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8. Cost of Capital
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*Book preference
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Cost of Capital
Reference Books 1. Financial Management, ICMR Book, Chapter 11 2. Financial Management, Prasanna Chandra, 7th Edition,
Chapter 14
3. Financial Management, I. M. Pandey, 9th Edition, Chapter 9
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= 12.4%
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2. Cost of Debenture
Cost of debenture is defined as the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows in the form of interest and principle repayments, i. e.
I(1 - t) F P t (1 kd) n t 1 (1 kd)
n
(1)
Where, kd = post-tax cost of debenture capital I =annual interest payment per debenture capital t = corporate tax rate F = redemption price per debenture P = net amount realized per debenture n = maturity period 7 / 46
2. Cost of Debenture
Interest payment I is multiplied by factor (1-t) because
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2. Cost of Debenture
Example: A company issued a debenture of Rs. 100 face value, 14% interest rate p.a. The debenture is redeemable at a premium of 5% after 10 years. Company realizes Rs. 97 per debenture and the corporate tax rate is 50%. Calculate the cost of this debenture to the company. n Solution P I(1 - t) t F n
t 1
(1 kd)
(1 kd)
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2. Cost of Debenture
To find out the value of kd in the above equation, several values of kd will have to be tried out in order to reach the input value. Therefore to start, consider a discount rate of 8% for kd. The expression becomes Rs. 7 x PVIFA(8%,10yrs)+ Rs.105 x PVIF(8%,10yrs) = Rs. 7 x 6.71 + Rs. 105 x 0.463 = Rs. 95.585 Since the above value is less than Rs. 97 realized price, we have to try with a less discounting rate kd. So let kd = 7%, then 10 / 46
2. Cost of Debenture
Rs. 7 x PVIFA(7%,10yrs)+ Rs.105 x PVIF(7%,10yrs) = Rs. 7 x 7.024 + Rs. 105 x 0.508 = Rs. 102.508 From above, it is clear that kd lies between 7% and 8%. We have to use linear interpolation between 7% and 8%.
kd 7 (8 7) x 102.508 - 97 102.508 - 95.585
2. Cost of Debenture
By computer Excel 97 7 x PVIFA(kd,10) 105 x PVIF(kd,10) In Excel, put all values of cash flows including initial outflow with minus sign in a row or column e. g.
-95
112
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3. Term Loans
Cost of term loans will be simply equal to the interest rate multiplied by (1 - tax rate). The interest is multiplied by (1 tax rate) as interest on term loans is also tax deductible.
kt I (1 t)
I = interest rate
t = corporate tax rate
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i. e.
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D F P t (1 kp) (1 kp) n t 1
(1)
Where, kp = cost of preference capital D = preference dividend per share payable annually F = redemption price P = net amount realized per share n = maturity period
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= 14 + 0.93 = 14.93
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(2)
Where, Pe = price per equity share Dt = expected dividend per share at the end of year one ke = rate of return required by the equity shareholders or the cost of equity capital 20 / 46
(3)
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Example: Share price of a company is Rs. 125. The dividend expected a year hence is Rs. 12 and the dividends are expected to grow at a constant rate of 8% per annum. Calculate the cost of equity capital of the company Solution: ke D1 g ke 12 0.08 0.176 or 17.6%
Pe 125
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Dt = dividend per share for year t payable at the end of year Pt = price per share at the end of year t 23 / 46
1
1.35
2
1.08
3
1.23
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Where ki = rate of return required on equity or the cost of equity Rf = risk free rate of return i = beta of security i Rm = rate of return on market portfolio 25 / 46
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Where E1 = expected EPS for the next year P0 = current market price per share E1 can be estimated by multiplying current EPS by (1+ growth rate)
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Cost of retained earnings is always less than the cost of new issue of common stock due to absence of floating costs. 29 / 46
Method 1
Where ke = cost of external equity ke = rate of return required by the equity holders f = floatation costs as a % of current market price
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Where We, Wp, Wd, Wt and Wr are the weights or the proportions of equity, preference, debentures, term loan and retained earnings resp. ke, kp, kd, kt and kr are the corresponding costs 32 / 46
Market price per equity share is Rs. 25. Next expected dividend per share is Rs. 2 and DPS is expected to grow at a constant rate of 8%. Preference shares are redeemable after 7 years at par and are currently quoted at Rs. 75 per share. Debentures are redeemable after 6 years at par and their current market price is Rs. 90 per share. Tax rate is 50%. Calculate WACC.46 33 /
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By trial-and-error method, start kp = 19%, the expression becomes Rs. 12 x PVIFA(19%,7yrs)+ Rs.100 x PVIF(19%,7yrs) = Rs. 12 x 3.706 + Rs. 100 x 0.296 = Rs. 74.072 Next, try kp = 18%, then
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= 18 + 0.70 = 18.70 %
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By trial-and-error method, start kp = 10%, the expression becomes Rs. 7 x PVIFA(10%,6yrs)+ Rs.100 x PVIF(10%,6yrs) = Rs. 7 x 4.355 + Rs. 100 x 0.564 = Rs. 86.885 Next, try kp = 9%, then
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= Rs. 91.002
0.25 x 0.16 0.30 x 0.16 0.025 x 0.187 0.175 x 0.0924 0.25 x 0.07 0.1263 or 12.63%
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3. 4.
Calculate the WACC for various ranges of total financing between the breaking points Prepare the weighted marginal cost of capital schedule which reflects the WACC for each level of total new financing 42 / 46
Preference Debt
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15 30
30 50
50 66.67
Equity Preference Debt Equity Preference Debt Equity Preference Debt Equity Preference Debt Equity Preference Debt
0.5 0.2 0.3 0.5 0.2 0.3 0.5 0.2 0.3 0.5 0.2 0.3 0.5 0.2 0.3
16 14 8 16 15 8 17 15 8 18 15 8 18 15 10
13.2
13.4
13.9
14.4
15
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50 66.67
66.67 and above
14.4
15
*****
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