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Cost of Capital

Minimum rate of return which a company is

expected to earn from a proposed project so


as to make no reduction in the earning per
share to equity shareholders and its market
price.
In economic terms there are two approaches
to define CoC:
1. It is the borrowing rate of the firm, at which it
can acquire funds to finance the proposed
project
2. It is the lending rate which the firm could
have earned if the firm would have invested
elsewhere

CoC is a combined cost of each type


of source by which a firm raises

CoC
Also referred to as cut-off rate, target

rate, hurdle rate, minimum required rate


of return, standard return, etc.
Assumption: that the firms business
and financial risks are unaffected by the
acceptance and financing of projects.
Business risk is the risk to the firm of
being unable to cover fixed operating
costs. Measured by: (EBIT/EBIT)/
(Sales/Sales)
Financial risk is the risk of being unable
to cover required financial obligations
such as interest, preference dividends.
Measured by: (EPS/EPS)/ (EBIT/EBIT)

Importance of CoC
Capital Budgeting Decisions
Designing the Corporate Financial Structure
Deciding about the method of financing in

lieu with capital market fluctuations


Performance of top management
Other areas eg., dividend policy, working
capital

Measuring CoC
A realistic measure of CoC should have the following
qualities of capital expenditure decisions:
1. It must account for the general uncertainty of
expected future returns from investment proposals.
2. It must allow for the various degrees of uncertainty
of expected future returns associated with different
uses of funds.
3. It must allow for the effects of uncertainty
associated with an incremental investment and the
uncertainty of returns from the entire asset
portfolio of the firm.
4. It must account for a variety of financing means
available to a firm.
5. It must allow for the differential effects of financing
combination on the amount and quality of residual
net benefits accruing to shareholders.
6. It must reflect the changes in the capital market.

Basic costs of capital


1. Cost of Equity Capital: the cost of obtaining

funds through the sale of common stock.


2. Cost of Preference Shares
3. Cost of Debt
4. Cost of Retained Earnings

Cost of Equity Capital


Ke is defined as the minimum rate of return

that a firm must earn on the equity-financed


portion of an investment project in order to
leave unchanged the market price of the
shares.
It is the rate at which investors discount the
expected dividends of the firm to determine
its share value.
The two approaches to measure ke are i.
Dividend valuation approach and ii.
Capital asset pricing model.

Cost of Equity
Most difficult and controversial cost to work out.
Conceptually, the cost of equity ke may be
defined as the minimum rate of return that a
firm must earn on the equity financed portion
of an investment project in order to leave
unchanged the market price of the shares.
The cost of equity capital is higher than that of
preference and debt because of greater
uncertainty of receiving dividends and
repayment of principal at the end.

2 approaches to measure
Ke
1. Dividend approach dividend valuation

model: assumes that the value of a share


equals the present value of all future
dividends that it is expected to provide
over an indefinite period.
Ke accordingly is defined as 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.

Formula
N

Po(1-f)= D1/(1+ke) + D2/(1+ke)2 +.+


n=1

= D1(1+g)n-1/(1+ke)n
n=1

Po(1-f) = D1/(keg) or
Ke = (D1/Po) + g; where
D1 = expected dividend per share
Po = net proceeds per share/current market price
g = growth in expected dividends

Assumptions of the Dividend


Approach
The market value of shares depends upon

the expected dividends.


Investors can formulate subjective
probability distribution of dividends per
share expected to be paid in various future
periods. The initial dividend is greater than
0.
Dividend payout ratio is constant.
Investors can accurately measure the
riskiness of the firm so as to agree on the
rate at which to discount the dividends.

