Cost of capital and Leverage

Presented By: Suhas Chavan

Cost of Capital
The cost of capital is the rate of return the company has to pay to various suppliers of funds in the company. There are variations in the costs of capital due to the fact that different kinds of investment carry different levels of risk, which is compensated for, by different levels of return on the investment.

Elements of Cost of Capital

The cost of capital consists of the following elements: Cost of Equity (KE) Cost of Retained Earnings (KR) Cost of Preferred capital (KP) Cost of Debt (KD)

Cost of Equity
The cost of equity may be defined as the minimum rate of return that a company must earn on the equity financed portion of an investment project so that market price of the shares remain unchanged. It is a permanent source of funds. The main objective of the firm is to maximize the wealth of the equity shareholders. If the companys business is doing well the ultimate beneficiaries are the equity shareholders.

Computation of Cost of Equity

Dividend Yield Method The discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. Dividend Growth Model

An allowance for future growth in dividend is added to the current dividend yield. Price Earning Method This method takes into consideration the Earnings per share (EPS) and the market price of share.

Dividend Yield Method

It is based on the assumption that the market value of shares is directly related to the future dividends on the shares. Another assumption is that the future dividend per share is expected to be constant and the company is expected to earn at least this yield to keep the shareholders content. Emphasizes future dividends to be constant. It does not follow any growth rate. But in reality, a shareholder expects the return from his investment to grow over a time. This approach has no relevance to the company.

Dividend Yield Method contd.

KE

D1 PE

Where, KE = Cost of equity D1 = Annual dividend per share PE = Ex-dividend per share

Dividend Growth Model

It is recognized that the current market price of a share reflects expected future dividends. Also called as Gordon Dividend Growth Model.

Dividend Growth Model contd.

D1 KE g PE
Where, D1 = Current dividend per Equity share PE = Market price per Equity share g = Growth in expected dividend

Price Earning Method

This method takes into consideration the Earnings per share (EPS) and the market price of share. Assumption that the investors capitalize the stream of future earnings of the share need not be in the form of dividend and also it need not be disbursed to the shareholders. In calculation of cost of equity share capital, the earnings per share is divided by the current market price.

Price Earning Method contd.

Where, E = Current earnings per share M= Market price per share

KE

E M

Cost of Retained Earnings (KR)

The retained earnings is the major sources of Finance. The equity shareholders of the company are entitled to these funds. As long the retained profits are not distributed to the shareholders, the company can use funds within the company for further profitable investment opportunities. Retained earnings are a slightly cheaper source of capital as compared to the cost of equity capital. Therefore treated separately from the cost of equity capital.

Cost of Retained Earnings contd.

K R K E 1 T
Where, KR = Cost of retained earnings KE = Cost of equity capital T = Tax rate of individuals

Cost of Preference shares (KP)

The cost of preference share capital is the rate of return that must be earned on preference capital financed investments; to keep unchanged the earnings available to the equity shareholders. Cost of Irredeemable Preference Shares. Cost of Redeemable Preference Shares.

Cost of Irredeemable Preference Shares

Where, KP = cost of irredeemable preference shares DP = Preference dividend NP = Net proceeds received from the issue of Preference shares after meeting the Issue expenses.

DP KP NP

Cost of Redeemable Preference Shares

RV SV
KP D N RV SV 2

Where, KP = Cost of Preference shares D = Constant annual dividend payment N = No. Of years to redemption RV = Redeemable value of preference shares at the time of redemption SV = Sale out value of preference shares less discount and floating expenses.

Cost of Debt (KP)

The capital structure of a firm normally includes the debt component also. The debt is carried a fixed rate of interest payable to them, irrespective of the profitability of the company. An important point to be remembered that dividends payable to Equity shareholders and Preference shareholders is an appropriation of profit, whereas the interest payable on Debt is charge against profit. This phenomenon is called Tax shield

Meaning of Leverage

Leverage refers to the ability of a firm in employing long term fund having fixed cost to enhance return to the owner. Leverage is using fixed costs to magnify the potential return to a firm

Types of fixed costs

Fixed Fixed

operating cost: - e.g. Rent, deprecation Financial: - e.g. interest cost from debt

Types of Leverage
Operating Leverage Operating Leverage is concerned with the operation of any firm. The cost structure of any firm gives rise to operating leverage because of the existence of fixed nature costs. This leverage relates to the Sales & Profit variations, sometime a small fluctuation in Sales would have great impact on profitability. This is because of the existence of fixed cost elements in the cost structure of a product.

