Cost of Capital

Equity Preference Share Debentures Riskfree security Government Bonds like RBI relief bonds

Cost of Capital
The firms cost of capital is the rate of return required to all the suppliers 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.

WACC Vs. Specific Cost of Capital

The 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. Suppose: Cost of Equity = 11% Cost of Debt = 6% Project A: Expected rate of return = 10% & Financed by Debt. Project B: Same Risk return class Financed by Equity (The debt equity ratio of the firm is 3:2)

 It can also be thought of a rate of return required by the all the capital providers. The cost of capital is the rate of return that a firm must earn to maintain the market value of the stock. It is considered as a hurdle rate. The cost of capital is estimated at a given point of time.

COST OF DEBT
Current Yield = Coupon / Current Market Price Yield to Maturity

Debt Issued at Par

INT kd i P0

Dutch Corporation, a major hardware manufacturer, is contemplating selling Rs.10 million worth of 20-year, 9% coupon bonds with a par value of Rs.1,000. The similar types of bonds offered by other companies offering 10% coupon rate. Because current market interest rates are greater than 9%, the firm must sell the bonds at discount. The issue price is Rs.980. Further the floatation costs are 2% of the face value of the bond. The net proceeds to the firm from the sale of each bond would be Rs.960. Calculate the cost of the bond.

Before-Tax Cost of Debt Approximating the Cost

Kd =

1000 960 90: 20 960+1000 2

92 980

= 9.4%

Tax adjustment
The interest paid on debt is tax deductible. The higher the interest charges the lower will be the amount of tax payable by the firm. As a result of these interest tax shield, the after tax cost of debt to the firm will be substantially less than the investors required rate of return.

After-tax cost of Debt = Kd(1-t)

Find the after-tax cost of debt for Dutch Corp. assuming it has a 40% tax rate:

kd = 9.4% (1-0.40) = 5.6%

This suggests that the after-tax cost of raising debt capital for Dutch is 5.6%.

COST OF PREFERENCE CAPITAL

Irredeemable Preference Share
PDIV kp P0

Dutch Corporation is contemplating the issuance of a 10% preferred stock that is having a face value of Rs.87per share. The cost of issuing and selling the stock is expected to be Rs.5 per share. The dividend is Rs.8.70 (10% x Rs.87). The net proceeds price (Np) is Rs.82 (Rs.87 Rs.5). KP = DP/Np = Rs.8.70/Rs.82 = 10.6%
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Example

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COST OF EQUITY CAPITAL Using 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 ()
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Example
Dutch Corporations investment advisor indicates that the firms beta is 1.5 and the market return Rm is equal to 11%. The 364-days T-bill rate is hovering around 7%. As per CAPM, the cost of equity share is

ke R f ( Rm R f )
Ke = 7 + 1.5 (11 7 ) = 13%

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COST OF EQUITY CAPITAL

Cost of External Equity: The Dividend Growth Model
DIV 1 ke g P 0

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 Dutch Corporation's shares are currently trading in the market at Rs.50 per share. The firm expects to pay a dividend of Rs.4 per share in the next year. The annual growth rate of dividend is coming at 5 percent p.a. The cost of equity capital would be Ke =
.4 .50

+ 0.05 = 0.08 + 0.05 = 13%

Example

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THE WEIGHTED AVERAGE COST OF CAPITAL

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 ) wd k e we k o k d (1 T ) D E ke DE DE

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WACC of Dutch
Sources of Capital Long Term Debt Preferred Stock Equity Shares Total Weights 0.40 0.10 0.50 1.00 Cost 5.6% 10.6% 13% Weighted Cost 2.2% 1.1% 6.5% 9.8%

WACC Book Value Approach

Source Amount Proportion (%) After tax Cost (%) Weighted Cost

Equity Capital
Reserve & Surplus Pref. Capital Debenture

45,00,000
15,00,000 10,00,000 30,00,000 100,00,000

45
15 10 30

18
18 11 8 WACC

8.1
2.7 1.1 2.4 14.3%

The Company issued 4,50,000 shares @ Rs.10 per share

WACC Market Value Approach

Source Amount Proportion (%) After tax Cost (%) Weighted Cost

Equity Capital
Pref. Capital Debenture

90,00,000
10,00,000 30,00,000 130,00,000

69.2
7.7 23.1

18
11 8 WACC

12.5
0.8 1.8 15.1%

The current market price per share is Rs.20.

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.

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Book Value Versus Market Value Weights

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

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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.
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