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Topic: Cost of Capital

Course: Advance Strategic Finance

Submitted To: Syed Zulfiqar Ali Shah

Submitted By:

Faryad Hussain Muhammad Tamoor Irfan Habib

PM123002 MM121006 MM113017

Department of Management Sciences MOHAMMAD ALI JINNAH UNIVERSITY ISLAMABAD

Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders. Cost of Capital is the required rate of return on the various types of financing. Assumption of Cost of Capital Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts: 1. It is not a cost as such. 2. It is the minimum rate of return. 3. It consists of three important risks such as zero risk level, business risk and financial risk. IMPORTANCE OF COST OF CAPITAL Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern. Importance to Capital Budgeting Decision Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision. Importance to Structure Decision Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure. Importance to Evolution of Financial Performance Cost of capital is one of the important determining which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm. Importance to Other Financial Decisions Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence; it plays a major part in the financial management.

Theories of cost of capital and capital structure.


ASSUMPTION OF THE CAPITAL STRUCTURE THEORIES There are only two resources in the capital structure, Debt and Equity share capital The dividends payout rate 100% which means that there is no scope for the retained earnings The life of the firm is perpetual

The total assets of the firm do not change The total financing remains constant through balancing taking place in between the debt and share capital No corporate taxes; this was removed later

NET INCOME APPROACH Net income approach was developed by Durand. In this he has portrayed the influence of the leverage on the value of the firm and cost of capital, which means that the value of the firm is subject to the application of debt. In this approach, the cost of debt is identified as cheaper source of financing than equity share capital. The weighted average cost of capital will come down due to more application of leverage in the capital structure, only with reference to cheaper cost of raising than the equity share capital cost. Ko= Ke(S/V) +Ki (B/V) The value of the firm is more in the case of lesser overall cost of capital due to more application of leverage in the capital structure Assumptions. There is no tax. The cost of debt is less than cost of equity. The investor perception dont change for use of debt The will be no change in cost of debt and cost of equity If debt is zero then K0 = Ke

NET OPERATING INCOME APPROACH This another approach developed by Durand, which has underlying principle that the application of leverage do not have any influence on the value of the firm through the overall cost of capital. The more application of leverage leads to bring down the explicit cost of capital on one side and on the other side implicit cost of debt is expected to go up. The more application of debt leads to increase the financial risk among the investors that warranted the equity share holders to bear additional financial risk of the firm. Due to additional financial risk, the share holders are requiring the firm to pay additional dividends over the existing. The increase in the expectations of the shareholders with reference to dividends hiked the cost of equity. Under this approach, no capital structure is found to be optimum capital structure. The major reason is that the debt-equity ratio does not influence the cost of overall capital, which always nothing but remains constant. It is finally concluded that this approach highlights that application of leverage never makes an attempt to enhance the value of the firm, in other words which is known as unaffected by the application of leverage. At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

Assumptions. Overall cost of capital is independent of capital structure. Cost of debt remains same. Cost of equity changes due to change in capital structure.

Calculations: K0 = EBIT/V Ke = K0 + (K0 Ki) B/S

MODIGLIANIMILLER APPROACH
It is the approach, attempts to explain the application of leverage does not have any influence on the value of the firm through behavioral pattern of the investors. The behavioral pattern of the investors is taken into consideration for explaining the value of the firm which is unaffected by the application of debt/leverage in the capital structure through arbitrage process. Assumptions of the MM approach: This approach is discussed under the perfect market conditions Securities are divisible infinitely. Investors are allowed to buy and sell securities Investors are rational to access the information No transaction costs involved in the process of the buying and selling of securities Arbitrage process: It is the process facilitates the individual investors to buy the investments at lower price at one market and sells them off at higher price in another market. With the help of arbitrage process, the investors are permitted to shift holding of the Levered firm to the unlevered firm which is known as undervalued. These two firms are identical in business risk except in the application of debt finance in the levered firm. In order to maintain the similar amount of the financial risk of the firm, the investor is required to undergo for personal leverage or homemade leverage to maintain the same proportion of investment in the unlevered firm. During this process, the investor could save something and this continuous arbitrage process will level the value of the both firms. It means that the value of the firm is unaffected by the application of leverage which is explained through the arbitrage process, nothing but behavioral pattern of the investors. The same thing could be applied in the case of reverse arbitrage process in between the Unlevered and levered. This also another kind of process in which the investor could gain through the transfer of the holdings from the unlevered firm to levered firm. The value of the firm is unaffected by the application of the leverage in the capital structure.