Note 1: if the growth rate is not uniform, then,

Po(1-f)or Po=D1/(1+ke) + D1(1+g1)/(1+ke)2 +

D1(1+g1) (1+g2)/(1+ke)3 .+
Note 2: if we limit the dividend payment upto

N years, then,
Po(1-f)or Po=D1/(1+ke) + D1(1+g)/(1+ke)2 ++

D1(1+g)N-1 /(1+ke)N +.+ PN/(1+ke)N


Where, PN is the share value at the end of the Nth
year.
Example: Expected dividend is Rs.2 in 1st year.
Growth rate expected 4% in perpetuity. Floatation
cost is 2%. What is the cost of equity? Assume
market price of share is Rs. 20.
So, 20(1-0.02)=2/ke-0.04
ke=0.04+2/20(1-0.02)=14.20%
If there are no floatation costs, then,

The Fincon Ltd. is planning an equity issue in

Jan 1998. it has an EPS of Rs.25 and declared


a dividend of Rs.15 per share in the current
year. Its present P/E ratio is 8. It wants to price
the issue at market price and floatation costs
are expected to be 10% of the issue price.
Determine required rate of return for equity
shares before issue and after the issue. How
will dividend tax under the Indian Income Tax
Act affect your calculations?
Cost of present equity:
Ke=[EPS/P0(1-f)]=[D1/Po(1-f)]+g=reciprocal of
P/E multiple
g=%Retimes[EPS/Po(1-f)]
Ke=1/8=.125=12.5% OR Ke=15/200+25/200(115/25)=.125=12.5%

Cost of equity for new issue:

Ke=15/200(1-0.10)+[25/200(1-0.10)](115/25)=15/180+(25/180)(0.40)=.1388=13.9%
Under new tax laws:
Po=D1/(Ke-g) OR Ke=D1/P0+g
But 10% tax is paid by company out of profits.
Thus, retained earnings or g alone is affected.
Thus, revised formula for g is:
g=EPS/P0[1-DPS(1+dt)/EPS] or g=[EPSDPS(1+dt)]/P0
where, dt is dividend tax
For existing issue, Ke=D1/P0+[EPSDPS(1+dt)]/P0
Ke=15/200+[25-15(1+0.1)]/200=15/200+[2516.5]/200=15/200+8.5/200=.1175=11.75%

For further issue of equity, Ke=D1/P0(1-f)+[EPSDPS(1+dt)]/P0(1-f)


Ke=15/200(1-0.1)+8.5/200(10.1)=15/180+8.5/200=23.5/180=0.13055=13
.1%
The new tax laws would result in:
a. Lower cost of equity
b. Perhaps it would promote investment also.

Example: suppose current dividend (D0)=Rs. 2

Current share price P0=Rs.100


Company growth rate: upto 5th year 10%
6-10th year=8%
11th year & beyond=6%
Then, P0
5

= 2*1.10(1.1)n-1/(1+ke)n +
n=1

10

D6(1.08)n-1/(1+ke)n +
n=6

D6(1.06)n-1/(1+ke)n +
n=11

2. Capital Asset Pricing Model


approach
The CAPM explains the behavior of

security prices and provides a mechanism


whereby investors could assess the impact
of proposed security investment on their
overall portfolio risk and return. In other
words, it formally describes the risk-return
trade-off for securities.
The basic assumption of CAPM are related
to
A. the efficiency of the market, and
B. investor preferences.

A. Efficient Market implies


All investors have common

(homogeneous) expectations regarding the


expected returns, variances and correlation
of returns among all securities;
All investors have the same information
about securities;
There are no restrictions on investments;
There are no taxes;
There are no transaction costs; and
No single investor can affect the market
price significantly.

B. Investors preference assumption is that all


investors prefer the security that provides the
highest return for a given level of risk or the
lowest risk for a given level of return. That is,
investors are risk averse.

Risk to which security investment is


exposed to are of 2 types:
Diversifiable/unsystematic risk: is the

portion of the securitys risk that is


attributable to firm-specific random causes;
can be eliminated through diversification. Eg.,
management capabilities and decisions,
strikes, unique government regulations,
availability of raw materials, competition.

Systematic/Non-diversifiable risk: is

the relevant portion of a securitys risk that


is attributable to market factors that affect
all firms; cannot be eliminated through
diversification. Eg., interest rate changes,
inflation or purchasing power change,
changes in investor expectations about the
overall performance of the economy and
political changes.
Since diversifiable risks can be eliminated
through diversification, investors should be
concerned with only non-diversifiable risks.

