRs. 1100. The bond has call provision to make a call at the end of4 year at 9 percent premium.


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Thank You


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The Cost of Capital• Cost of preferred stock

• Cost of equity and retained earning


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Preferred Stock

• The long-term source of financing.

• An intermediate position between long-term debt and common stock.

• Claim on assets comes after that of creditors but before that of commonstockholders.

• Income preferred stock dividend is distributed after payment of interest

but before distribution of common stock dividend.• A hybrid form of financing with combined futures of both debt (and bond)

and common stock.

• May be perpetual and redeemable.

• Perpetual preferred stock does not have maturity period and pays

coupon forever.• Redeemable preferred stock has stated maturity and pays fixed dividend

and repay the par at the end of maturity.

• Valuation and calculating returns of preferred stock is similar with bonds.


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Cost of Preferred Stock

For redeemable or callable preferred stock.

E l 2


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Example - 2Calculate the after tax cost of the following assuming 35 percenttax bracket:

a.Rs. 100 par, 10-year perpetual preferred stock selling at Rs.120.

b.Rs. 100 par, 11%, 10-year preferred stock selling at Rs. 90.

c.Rs. 100 par, 12%, 15-year preferred stock selling at Rs. 109.

The bond has call provision to make a call at the end of 5 year at15 percent premium.


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Common Stock • Common stock holders won’t receive fixed divided from their

investment.• The valuation on common stock is similar to the valuation of other

securities such as bonds and preferred stocks.

• The value of a share of common stock is equal to the present valueof all future benefits it is expected to provide.

• Valuation of a share of common stock is more difficult than thevaluation of bond due to the lack of fixed dividend and par valuerepayment and maturity.

• Investors expect dividends after the observation of past dividendsand expect value of security to be received at the end of holding

period.• As per investors expectation, stock may be classified zero growth,

constant growth and non-constant and supernormal growth.

C f E i


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Concept of Equity:

Concept of stocks or shares or equity A security issued by a company to raise equity capital.

The major sources of long-term (permanent) capital.

Funds provided by equity are used to finance major portion of the firm’s fixedassets such as land and building, plant and machinery, vehicle, etc.

No fixed dividend.

No maturity.

Equity holders are real owner of the corporation.

They enjoy from right to right to right share, right to dividend, right to vote.

Residual claim.

Includes common stock and preferred stock.


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Cost of internal equity retained earning

1. Div idend d iscount model:

a. For zero growth stock:

b. For constant or perpetual growth:


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Where,g = constant growth rate i.e. % increase in

DPS, MPS & EPS.

‘g’ can be calculated as using following equations:


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c. For non-constant or supper normal growth:

• There are different growth rates, higher growths are supper growth rates, constantgrowth at the end of maturity or terminal

date is constant growth i. e. gn and theending period of higher growth rate ismaturity period i. e. n.

• The cost of equity can be calculated usingtrial and error approach as below:


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The value of stock would be:


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2. Capital assets pricing model:

• Under CAPM, Ke can be calculated as:

3. Bond Yield Plus Risk Premium Approach


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D. Cost of new/marginal/external equity

Example 3


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Example - 3The earnings, dividends, and stock price of Carpet to

Technologies Inc. are expected to grow at 7 percent per year

in the future. Carpet's common stock sells for $23 per share,

its last dividend was $2.00, and the company will pay a

dividend of $2.14 at the end of the current year.

a.Using the discounted cash flow approach, what is its cost ofcommon equity?

b.If the firm’s beta is 1.6, the risk -free rate is 9 percent, and

the average return on the market is 13 percent, what will be

the firm’s cost of common equity using the CAPM approach?

c.If the firm’s bonds earn a return of 12 percent, what will k,

be using the bond yield plus risk premium approach?

Example 4


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Example - 4The Bouchard Company’s EPS was $6.50 in

2002 and $4.42 in 1997. The company pays out40 percent of its earnings as dividends, and thestock sells for $36.

a. Calculate the past growth rate in earnings.

b. Calculate the next expected dividend per share,D1. Assume that the past growth rate willcontinue.

c. What is the cost of retained earnings, ks for theBouchard Company?


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Thank You


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Weighted average Cost of Capital, WACC

• The following steps are involved for calculating the firm’s WACC: – Calculate the cost of specific sources of

funds – Multiply the cost of each source by itsproportion in the capital structure.

– Add the weighted component costs to

get the WACC. – Calculate using the following equation.


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Factors affecting WACC

• The level of interest rates

• Tax rates

• Capital structure policy• Dividend Policy

• Investment Policy


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Weighted average Cost of Capital, WACC

E l 6


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Example - 6

Percy Motors has a target capital structure of40 percent debt and 60 percent equity. Theyield to maturity on the company’s outstandingbonds is 9 percent and the company’s tax rateis 40 percent. Percy’s CFO has calculated the

company’s WACC as 9.96 percent. What is thecompany’s cost of common equity?

Example 7


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Example - 7

The Manx Company was recently formed to manufacture anew product. It has the following capital structure in market

value terms:Debentures $ 6,000,000Preferred stock 2,000,000

Common stock (320,000 shares) 8,000,000

$16,000,000

The company has a marginal tax rate of 40 percent. A study of

publicly held companies in this line of business suggests that the

required return on equity is about 17 percent. (The CAPM

approach was used to determine the required rate of return.) The

Manx Company’s debt is currently yielding 13 percent, and its preferred stock is yielding 12 percent. Compute the firm’s present

weighted average cost of capital.

Example 8


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Example - 8

The capital structure of the S. Hotel, consists of,

(i) 9% coupon, 20,000 bond of Rs.1000 each, 20 years

maturity, currently selling at a discount of 10%.(ii) 12%, 100,000 preferred stock of Rs.100 each, selling atRs.110 each.

(iii) 500,000 common stock of Rs.50 each, selling at per,

expected dividend Rs.2.50 per share and growth rate isexpected to be 8%.

(iv) The retained earning balance is Rs.4000,000, withbrokerage charge of 7%.

The corporate tax rate of the Hotel is 50% and the majorityof shoulders personal tax liability is 25%.

Required: a) Calculate the cost of each source of capital

b) Calculate the weighted average cost of capital.


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Thank You

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Cost_of_Capital.pdf