Financial Management

Cost of Capital
Weighted Average Cost of Capital



Presented By :

D.B.Koteswar Rao

Hima bindu Kolluri

Sheetal

Mohan Murthy
(MBA SECTION D Group 6)













COST OF CAPITAL
It is an important element used in evaluating the capital expenditure decisions.
It is defined as the minimum required rate of earning or the cut-off rate for
capital expenditures. Cost of capital is the value paid for availing and using
capital from a particular source.
If we perceive investors as the sources of capital, then they always desire that
their money be safe in the hands of investee and that they receive fair return of
their capital also. In this sense, the management of investee concern must earn
on the funds borrowed from the investors at least equal to the rate of return
expected by the investors. Thus, in operational terms, cost of capital refers to
the minimum rate of return which a concern must earn on its investments so that
the market value of the concern remains unchanged, if not increased.
Cost of capital is the rate of return on the best alternative investment
opportunities available to a business concern. Thus cost of capital can be
explained in terms of opportunity cost.




Cost of preference capital:
Is a function of dividend expected by investors
Cost of preference share capital is that part of cost of capital in which
we calculate the amount which is payable to
preference shareholders in the form of dividend with fixed rate
There are four types of preference share capitals
Redeemable preference share capital
Irredeemable preference share capital
Cumulative and non cumulative preference share capital


Cumulative and Non-cumulative: a non-cumulative or simple
preference shares gives right to fixed percentage divided or profit of
each year. In case no dividend thereon is declared in any year because
of absence of profit, the holders of preference shares get nothing nor
can they claim unpaid dividend in the subsequent year or years in
respect of that year. Cumulative preference shares however give the
right to the subsequent year or years when the profits are available for
distribution , In this case dividends which are not paid in any year are
accumulated and are paid out when the profits are available
Irredeemable preference share capital

The preference share may be treated as a perpetual security if it is
irredeemable
Irredeemable preference shares are those shares which cannot be
redeemed during the lifetime of the company.
Cost is given by
kp=pdiv/po
Kp=cost of preference share
PDIV= expected preference dividend
Po= issue price of preference share
Eg. A company issues 10% irredeemable preference shares. The face
value of share is 100, but the issue price is 95. what is the cast of a
preference share?
What is the cost when issue price is 105?
Issue price 95
Kp=PDIV/Po =10/95 = 0.1053 or 10.53%
Issue price =105
Kp=PDIV/Po =10/105=0.0952 or 9.52%
Redeemable preference share capital
Redeemable preference share with finate maturity
Redeemable preference shares can be redeemed on or after a period fixed
for redemption under the terms of issue or after giving a proper notice of
redemption to preference shareholders.
At the time of maturity

Cost of redeemable pref. share capital =
D = Annual dividend

MV = Maturity value of pref. shares

NP = Net proceeds of pref. shares

N= number of years
Eg. Suppose, we have to pay Rs.10, 00,000 but at the time of issue of
pref. share, we had paid Rs.2 per issue of pref. share. So, net proceed is
Rs.9,80,000 but if this amount is payable after 10 years at 10% premium,
this will also benefit to pref. share capital and total cost of pref. share
capital will increase. Rate of dividend is 10%.








Retained earnings
The accumulated net income that has been retained for reinvestment in the
business rather than being paid out in dividends to stockholders


Weighted Average Cost of Capital

A firm obtains capital from various sources, because of the risk differences
between the firm and the investors the cost of capital of each source of capital
differs. The cost of capital of each source is known as component. The
combined cost of all the sources is known as average cost of capital and if the
component cost are combined according to the weights of each component
capital to obtain the average costs of capital it is known as weighted average
cost of capital.
The weights that we use to calculate the WACC will obviously affect the result
Therefore, the obvious question is: where do the weights come from?
There are two possibilities:
Book-value weights
Market-value weights
Book-value Weights
One potential source of these weights is the firms balance sheet, since it lists
the total amount of long-term debt, preferred equity, and common equity
We can calculate the weights by simply determining the proportion that each
source of capital is of the total capital
If you dont know the targets, it is better to estimate the weights using current
market values than current book values.
If you dont know the market value of debt, then it is usually reasonable to use
the book values of debt, especially if the debt is short-term.
The following table shows the calculation of the
book-value weights for RMM:
Source Text book value %total
Long term debt 400000 40
Preferred equity 100000 10
Common equity 500000 50
Grand total 1000000 100%