Market Portfolio
Systematic risk can be measured in

relation to the risk of a diversified


portfolio which is commonly referred to
as the market portfolio of the market.
According to CAPM, the non-diversifiable
risk of an investment/security/asset is
assessed in terms of the beta
coefficient.
Beta is the measure of the volatility of a
securitys return relative to the returns
of a broad-based market portfolio. Beta
coefficient of 1 would imply that the risk
of the specified security is equal to the

Formula
ke = rf + (km rf);

Where,
ke = cost of equity capital;
rf = the rate of return required on a risk free
asset/security/investment
km = required rate of return on the market
portfolio of assets that can be viewed as
the average rate of return on all assets
= the beta coefficient.
for market portfolios is 1, while it is 0 for
risk-free investments.

ke
rm
rf
1

Difference b/w CAPM and Dividend


Valuation method
Valuation model does not consider the risk as

reflected in beta.
CAPM model suffers from the problem of
collection of data.
Beta measures only systematic risk.
Example: =1.4, rf=8%, km=12%
ke=8%+1.4(12%-8%)
=8%+1.4*4%=13.6%

Note: CAPM approach is theoretically sound

but has limitations:


1. It does not incorporate floatation costs.
2. Difficult to get values.
3. Poorly diversified investors would be
concerned with not only systematic but total
risk.
So, dividend approach is better.

Cost of Preference
Capital
They are a hybrid security between debt and

equity. The shareholders are paid a dividend


yearly. Though, this payment is not taxdeductible but the company is required to
make payments; since, if it does not pay, it
cant pay dividends to the equity holders.
Also, preference dividend, if unpaid, gets
accumulated over years. Preference shares
may be redeemable/irredeemable. (now
irredeemable preference shares are not
allowed. Have to be redeemed in maximum
10 years)
Cost of preference share capital is the annual
preference share dividend divided by the net
proceeds from the sale of preference shares.

Cost of Preference Shares


The preference shareholders carry a prior right to

receive dividends over the equity shareholders.


Moreover, preference shares are usually
cumulative which means that preference dividend
will keep getting accumulated unless it is paid.
Further, non-payment of preference dividend may
entitle their holders to participate in the
management of the firm as voting rights are
conferred on them in such cases.
Above all, the firm may encounter difficulty in
raising further equity capital mainly because the
non-payment of preference dividend adversely
affects the prospects of ordinary shareholders.

A. Irredeemable (perpetual)

kp=dp/P0(1-f); where,
dp=constant annual dividend,
P0=expected sales price of preference share
f= floatation costs
Example: a 12% irredeemable preference share of
face value of Rs.100, f=5%. What is kp if
preference share issued at i. par, ii.10% premium,
iii. 10% discount
i. At par, kp=12/100(1-0.05)=12/95=12.63%
ii. At 10% premium, kp=12/110(1-0.05)=11.48%
iii. At 10% discount, kp=12/90(1-0.05)=14.03%

B. Redeemable preference shares


N

Po(1-f)= dp/(1+kp)n +PN/(1+kp)N ;


n=1

Example: 14% preference dividend on face


value of Rs.100 to be redeemed after 10
years. Floatation cost is 5%. Kp?
N

100(1-0.05)= 14/(1+kp)n +100/(1+kp)10 ;


n=1

By trial and error kp=15% approximately.

Cost of Debt
Debt is the cheapest form of long-term

debt from the companys point of view as:


Its the safest form of investment from the
point of view of creditors because they are
the first claimants on the companys assets
at the time of its liquidation. Likewise they
are the first to be paid their interest.
Another, more important reason for debt
having the lowest cost if the taxdeductibility of interest payments.

Cost of Debt
It is the interest rate which equates the

present value of the expected future receipts


with the cost of the project. The present value
of tax-adjusted interest costs plus repayments
of the principal is equated with the amount
received at the time the loan is consummated.