TRADITIONAL APPROACH The traditional approach is known as intermediate approach in between the Net income approach and NOI approach. The value of the firm and the cost of capital are affected by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of overall capital will come down due to the application cheaper source of financing, Debt financing to some extent, after certain usage, the application of debt will enhance the financial risk of the firm, which will require the share holders to expect additional return nothing but is risk premium. The risk premium which is expected by the investors will enhance the overall cost of capital. The optimum capital structure "the marginal real cost of debt, defined to include both implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before that level, the marginal cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of equity Features. It is a mid way of NI approach and NOI approach. Due to more debt risk of creditor increase. Due to debt the financial risk of shareholders increases. K0, Ke and Ki change as the structure changes. COMPUTATION OF COST OF CAPITAL Computation of cost of capital consists of two important parts: 1. Measurement of specific costs 2. Measurement of overall cost of capital Measurement of Cost of Capital It refers to the cost of each specific sources of finance like: Cost of equity Cost of debt Cost of preference share Cost of Equity Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value. Conceptually the cost of equity capital (Ke) defined as the Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares. Cost of equity can be calculated from the following approach:

Book Based models. Dividend price (D/P) approach Dividend price plus growth (D/P + g) approach Free cash Flow Residual Free cash Flow

Market Based Model. CAPM Arbitrage pricing theory Multifactor Model

Dividend Price Approach The cost of equity capital will be that rate of expected dividend which will maintain the present market price of equity shares. Dividend price approach can be measured with the help of the following formula: Ke = D/P0

Where, Ke = Cost of equity capital D = Dividend per equity share P0 = current price of share Dividend Price plus Growth Approach The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend. It can be measured with the help of the following formula:

Ke = D/P0 + g Where, Ke = Cost of equity capital

D = Dividend per equity share g = Growth in expected dividend P0 = current price of share Free cash flow. This is a book based model which is used to calculate the cost of equity. Ke = FCF/V + g Where, Ke = Cost of Equity FCF = Free Cash Flow V = Value of firm g = growth in cash flows FCF = Operating profit Interest(1-t) +depreciation +- change in working capital capital expenditures Residual Free cash Flow. This is a book based model which is used to calculate the cost of equity. Ke = RCF/V + g Where, Ke = Cost of Equity RCF = Residual Cash Flow V = Value of firm g = growth in cash flows RCF = Operating profit Interest(1-t) +depreciation +- change in working capital capital expenditures Debt repayment + Increase in Debt +Tax benefit

Capital Asset Pricing Model (CAPM).


It is a market based model which considers the risk. We can calculate cost of equity by using CAPM.

Ke = Rf + (Rm Rf) Where, Ke = Cost of Equity Rf = Risk free rate = Measure of systematic risk Rm = Return of market

Fama and French Tree factor model:


Eugene Fama and Kenneth French 3 factor model FF3, Fama and French (1992, JoF) E[Ri ] = rf + bi ,m (E[Rm] - rf ) + bi ,smbE[SMB] + bi ,HMLE[HML] SMB is the return on a small stock portfolio minus a big stock portfolio (small minus big) HML is the return on a high book to market minus a low book to market portfolio (high minus low)

Arbitrage Pricing Theory.


Arbitrage Pricing Theory (APT) was developed by Ross (1976). APT predicts a security market line as CAPM and shows a linear relation with expected return and risk. According to APT: Security returns are described by a factor model There are sufficient securities to diversify away idiosyncratic risk Well-functioning security markets do not allow for the persistence of arbitrage opportunities.

There are only three assumptions employed this time to obtain the same relationship as CAPM: A factor model describing security returns A sufficient number of securities to form well-diversified portfolios Absence of arbitrage opportunities

This approach under new assumptions is called Arbitrage Pricing Theory. APT does not require the benchmark portfolio on SML to be the true market portfolio. Thus, the problems related to have an unobservable market portfolio in CAPM are not problems in APT.

Also, the index portfolio can easily be employed as a benchmark portfolio since it is welldiversified in APT even though it is not true market portfolio. E(Ri) = 0 + 1bi1 + 2bi2+ kbik Where, 0 = the expected return on an asset with zero systematic risk 1 = the risk premium related to the 1st common risk factor bi1 = the pricing relationship between risk premium and asset

Multifactor Models:
Factor models are employed to describe and quantify the different factors that affect the rate of return on security.In multifactor models stocks exhibit different sensitivities to the different components of systematic risk. Suppose there are two most important macroeconomic sources of risk are: Uncertainties surrounding the state of the business cycle (unanticipated growth in GDP) Unexpected changes in interest rates. Rit = i + [bi1F1i + bi2F2i + bikFki] +it Cost of Debt Cost of debt is the after tax cost of long-term funds through borrowing. Ki = Kd(1 t) Cost of Preference Share Capital Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share. There are two types of preference shares irredeemable and redeemable. Cost of redeemable preference share capital is calculated with the help of the following formula: Kp = Dp/Vp Where, Kp = Cost of preference share Dp = Fixed preference dividend

Vp = Value of preference shares Measurement of Overall Cost of Capital It is also called as weighted average cost of capital and composite cost of capital. Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firms capital structure.

