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8/13/2019 Financial Risk and Relationship Between Cost of Capital
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Cost of capital andLeverage
Presented By: Suhas Chavan
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Cost of Capital
The cost of capital is the rate of return the company
has to pay to various suppliers of funds in thecompany.
There are variations in the costs of capital due to the
fact that different kinds of investment carry differentlevels of risk, which is compensated for, by different
levels of return on the investment.
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Elements of Cost of Capital
The cost of capital consists of the following elements:
Cost of Equity (KE)
Cost of Retained Earnings (KR)Cost of Preferred capital (KP)
Cost of Debt (KD)
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Cost of Equity
The cost of equity may be defined as theminimum rate of return that a company must
earn on the equity financed portion of an
investment project so that market price of the
shares remain unchanged.
It is a permanent source of funds.
The main objective of the firm is to maximize
the wealth of the equity shareholders.
If the companys business is doing well the
ultimate beneficiaries are the equity
shareholders.
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Computationof Cost of Equity
Dividend Yield MethodThe discount rate that equates the present value of all
expected future dividends per share with the net proceeds
of the sale (or the current market price) of a share.
Dividend Growth Model
An allowance for future growth in dividend is added to the
current dividend yield.
Price Earning MethodThis method takes into consideration the Earnings per share
(EPS) and the market price of share.
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Dividend Yield Method
It is based on the assumption that the market value ofshares is directly related to the future dividends on theshares.
Another assumption is that the future dividend per share
is expected to be constant and the company is expected toearn at least this yield to keep the shareholders content.
Emphasizes future dividends to be constant.
It does not follow any growth rate.
But in reality, a shareholder expects the return from hisinvestment to grow over a time.
This approach has no relevance to the company.
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Dividend Yield Methodcontd.
Where,
KE= Cost of equity
D1 = Annual dividend per share
PE = Ex-dividend per share
E
E
P
DK
1
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Dividend Growth Model
It is recognized that the current market price
of a share reflects expected future dividends.
Also called as Gordon Dividend Growth
Model.
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Dividend Growth Model contd.
Where,D1 = Current dividend per Equity share
PE = Market price per Equity share
g = Growth in expected dividend
gP
D
KE
E
1
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Price Earning Method
This method takes into consideration the Earningsper share (EPS) and the market price of share.
Assumption that the investors capitalize the
stream of future earnings of the share need not bein the form of dividend and also it need not bedisbursed to the shareholders.
In calculation of cost of equity share capital, theearnings per share is divided by the currentmarket price.
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Price Earning Method contd.
Where,
E = Current earnings per share
M= Market price per share
M
E
KE
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Cost of Retained Earnings (KR)
The retained earnings is the major sources of Finance.
The equity shareholders of the company are entitled to
these funds.
As long the retained profits are not distributed to theshareholders, the company can use funds within the
company for further profitable investment opportunities.
Retained earnings are a slightly cheaper source of capital
as compared to the cost of equity capital.
Therefore treated separately from the cost of equity
capital.
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Cost of Retained Earnings contd.
Where,
KR = Cost of retained earnings
KE = Cost of equity capital
T = Tax rate of individuals
TKKER 1
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Cost of Preference shares (KP)
The cost of preference share capital is the rate of return
that must be earned on preference capital financed
investments; to keep unchanged the earnings available to
the equity shareholders.Cost of Irredeemable Preference Shares.
Cost of Redeemable Preference Shares.
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Cost of Irredeemable Preference Shares
Where,
KP= cost of irredeemable preference shares
DP= Preference dividend
NP = Net proceeds received from the issue of
Preference shares after meeting the Issue
expenses.
NP
D
K
P
P
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Cost of Redeemable Preference Shares
Where,
KP = Cost of Preference shares
D = Constant annual dividend payment
N = No. Of years to redemption
RV= Redeemable value of preference shares at the time of redemption
SV = Sale out value of preference shares less discount and floating expenses.
2
VV
VV
PSR
N
SR
DK
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Cost of Debt (KP)
The capital structure of a firm normally includes the debtcomponent also.
The debt is carried a fixed rate of interest payable tothem, irrespective of the profitability of the company.
An important point to be remembered that dividendspayable to Equity shareholders and Preferenceshareholders is an appropriation of profit, whereas theinterest payable on Debt is charge against profit.
This phenomenon is called Tax shield
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Meaning of Leverage
Leverage refers to the ability of a firm in
employing long term fund having fixed cost to
enhance return to the owner.