Cost of Debt
Cost of debt is the after-tax cost of long-

term funds through borrowing.


Net cash proceeds are the funds actually
received from the sale of security.
Flotation cost is the total cost of issuing
and selling securities.
Cost of perpetual/irredeemable debt
Cost of redeemable debt

Cost of Perpetual/Irredeemable debt


The nominal cost of debt is the periodical interest paid
on it. The interest rate/market yield is said to be cost of
debt.
Suppose a bond is issued to procure perpetual debt.
Then,
ki=I/SV; where I is annual interest payment (coupon
payment); SV is sale proceeds of bond/debenture.
kd=I(1-T)/SV; where T is tax rate.
Example: A 12% perpetual debt of nominal value of
Rs.100000. Tax rate is 50%. Cost of debt when issued
at i. Par, ii. At discount of 5% and iii. premium of 10%.
i. At par ki=12000/100000=12%
kd=12%(1-0.5)=6%
ii. At discount of 5%, that is value received is 95,000.

iii. At a premium of 10%, that is value


received is 110,000.
ki=12000/110,000=10.91%
kd=10.91%(1-0.5)=5.45%
So here (ii) 6.32% is highest cost followed by
(i) 6% or (iii) 5.45%.

Cost of Redeemable debt


To find the cost, initial net proceeds are to be

equated with net outflows.

Co= In/(1+kd)n +PN/(1+kd)N ; if principal


n=1
payment is made
at the end of
Nth year
Or,

Co= In+PN /(1+kd)n ; if payment of principal is


done in n=1
installments

Example: 15% debentures of Rs.1000 (face

value) to be redeemed after 10 years. Net


proceeds are after 5% floatation costs and 5%
discount. The tax rate is 50%. What is the cost
of debt?
Year Cashflows
0
1000-5%of 1000(floatation)5%ofdiscount
=900
1-10
Rs. 15% of 1000(1-0.5)=Rs.75
10
Rs. 1000 (repayment)
10

So, 900= = 75/(1+kd)n +1000/(1+kd)10


n=1

By trial and error; kd =9% approx.

Example: of redemption on yearly basis

(coupon rate=15%). The par value of


debenture is Rs.100000. the floatation cost is
10%. Principal to be paid back in 5 equal
installments at the year end. Tax rate is 50%.
Net proceeds=100000-10%=90000
Outflows:
Net coupon
Principal Total
Yr 1
15000(1-0.5)=7500
20000
27500
Yr 2
80000*.15(1-0.5)=6000 20000
26000
Yr 3
60000*.15(1-0.5)=4500 20000
24500
Yr 4
40000*.15(1-0.5)=3000 20000
23000
Yr 5
20000*.15(1-0.5)=1500 20000

Cost of Retained Earnings


May be defined as the opportunity cost in

terms of dividends foregone by/withheld from


the equity shareholders.
Cost of retained earnings is the same as the
cost of an equivalent fully subscribed issue of
additional shares, which is measured by the
cost of equity capital.
Retained earnings are dividends withheld,
that is, if were in the hands of the investors
(shareholders) they could have earned on
these by investing somewhere else. The
assumption is that the firm is earning at least
equal to ke on these retained earnings. So the
cost kr is approximately equal to ke (a little

Weighted Average Cost of


Capital (WACC)
This gives us the overall cost of capital.

Weight age is given to the cost of each


source of funds by assessing the relative
proportion of each source of fund to the
total, and is ascertained by using the book
value or the market value of each type of
capital. The cost of capital of the market
value is usually higher than it would be if
the book value is used.

Steps in Calculation of
WACC (Ko)
Assigning weights to specific costs.
Multiplying the cost of each sources by the

appropriate weights.
Dividing the total weighted cost by the total
weights.