The computation of the overall cost of capital (Ko) involves the following steps. (a) Assigning weights to specific costs. (b) Multiplying the cost of each of the sources by the appropriate weights. (c) Dividing the total weighted cost by the total weights. The overall cost of capital can be calculated with the help of the following formula; Ko= KiWi + KpWp + KeWe Where, Ko = Overall cost of capital Kd = Cost of debt Kp = Cost of preference share Ke = Cost of equity Wi= Percentage of debt of total capital Wp = Percentage of Preference share of total capital We = Percentage of Equity of total capital

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Literature Review:
Sardar Esmeelzadeh, Mohammad Ahmad ifard and Mehrdad Boustani have performed research on the topic Identifying the factors affecting the cost of capital and determining an appropriate model for calculating the cost of capital (2012). The take size of company, debt ratio, level of disclosure and type of industry as independent variable and cost of capital as dependent variable. They took data of 90 companies listed on Tehran stock exchange. Variables. Cost of capital Models: 1 Average realized return model. According to this modal the investor expectation there investment in the common stock is equal to the same return which they have obtain in the past period. 2 Adjusted Average realized return model: this model is realized return model which is adjusted for dividend growth and profits. According to this model, the common stockholders expected return is a factor by two other variables including the growth rate future profits and percentage of dividend interest. 3. Capital asset pricing model: CAPM model indicates that expected return on common stock is equal to the risk free rate of stock return = a risk that shareholder demands because of assuming a certain level of risk 4. Accounting base assessment model: This model is known the EBO, in which the share prices defined as a function of book value and value of future unexpected earnings and the discount rate use in this model is a cost of capital\ 5. Tobins Q model: This model is based on the fact that there is direct relation between corporate cost of capital and rate of Q. According to this model each company will have the tendency of new investment only when market value exceeds new capital unit per spend cost in order to financing it. 6. Dividend Growth Model: According to this model cost of equity is calculated as Dividend Current value +growth of dividend The multiple regression model is used to determine the relationship. They found that accounting based assessment model is appropriate and. reliable model for calculating the cost of capital. The type and size of company have been identified as factor affecting the cost of capital. Ionascu and Olimid has performed study on Preliminary Views on the determinants of the Cost of capital for the emerging markets of Romania. There took 19 companies listed on Romanian

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stock exchange. The Size corporate Governance, and Growth are independent variables and cost of capital is Dependent variable. Variables, Cost of capital 1. rGORPREM

Where rGOR = the estimated cost of capital. 2. rPEGPREM

Independent variables.

indGOV. An aggregate index for corporate governance which include board size, nonexecutive directors and duality of chairman. Size. Natural log of market value of equity. Growth. Short term growth on EPS. Leverage. Total liabilities/ equity State ownership. Dummy is used. By applying Regression model they conclude that larger companies and companies have better corporate governance are able to get benefits. Mohammad Omran and John Pointon have conducted a study on The determinants of cost of capital by industry within an emerging economy (2004). They have taken 119 companies to perform the study. They have taken reserves, total investment, net earnings growth, nature log of market capitalization gearing, standard deviation and Q ratio as independent variable and Cost of capital as dependent variable.

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Models for cost of capital:

=(

They used step vise multiple regression, growth size actively traded companies are important determinants of cost of capital but they has not found satisfactory model. Raj S Dhankar and A jit S Boora have performed a research on cost of capital optimal capital structure and Value of firm. They have conducted study on 300 large scale companies from 15 different industry groups for a period from 1981 to 1991. Measure of Variables; Capital Structure: C= Sum of the book value of various components of capital structure. Market Value of equity: E= Number of share outstanding at the end of an accounting year X average market price per share Market Value of Firm: V =market value of equity + book value of preference share and debt. Cost of Capital= Kp.P+Kd.D+Ke.E P+D+E Leverage:L= debt of total capital ratio L=D/(F+E)=D/C