Leverage is using fixed costs to magnify the
potential return to a firm
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Types of fixed costs
Fixed operating cost: - e.g. Rent, deprecation
Fixed Financial: - e.g. interest cost from debt
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Types of Leverage
Operating LeverageOperating Leverage is concerned with theoperation of any firm. The cost structure
of any firm gives rise to operating
leverage because of the existence offixed nature costs. This leverage relatesto the Sales & Profit variations, sometime
a small fluctuation in Sales would havegreat impact on profitability. This is
because of the existence of fixed costelements in the cost structure of a
product.
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Degree of operatingleverage
Degree of operating leverage (DOL): -It measures the EBIT's percentagechange as a result of a change of onepercent in the level of output. - It helps
in measuring the business risk.
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Operating Leverage
Operating Leverage measures the sensitivity of a
firms operating income to change in Sales.
Degree of operating leverage =
% change in EBI
% Change in Sales
A change in Sales -------------A large change
in EBIT
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Operating Leverage (DOL)
How efficiently is the fixed cost used in firms
operations
Is it optimal?
DOL or Degree of Operating Leverage
measures how the fixed cost is deployed in
operations. Should the firm decrease or
increase it in its operations?
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Financial Leverage
How efficiently is the fixed charge capital
used in firms finances
Is it optimal?
DFL or Degree of Financial Leverage
measures how the interest, lease and other
such fixed charges are deployed.
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Degree of financialleverageThe degree of financial leverage
(DFL) is defined as the percentage
change in earnings per share [EPS] that
results from a given percentage changein earnings before interest and taxes
(EBIT):
DFL = Percentage change in EPS
divided by Percentage change in EBIT
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Computation of Financial
Leverage
FL = EBIT
EBT
DFL = % change in EPS
% change in EBIT
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Degree of combinedleverage
The degree of combined leverage is
also known as degree of total leverage
(DTL). To compute it use the following
formula:
DCL = DOL * DFL
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Combined Leverage
(DCL)
How efficiently are all the fixed charges used in thefirm
Is the business risk optimal?
DCL or Degree of Combined Leverage measures
how all fixed charges are deployed by the firm.
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Computation of Combined
Leverage
DCL = (NI / NI) / (S / S)
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Capital Structure Theories
Weighted Average Cost of Capital.
Net Income Approach.
Net Operating Income Approach.
Modigliani & Miller Theory.
A ti i C it l St t
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Assumptions in Capital Structure
Theories
Company distributes all its earnings as dividends to its
shareholders.
Taxation & its effect on cost of capital is ignored.
Business risk is treated constant at different capitalstructure of company.
No transaction costs & a company can alter its capital
structure.
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Weighted Average Cost of Capital
WACC is defined as the weighted average cost ofvarious sources of finance.
WACC is considered as the minimum rate of return
required from project to pay-off the expected return of
investors.The combined cost of Equity capital and Debt capital
is the WACC for a company as whole.
WACC = (Cost of Equity * %Equity) + (Cost of
Debt * % Debt)
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Net Income Approach
This approach is given by Durant David.
According to this approach capital structure decision is
relevant to the valuation approach.
As such a change in the capital structure causes an overall
change in the cost of capital & also in the total value of thefirm.
There are usually 3 basic assumptions of the approach
- Corporate taxes do not exist.
- Debt content does not change the risk perception of theinvestors.
- Cost of debt is less than cost of equity.
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Net IncomeApproach
Value of Firm (V)Where,
S = Market value of Equity.
B = Market value of Debt.
Market value of Equity (S)
Where,
NI = Net income available for Equity
shareholdersKe = Equity capitalization rate
eK
NIS
BSV
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Net Operating Income Approach
Value of the firm is independent on its Capitalstructure.
It assumes that the Weighted average cost of capital, is
unchanged irrespective of the level of gearing.
NOI approach is opposite to the NI approach.Market value of the firm depends upon the net
operating profit or EBIT.
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Net Operating Income Approach contd
The NOI approach is based on the following assumptions:
The cost of debt is constant.
There is no tax.
Overall cost of the capital of the firm is constant.
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Net Operating Income Approach contd
Value of the Firm (V)
Where,
EBIT : Earnings before interest andtax
KO : Overall cost of capital.
Value of Equity (S)
Where,
S = Market value of Equity.B = Market value of Debt.
OK
EBITV
BVS
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Net Operating Income Approach contd
Cost of Cost of Equity
Capital
WACC
Cost of Debt
0
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MM THEORY
Cost of capital is independent of Capital structure.
It closely resembles Net operating income approach.
It argues the overall cost of capital is the weighted
average of cost of debt and cost of equity capital.
Investors are rational
There are no taxes or transaction cost.
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Conclusion
Under the net income and net operating
approach cost of capital increases if the
leverage decreases and vice-versa.
Under the traditional and MM theory the cost
of capital decreases if the leverage also
decreases and vice-versa.
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