Unit II, Chapter 5

Cost of Capital & Leverages

Cost of capital

The return that an investor receives
from a security is the cost of that
security to the company that issues it.

It is the average rate of return required
by the investors who provide capital to
the company.


A companys cost of capital is the
average cost of the various capital
components (equity, preference, and
debt) employed by it.

A firms cost of capital may also be
defined as the rate of return the firm
requires from investment in order to
increase the value of the firm in the
market place.

Importance of cost of capital

Capital budgeting decisions

Capital structure decisions

Types of cost of capital

Cost of debentures

Cost of preference shares

Cost of equity shares

Cost of retained earnings

Weighted average cost of capital

Once the component costs have been
calculated, they are multiplied by the
weights of the various sources of
capital to obtain a weighted average
cost of capital (WACC).

The following steps are involved in
calculating WACC:

Calculate the cost of the 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 firms WACC.
Kw=K1W1+K2W2+K3W3+.
Where
K1,K2,K3are component cost

W1,W2,W3are weights of various
types of capital employed.



Leverages

The employment of an asset or source
of funds for which the firm has to pay a
fixed cost or fixed return may be
termed as leverage.

There are two types of leverages
Operating leverage
Financial leverage


The leverage associated with
investment (asset acquisition) activities
is referred to as operating leverage,
while leverage associated with
financing activities is called financial
leverage.

Operating leverage

Operating leverage refers to the use of
fixed costs in the operations of the
firm.

Operating leverage results from the
existence of fixed operating expense in
the firms income stream.
A firm will have no operating leverage if
the ratio of fixed costs and variable
cost is nil. For such a firm, a given
change in sales would produce the
same percentage of change in
operating profits.

If a firm has fixed cost, it would have
operating leverage and with the change
in sales, the percentage change in
profit will be more.
Operating profits of a highly leveraged
firm would increase at a faster rate for
any given increase in sales.

However, if the sale falls, a firm with a
higher operating leverage would suffer
more loss than a firm with no or low
operating leverage.
Operating leverage is a double edged
sword.

It can be defined as the firms ability to
use fixed operating costs to magnify
the effect of change in sales on its
earning before interest and taxes.




Degree of operating leverage

It can be defined as the percentage
change in operating profits resulting
from a percentage changes in sales.
Thus:
DOL=%Change in operating profit
%Change in sales

Financial leverage

The use of fixed charges sources of
funds, such as debt and preference
capital along with the owners equity in
the capital structure, is described as
financial leverage.

The financial leverage employed by a
company is intended to earn more on
the fixed charges funds than their
costs.
Financial leverage at once provides the
potentials of increasing the
shareholders earnings as well as
creating the risks of loss to them. it is a
double edged sword.

The financial leverage will have a
favorable impact on EPS only when the
firms return on investment (ROI)
exceeds the fixed cost of debt (i).
The impact will be unfavorable if the
ROI is less than the interest cost.

If the ROI is equal to the cost of debt
than there is no effect of financial
leverage on EPS.

Effect of leverage
Favorable ROI>i
Unfavorable ROI<i
Neutral ROI=i




Degree of financial leverage

When the economic conditions are
good and the firms EBIT is increasing,
its EPS increases faster with more debt
in the capital structure.
The degree of financial leverage is
defined as the percentage change in
EPS due to a given percentage change
in EBIT.

DFL=%Change in EPS
% Change in EBIT

Combined/Composite
leverage
It expresses the relationship between
quantity produced and sold and EPS.

In other words, the effect of combining
financial and operating leverages is a two-
step magnification of any change in sales
into a relative change in earning per share.
DCL=DOL DFL