They found no significant relationship between change in capital structure and value of firm at Micro level. It was also found that Indian companies dont imply a specific model for computing the cost of capital. Hosein Nia and Amiri (2012) have conducted on the effect of systematic Risk on Cost of Capital determinants Applying CAPM model. Cost of Capital as dependent variable and Cost of capital components and systematic risk are independent variables. The models were following Expected return=risk less rate + beta (risk premium) Implied equity risk premium=the required rate of return on equity-the risk less rate Degree of operating leverage=%change in operating profit(EBIT)/% change in sales Cost of Capital=

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They perform regression analysis and concluded that there is insignificant relationship between systematic risk and debt financial leverage. Syed Zulfiqar Ali Shah, and Safdar Ali Butt (2009) studied the Impact of Corporate governance on the Cost of Equity: in Pakistani Listed companies. They have taken 114 listed companies for the period 2003 to 2007 they used the OLS and Fixed effect model for test the panel data. They find that there is negative relationship between managerial ownership and board size with cost of equity and a positive relationship between board independence, audit committee independence and corporate governance with cost of equity. A Study for Identifying Cost-of-Equity Models and Factors Affecting on Cost-of-Capital is conducted by Hossein Panahian and Aliakbar Farzinfar (2011). The study covers data over a period of five years from 2001-2005. The study analyzed and tested relevant data to firms debt ratio and corporate size as effective factors on Cost-of-equity. They used multivariate regression model. Findings indicated that contrary to the commonly held belief in financial management theorems debts ratio has the least effect on cost-of-equity. Nevertheless the study found that the variant of companys size has a meaningful relation with cost-of-equity and. To calculate costof-equity, CAPM, Gordon and return ratio methods were used. Findings showed that CAPM has more validity in comparison to other varieties.

Size = Ln(BVATit +ST)/ 2 Srivastava (2011) has conducted an analytical research on cost of capital and decision making. The objective of this paper is to highlight the different aspect of cost of capital and emphasize the importance of this concept in present business era. Analytical research method is adopted for this purpose where newspapers comments views and reviews by noted authorities apart from standard books on this topic have also been consulted and analyzed to arrive at concrete conclusion which envisage that investment decisions which are irreversible and involves huge funds should be taken after considering cost of capital apart from other aspects then only the financial policy will provide healthy platform to the stakeholders of the company.

Future Research directions


Comparison of listed and unlisted should be made to determine the best technique of cost of capital. Estimation techniques should be applied on weak and strong firms separately then make comparison. Comparison of developing and developed countries should be made by considering the approaches of cost of capital and capital structure.

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References.
Ali Shah, S., & Butt, S. (2009). The Impact of Corporate Governance on the Cost of Equity: Empirical Evidence from Pakistani Listed Companies. The Lahore Journal of Economics, 14(1), 139-171. Alouj, A., H., Nia., M., N., & Amiri., S., M., S. (2012)., The effect of Systematic risk on cost of capital determinants Applying CAPM Model:Evidence from Tehran stock exchange., Australian journal of basic and applied sciences 6(10) 180-188. Brealey, Richard and Stewart Myers, 1991, Principles of Corporate Finance, 4th Ed., New York, NY, McGraw- Hill, 197. Brigham, Eugene and Louis Gapenski, 1991, Financial Management, Theory and Practice, 6th Ed., Chicago, IL, Dryden Press. Dhankar., S., R., & Boora., S., A., (1996)., Cost of capital, optimal capital structure and value of firm: An empirical study of Indian Companies., Vol., 21., No. 3 Durand, D., Bank Stock Prices and the Bank Capital Problem, Occasional Paper 54, New York, NBER, 1954. Esmaeelzadeh., S., ahmedifard., M., & Boustani., M., (2012)., Identifying the factors Affecting the cost of capital and determining an appropriate model for calculating the cost of capital., Journal of basic and Applied Scientific research., 2765-2772. Gitman, Lawrence J., 1991, Principles of Managerial Finance, 6th Ed., New York, NY, HarperCollins. Ionascu., M., et al., (2012)., Preliminary Views on the determinants of the cost of capital for the emerging market of Romania., World academy of Science, engineering and technology 10371041. Modigiliani , F.,& Miller , M. ( 1958). The Cost of Capital , Corporation Finance and The Theory of Investment. American Economic Review. 261-297 Omran, M., & Pointon, J. (2004). The determinants of the cost of capital by industry within an emerging economy: evidence from Egypt. International Journal of Business, 9(3). Panahian., H., & Farzinfar., A., (2011)., A Study for Identifying Cost-of-Equity Models and Factors Affecting on Cost-of-Capital., International Research Journal of Finance and Economics 157-165.

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Ross, Stephen, Randolph Westerfield, and Jeffrey Jaffe, 1996, Corporate Finance, 4th Ed., Chicago, IL, Irwin.

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