CHAPTE R 9

THE COST OF CAPITAL

LEARNING OBJECTIVES
2

Explain

the general concept of the opportunity cost of capital Distinguish between the project cost of capital and the firms cost of capital Learn about the methods of calculating component cost of capital and the weighted average cost of capital Recognize the need for calculating cost of capital for divisions Understand the methodology of determining the divisional beta and divisional cost of capital Illustrate the cost of capital calculation for a real company

INTRODUCTION
3

projects cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firms cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects
The

SIGNIFICANCE OF THE COST OF CAPITAL

Evaluating Designing

investment decisions a firms debt policy financial performance of top

Appraising the

management

THE CONCEPT OF THE OPPORTUNITY COST OF CAPITAL

5

The

opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.

Risk-return relationships of various securities

Shareholders Opportunities and Values

The

required rate of return (or the opportunity cost of capital) is shareholders is market-determined. an all-equity financed firm, the equity capital of ordinary shareholders is the only source to finance investment projects, the firms cost of capital is equal to the opportunity cost of equity capital, which will depend only on the business risk of the firm.

In

Creditors Claims and Opportunities

have a priority claim over the firms assets and cash flows. The firm is under a legal obligation to pay interest and repay principal. There is a probability that it may default on its obligation to pay interest and principal. Corporate bonds are riskier than government bonds since it is very unlikely that the government will default in its obligation to pay interest and principal.
Creditors

General Formula for the Opportunity Cost of Capital

Opportunity

cost of capital is given by the following formula:

where

Io is the capital supplied by investors in period 0 (it represents a net cash inflow to the firm), Ct are returns expected by investors (they represent cash outflows to the firm) 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 these funds if they had been distributed as dividends to them

Cost of Capital
9

from all investors point of view, the firms cost of capital is the rate of return required by them for supplying capital for financing the firms investment projects by purchasing various securities. The rate of return required by all investors will be an overall rate of return a weighted rate of return.
Viewed

Weighted Average Cost of Capital vs. Specific Costs of Capital

10

The

cost of capital of each source of capital is known as component, or specific, cost of capital. The overall cost is also called the weighted average cost of capital (WACC). Relevant cost in the investment decisions is the future cost or the marginal cost. Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now, or in the near future. The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making.

11

DETERMINING COMPONENT COSTS OF CAPITAL

Generally,

the component cost of a specific source of capital is equal to the investors required rate of return, and it can be determined by using

But

the investors required rate of return should be adjusted for taxes in practice for calculating the cost of a specific source of capital to the firm.

COST OF DEBT
12

Debt

Issued at Par
INT kd i B0

Debt

Issued at Discount or Premium

B0
n

INTt

t 1 (1 k d ) t

Bn (1 k d ) n

Tax

adjustment
After tax cost of debt k d (1 T)

EXAMPLE
13

Now,

Cost of the Existing Debt

14

Sometimes

a firm may like to compute the current cost of its existing debt. such a case, the cost of debt should be approximated by the current market yield of the debt.

In

15

COST OF PREFERENCE CAPITAL

Irredeemable

Preference Share
PDIV kp P0

Redeemable

Preference Share
n

P0

PDIVt

t 1 (1 k p ) t

Pn (1 k p ) n

Example
16

COST OF EQUITY CAPITAL

17

Is

Equity Capital Free of Cost? No, it has an opportunity cost. Cost of Internal Equity: The Dividend-Growth Model DIV1

Normal growth
Supernormal growth Zero-growth

P0

(k e g)
DIV0 (1g s ) t DIVn 1 1 k e g n (1k e ) n (1k e ) t

P0

t 1

ke

DIV1 EPS1 P0 P0

(since g 0)

COST OF EQUITY CAPITAL

18

Cost

of External Equity: The Dividend Growth Model

ke DIV 1 g P0

EarningsPrice
ke

Ratio and the Cost of Equity

(g br) (b 0)

EPS1 ( 1 b ) br P 0

EPS1 P 0

Example
19

Example: EPS
20

firm is currently earning Rs 100,000 and its share is selling at a market price of Rs 80. The firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to remain stable, and it has a payout ratio of 100 per cent. What is the cost of equity? We can use expected earnings-price ratio to compute the cost of equity. Thus:

21

THE CAPITAL ASSET PRICING MODEL (CAPM)