Weighting can be using marginal or


historical weights
Why marginal weights? Because it is the new
capital being raised for new investment that is
important so the weighted cost of new capital
is of relevance. Else, projects with costs higher
than managerial costs may be accepted,
giving negative results and vice-versa.
But the problem is that if we go by marginal
weighting, we may resort to too much
borrowing and accept many projects because
of lower cost at the moment. But, at a later
date, company may have the problem of
raising more finance. Marginal weights ignore
long term view.
Thus, the fact that todays financing affects

Historical weights take a long term view and

try to raise financing also in the proportion of


existing capital structure considered
superior.
Historical weights can be divided into book
value weights and market value weights.
Calculations based on the book value weights
are more easy operationally while those based
on market values are more sound theoretically
since the sale price of securities is going to be
more close to the market value. But the
problem is how to choose the market value
because they fluctuate widely sometimes and
almost everyday their values are different.

Example: capital structure (book value based)

Debt 30% (Rs.6000)


cost kd=8%
Preference shares 30% (Rs.6000) cost kp=13%
Equity 40% (Rs.8000)
cost k=14%
Ko=WACC= wiki=30%*8%+30%*13%

+40%*14%
=2.4%+3.9%+5.6%=11.9%
Note: ko calculated on the basis of market value is
likely to be greater than the one calculated on the
basis of book value since market values of equity
and preference shares is usually higher than book
value and hence their weight is more with respect
to debt. For example, in the above example,
market values are:

Debt 25% (Rs.60000)


cost kd=8%
Preference shares 29.17% (Rs.70000) cost
kp=13%
Equity 45.83% (Rs.110000)
cost k=14%
Total=240000
Ko=WACC=
wiki=0.25*0.08+0.2917*0.13+0.4583*0.14=
0.0200+0.03792+0.06416=0.122082=12.21
%

Market Value vs. Book Value


Weights
MV sometimes preferred to BV for the MV

represents the true expectations of the


investors. However, it suffers from the
following limitations:
1. MV undergoes frequent fluctuations and
have to be normalized;
2. The use of MV tends to cause a shift
towards larger amounts of equity funds,
particularly when additional financing is
undertaken.

MV more appealing than


BV as:
Market values of securities closely

approximate the actual amount to be received


from their sale
Costs of specific sources of finance which
constitute the capital structure of the firm are
calculated using prevalent market prices.

Advantages of BV
weights
1. The capital structure targets are usually

fixed in terms of book value.


2. It is easy to know the book value.
3. Investors are interested in knowing the
debt-equity ratio on the basis of book
values.
4. It is easier to evaluate the performance of
a management in procuring funds by
comparing on the basis of book values.

Relevant costs closely


related to CoC
1. Marginal cost of capital: average cost of new or
incremental funds raised by the firm. MC tens to
increase proportionately as the amount of debt
increases.
2. Explicit cost and implicit cost:
a. Explicit cost: of any source of finance is the
discount rate that equates the present value of
the cash inflows that are incremental to the
taking of the financial opportunity with the
present value of the incremental cash outflows.
The explicit cost of a debt would be 0 if it is
interest free. The explicit cost of a gift would
be 100%.

b. Implicit cost: is the opportunity cost. It


is the rate of return associated with
the best investment opportunity for the
firm and its shareholders that will be
foregone if the project presently under
consideration by the firm were accepted.
It is not concerned with any particular
source of finance.
The explicit cost include only the CoC to
be paid and ignores the other factors
such as risk involved, flexibility and
leverage characteristics which are
adversely affected with an increase in
debt contents in its capital structure and
these changes imply additional but

3. Future cost and Historical cost


We always consider the projects expected

internal rate of return and compare it with the


expected (future) cost of capital while making
capital expenditure decision. Historical costs
(past costs) help in predicting the future costs
and provide an evaluation of the past
performance

4. Specific cost and


Inclusive/Combined/Composite CoC
a. Specific CoC is associated with a specific
component of capital structure.
b. Inclusive CoC is an aggregate of the CoC
from all sources. In other words, it is WACC.

5. Spot costs and Normalized costs


a. Spot costs represent those costs prevailing in
the market at a certain time.
b. Normalized cost indicate an estimate of cost
by some averaging process from which
cyclical element is removed.