Chapter 14

THE COST OF CAPITAL

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OUTLINE
Some Preliminaries Cost of Debt and Preference Cost of Equity Determining the Proportions Weighted Average Cost of Capital Weighted Marginal Cost of Capital

Floatation Costs and the WACC

Divisional and Project Cost of Capital

Cost of Capital in Practice

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COST OF CAPITAL The cost of capital of any investment (project, business, or

company) is the rate of return the suppliers of capital

would expect to receive if the capital were invested elsewhere in an investment (project, business, or company) of comparable risk

The cost of capital reflects expected return

The cost of capital represents an opportunity cost

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WEIGHTED AVERAGE COST OF CAPITAL (WACC) WACC = wErE + wprp + wDrD (1 tc)

wE = proportion of equity
rE = cost of equity

wp = proportion of preference
rp = cost of preference

wD = proportion of debt
rD = pre-tax cost of debt

tc = corporate tax rate

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KEY POINTS Only three types of capital (equity; nonconvertible,

noncallable preference; and nonconvertible, noncallable

debt) are considered. Debt includes long-term debt as well as short-term debt.

Non-interest bearing liabilities, such as trade creditors,

are not included in the calculation of WACC.

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COMPANY COST OF CAPITAL AND PROJECT COST OF CAPITAL The company cost of capital is the rate of return expected by the existing capital providers. The project cost of capital is the rate of return expected by capital providers for a new project the company proposes to undertake

The company cost of capital (WACC) is the right discount rate for an investment which is a carbon copy of the existing firm.
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COST OF DEBT
n I F P0 = + t = 1 (1 + rD)t (1 + rD)n P0 = current price of the debenture
I = annual interest payment

n = number of years left to maturity

F = maturity value rD is computed through trial-and-error. A very close approximation is:

rD =

I + (F P0)/n 0.6P0 + 0.4F

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ILLUSTRATION Face value = 1,000

Coupon rate = 12 percent

Period to maturity = 4 years

Current market price = Rs.1040

The approximate yield to maturity of this debenture is : 120 + (1000 1040) / 4 rD = 0.6 x 1040 + 0.4 x 1000
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= 10.7 percent

COST OF PREFERENCE

Given the fixed nature of preference dividend and principal repayment commitment and the absence of tax deductibility, the cost of preference is simply equal to its yield.

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ILLUSTRATION Face value : Rs.100 Dividend rate : 11 percent Maturity period : 5 years Market price : Rs.95 Approximate yield :

11 + (100 95) / 5
= 12.37 percent 0.6 x 95 + 0.4 x 100
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COST OF EQUITY Equity finance comes by way of (a) retention of earnings and (b) issue of additional equity capital. Irrespective of whether a firm raises equity finance by retaining earnings or issuing additional equity shares, the cost of equity is the same. The only difference is in floatation cost. Floatation costs will be discussed separately.

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APPROACHES TO ESTIMATE COST OF EQUITY Security Market Line Approach Bond Yield Plus Risk Premium Approach Dividend Growth Model Approach

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SECURITY MARKET LINE APPROACH rE = Rf + E [E(RM) Rf ]

rE = required return on the equity of the company

Rf = risk-free rate

E = beta of the equity of the company

E(RM) = expected return on the market portfolio

Illustration
Rf = 7%,

E = 1.2, E(RM) = 15%

rE = 7 + 1.2 [15 7] = 16.6%

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INPUTS FOR THE SML

While there is disagreement among finance practitioners, the following would serve.

The risk-free rate may be estimated as the yield on longterm bonds that have a maturity of 10 years or more. The market risk premium may be estimated as the difference between the average return on the market portfolio and the average risk-free rate over the past 10 to 30 years.
The beta of the stock may be calculated by regressing the monthly returns on the market index over the past 60 months or so.
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BOND YIELD PLUS RISK PREMIUM APPROACH Yield on the Cost of = long-term bonds + Risk equity premium of the firm Should the risk premium be 2 percent, 4 percent, or n

percent ? There seems to be no objective way of

determining it.

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DIVIDEND GROWTH MODEL APPROACH

If the dividend per share grows at a constant rate of g percent.

D1
P0 =

rE g
D1 +g

So, rE =

P0
Thus, the expected return of equity shareholders, which in equilibrium is also the required return, is equal to the dividend yield plus the expected growth rate
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GETTING A HANDLE OVER g

Analysts forecasts of growth rate. Average annual growth rate in the preceding 5 - 10 years. (Retention rate) (Return on equity)

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DETERMINING THE PROPORTIONS OR WEIGHTS The appropriate weights are the target capital structure weights stated in market value terms. The primary reason for using the target capital structure is that the current capital structure may not reflect the capital structure expected in future.

Market values are superior to book values because in order to justify its valuation the firm must earn competitive returns for shareholders and debtholders on the current (market) value of their investments.
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WACC

Source of Capital Debt Preference Equity

Proportion (1) 0.60 0.05 0.35

Cost (2) 16.0% 14.0% 8.4%

Weighted Cost [(1) x (2)] 9.60% 0.70% 2.94%

WACC = 13.24%

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Return, Cost (%) 18 17

DETERMINING THE OPTIMAL CAPITAL BUDGET

A Investment Opportunity Curve

B
C 14.6% 14.0% 13.2% D E

16
15 14 13 12 11 10

Marginal Cost of Capital Curve

Optimal Capital Budget

10

20

30

40

50

60

70

80

90

100

110 120 130 140

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Amount (in million rupees)

DIVISIONAL AND PROJECT COST OF CAPITAL

Using WACC for evaluating investments whose risks are different from those of the overall firm leads to poor decisions. In such cases, the expected return must be compared with the risk-adjusted required return, as calculated by the security market line. Multidivisional firms that have divisions characterised by differing risks may calculate separate divisional costs of capital. Two approaches are commonly employed for this purpose: The pure play approach The subjective approach
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FLOATATION COSTS Floatation or issue costs consist of items like underwriting costs, brokerage expenses, fees of merchant bankers, underpricing cost, and so on. One approach to deal with floatation costs is to adjust the WACC to reflect the floatation costs: WACC Revised WACC = 1 Floatation costs

A better approach is to leave the WACC unchanged but to consider floatation costs as part of the project cost.
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SOME MISCONCEPTIONS Several misconceptions characterise the calculation and application of cost of capital in practice. The concept of cost of capital is too academic or impractical.

The cost of equity is equal to the dividend rate or return on equity. Retained earnings are either cost free or cost significantly less that the external equity. Share premium has no cost
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SOME MISCONCEPTIONS Depreciation has no cost

The cost of capital can be defined in terms of an accounting-based measure.

A company must apply the same cost of capital to all projects. If a project is financed heavily by debt, its WACC is low.
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SUMMING UP
A companys cost of capital is the weighted average cost of the various sources of finance used by it, viz., equity, preference and debt. Since debt and preference entail more or less fixed payments, estimating their cost is relatively easy. Three approaches are commonly used to estimate the cost of equity : security market line approach, bond yield plus risk premium approach, and dividend growth model approach. The appropriate weights in the WACC calculation are the target capital structure weights stated in market value terms In multidivisional firms, it is advisable to calculate divisional costs of capital. Floatation costs may be considered as part of project cost.

Several misconceptions characterise cost of capital in practice.

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