As

per the CAPM, the required rate of return on equity is given by the following relationship:

k e R f (R m R f ) j
Equation

requires the following three parameters to estimate a firms cost of equity:

The risk-free rate (Rf) The market risk premium (Rm Rf) The beta of the firms share ()

Example
22

Suppose

in the year 2002 the risk-free rate is 6 per cent, the market risk premium is 9 per cent and beta of L&Ts share is 1.54. The cost of equity for L&T is:

23

COST OF EQUITY: CAPM VS. DIVIDENDGROWTH MODEL

The

dividend-growth application in practice

approach

has

limited

It assumes that the dividend per share will grow at a constant rate, g, forever. The expected dividend growth rate, g, should be less than the cost of equity, ke, to arrive at the simple growth formula. The dividendgrowth approach also fails to deal with risk directly.

Cost of equity under CAPM

24

25

COST OF EQUITY: CAPM VS. DIVIDENDGROWTH MODEL

CAPM

has a wider application although it is based on restrictive assumptions. The only condition for its use is that the companys share is quoted on the stock exchange. All variables in the CAPM are market determined and except the company specific share price data, they are common to all companies. The value of beta is determined in an objective manner by using sound statistical methods. One practical problem with the use of beta, however, is that it does not probably remain stable over time .

THE WEIGHTED AVERAGE COST OF CAPITAL

26

The

following steps are involved for calculating the firms WACC:

Calculate the cost of specific sources of funds Multiply the cost of each source by its proportion in the capital structure. Add the weighted component costs to get the WACC.
k o k d (1 T) w d k d w e k o k d (1 T) D E ke DE DE

WACC

is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firms target capital structure.

27

Book Value Versus Market Value Weights

Managers

prefer the book value weights for calculating WACC

Firms in practice set their target capital structure in terms of book values. The book value information can be easily derived from the published sources. The book value debt-equity ratios are analysed by investors to evaluate the risk of the firms in practice.

28

Book Value Versus Market Value Weights

The

use of the book-value weights can be seriously questioned on theoretical grounds;

First, the component costs are opportunity rates and are determined in the capital markets. The weights should also be market-determined. Second, the book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values

29

Book Value Versus Market Value Weights

Market-value

weights are theoretically superior to book-value weights:

They reflect economic values and are not influenced by accounting policies. They are also consistent with the market-determined component costs.

The difficulty in using market-value weights: The market prices of securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.

FLOTATION COSTS, COST OF CAPITAL AND INVESTMENT ANALYSIS

30

A new issue of debt or shares will invariably involve flotation costs in the form of legal fees, administrative expenses, brokerage or underwriting commission. One approach is to adjust the flotation costs in the calculation of the cost of capital. This is not a correct procedure. Flotation costs are not annual costs; they are one-time costs incurred when the investment project is undertaken and financed. If the cost of capital is adjusted for the flotation costs and used as the discount rate, the effect of the flotation costs will be compounded over the life of the project. The correct procedure is to adjust the investment projects cash flows for the flotation costs and use the weighted average cost of capital, unadjusted for the flotation costs, as the discount rate.

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DIVISIONAL AND PROJECT COST OF CAPITAL

A

most commonly suggested method for calculating the required rate of return for a division (or project) is the pure-play technique. The basic idea is to use the beta of the comparable firms, called pure-play firms, in the same industry or line of business as a proxy for the beta of the division or the project

32

DIVISIONAL AND PROJECT COST OF CAPITAL

The

pure-play approach for calculating the divisional cost of capital involves the following steps: Identify comparable firms Estimate equity betas for comparable firms: Estimate asset betas for comparable firms: Calculate the divisions beta: Calculate the divisions all-equity cost of capital Calculate the divisions equity cost of capital: Calculate the divisions cost of capital

Firms cost of capital

33

Example
34

The Cost of Capital for Projects

35

simple practical approach to incorporate risk differences in projects is to adjust the firms WACC (upwards or downwards), and use the adjusted WACC to evaluate the investment project:

Companies

in practice may develop policy guidelines for incorporating the project risk differences. One approach is to divide projects into broad risk classes, and use different discount rates based on the decision makers experience.

The Cost of Capital for Projects

36

For

example, projects may be classified as:

Low risk projects

Medium risk projects High risk projects

discount rate < the firms WACC

discount rate = the firms WACC

discount rate > the firms WACC