Market-value Weights
The problem with book-value weights is that the book values are historical, not
current, values
The market recalculates the values of each type of capital on a continuous basis.
Therefore, market values are more appropriate
Calculation of market-value weights is very similar to the calculation of the
book-value weights
The main difference is that we need to first calculate the total market value
(price times quantity) of each type of capital
Calculating the Market-value Weights
Source Price per
unit
units Market value %total
Long term debt 905 400 362000 31.15
Preferred 100 1000 100000 8.61
equity
Common
equity
70 10000 700000 60.24
Grand total 1162000 100%

WACC= w
e
Ke +W
p
K
p
+W
cs
K
cs


Market vs Book Values
It is important to note that market-values is always preferred over book-value
The reason is that book-values represent the historical amount of securities sold,
whereas market-values represent the current amount of securities outstanding
For some companies, the difference can be much more dramatic than for RMM
Finally, note that RMM should use the 10.27 WACC in its decision making
process


Factors influencing a companys WACC
Market conditions, especially interest rates and tax rates.
The firms capital structure and dividend policy.
The firms investment policy. Firms with riskier projects generally have a
higher WACC.

Cost of debt:
A company may raise debt in a variety of ways by either borrowing funds from
financial institutions or public in the form of public deposits or debentures for a
specified period at a certain interest. A debenture or bond may be issued at par
or at a discount or at a premium as compared to its face value. The contractual
rate of interest forms the basis for calculating the cost of debt
Recall that the formula for valuing bonds is:
( )
( )
N
d d
N
d
B
k
FV
k
k
Pmt V
+
+
(
(
(

=
1
1
1
1

We cannot solve this equation directly for k
d
, so we must use an iterative trial
and error procedure (or, use a calculator).Note that k
d
is not the appropriate cost
of debt to use in calculating the WACC, instead we should use the after-tax cost
of debt.
After tax debt:
Recall that interest expense is tax deductible.Therefore, when a company pays
interest, the actual cost is less than the expense.As an example, consider a
company in the 34% marginal tax bracket that pays $100 in interest.The
companys after-tax cost is only $66. The formula is:
( ) t k tax Before k tax After
d d
= 1 .
Cost of debt with floatation cost:
Simply subtract the flotation costs (F) from the price of the bonds, and calculate
the cost of debt as usual: ( )
( )
( )
N
d d
N
d
B
k
FV
k
k
Pmt F V
+
+
(
(
(

=
1
1
1
1
.

Cost of equity capital:
Firms may raise equity capital internally by retaining earnings , alternatively
they could distridute the entire earnings to equity share holders and raise equity
firm and equity share holders required rate of return would be same in both
cases.
From firms point of view retaining and issue of equity shares are different
because issue of shares means they have to price them lower than market price,
thus external equity will cost more to a firm than internal equity.

In finance, the cost of equity is the return (often expressed as a rate of return) a
firm theoretically pays to its equity investors, i.e., shareholders, to compensate
for the risk they undertake by investing their capital. Firms need to acquire
capital from others to operate and grow. Individuals and organizations who are
willing to provide their funds to others naturally desire to be rewarded. Just as
landlords seek rents on their property, capital providers seek returns on their
funds, which must be commensurate with the risk undertaken. Simply subtract
the flotation costs (F) from the price of common, and calculate the cost of
common as usual:
( )
( ) ( )
g
F V
D
g
F V
g D
k
CS CS
CS
+

= +

+
=
1 0
1
.

According to finance theory, as a firm's risk increases/decreases, its cost of
capital increases/decreases. This theory is linked to observation of human
behaviour and logic: capital providers expect reward for offering their funds to
others. Such providers are usually rational and prudent preferring safety over
risk. They naturally require an extra reward as an incentive to place their capital
in a riskier investment instead of a safer one. If an investment's risk increases,
capital providers demand higher returns or they will place their capital
elsewhere.
Knowing a firm's cost of capital is needed in order to make better decisions.
Managers make capital budgeting decisions while capital providers make
decisions about lending and investment. Such decisions can be made after
quantitative analysis that typically uses a firm's cost of capital as a model input