Degree of operating leverage.

Degree of operating leverage (DOL): It measures the EBIT's percentage change as a result of a change of one percent in the level of output. - It helps in measuring the business risk.

Operating Leverage

Operating Leverage measures the sensitivity of a firms operating income to change in Sales. Degree of operating leverage = % change in EBI % Change in Sales A change in Sales -------------A large change in EBIT

Operating Leverage (DOL)

How efficiently is the fixed cost used in firms operations Is it optimal? DOL or Degree of Operating Leverage measures how the fixed cost is deployed in operations. Should the firm decrease or increase it in its operations?

Financial Leverage

How efficiently is the fixed charge capital used in firms finances Is it optimal? DFL or Degree of Financial Leverage measures how the interest, lease and other such fixed charges are deployed.

The degree of financial leverage (DFL) is defined as the percentage change in earnings per share [EPS] that results from a given percentage change in earnings before interest and taxes (EBIT): DFL = Percentage change in EPS divided by Percentage change in EBIT

Degree of financial leverage.

Computation of Financial Leverage

FL = EBIT EBT

DFL = % change in EPS % change in EBIT

Degree of combined leverage

The degree of combined leverage is also known as degree of total leverage (DTL). To compute it use the following formula:

DCL = DOL * DFL

Combined Leverage (DCL)

How efficiently are all the fixed charges used in the firm Is the business risk optimal? DCL or Degree of Combined Leverage measures how all fixed charges are deployed by the firm.

Computation of Combined Leverage

DCL = (NI / NI) / (S / S)

Capital Structure Theories

Weighted Average Cost of Capital. Net Income Approach. Net Operating Income Approach. Modigliani & Miller Theory.

Assumptions in Capital Structure Theories

Company distributes all its earnings as dividends to its shareholders. Taxation & its effect on cost of capital is ignored. Business risk is treated constant at different capital structure of company. No transaction costs & a company can alter its capital structure.

Weighted Average Cost of Capital

WACC is defined as the weighted average cost of various sources of finance. WACC is considered as the minimum rate of return required from project to pay-off the expected return of investors. The combined cost of Equity capital and Debt capital is the WACC for a company as whole. WACC = (Cost of Equity * %Equity) + (Cost of Debt * % Debt)

Net Income Approach

This approach is given by Durant David. According to this approach capital structure decision is relevant to the valuation approach. As such a change in the capital structure causes an overall change in the cost of capital & also in the total value of the firm. There are usually 3 basic assumptions of the approach - Corporate taxes do not exist.
- Debt content does not change the risk perception of the investors. - Cost of debt is less than cost of equity.

Net Income Approach

Value of Firm (V)

V SB

Where, S = Market value of Equity. B = Market value of Debt.

NI S Ke

Market value of Equity (S) Where, NI = Net income available for Equity shareholders Ke = Equity capitalization rate

Net Operating Income Approach

Value of the firm is independent on its Capital structure. It assumes that the Weighted average cost of capital, is unchanged irrespective of the level of gearing. NOI approach is opposite to the NI approach. Market value of the firm depends upon the net operating profit or EBIT.

Net Operating Income Approach contd

The NOI approach is based on the following assumptions: The cost of debt is constant. There is no tax. Overall cost of the capital of the firm is constant.

Net Operating Income Approach contd

Value of the Firm (V) Where, EBIT : Earnings before interest and tax EBIT V KO : Overall cost of capital.

KO

Value of Equity (S)

S V B

Where, S = Market value of Equity. B = Market value of Debt.

Net Operating Income Approach contd

Cost of Capital

Cost of Equity

WACC Cost of Debt

0

MM THEORY
Cost of capital is independent of Capital structure. It closely resembles Net operating income approach. It argues the overall cost of capital is the weighted average of cost of debt and cost of equity capital. Investors are rational There are no taxes or transaction cost.

Conclusion

Under the net income and net operating approach cost of capital increases if the leverage decreases and vice-versa. Under the traditional and MM theory the cost of capital decreases if the leverage also decreases and vice-versa.