COST OF CAPITAL

The concept of cost of capital budgeting is concerned with cost of capital. The concept of cost of capital is significant not only for capital budgeting it is also indispensable in other areas of financial management. In operational terms the Cost of capital is the rate of return of a firm must earn on its investments so that market value of the concern remain unchanged.

DEFINITION
Cost of capital is the minimum required rate of earning or the cut off rate for capital expenditure. Soloman Ezra

(i) Designing the optimal Capital structure (ii) Assisting in investment decisions (iii) Helpful in evaluation of expansion projects (iv) Rational allocation of national resources

COMPONENTS

Cost of debt Cost of preference capital Cost of equity Weighted average capital cost of capital (WACC)

Cost of Debt
The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity: After-tax cost of debt = yield x (1 - tax rate) The cost of debt should also be adjusted for flotation costs (associated with issuing new bonds)

Example: Tax effects of financing with debt

EBIT - interest expense EBT - taxes (34%) EAT


with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

Now, suppose the firm pays $50,000 in dividends to the shareholders

Example: Tax effects of financing with debt

EBIT - interest expense EBT - taxes (34%) EAT - dividends Retained earnings with stock 400,000 0 400,000 (136,000) 264,000 (50,000) 214,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000

After-tax cost of Debt

=
=

Before-tax cost of Debt

Tax Savings

33,000
OR

50,000

17,000

33,000

50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

After-tax % cost of Debt

Before-tax % cost of Debt

1-

Marginal tax rate

Kd .066

= =

kd (1 - T) .10 (1 - .34)

Cost of irredeemable/perpetual debt

The debt fund whose principal amt. is not to be returned after a fixed period of time are termed as irredeemable debt. kd = interest /price

Kd = interest/ net proceed

The debt whose principal amount is repayable after a fixed maturity period is termed as redeemable debt
I (1-t) + RV NP kd = n NP+RV 2 I = amount of interest t = Tax rate RV = redeemable value NP = Net proceeds n = no. of years to maturity

Preferred stock: has a fixed dividend (similar to debt) has no maturity date dividends are not tax deductible and are expected to be perpetual or infinite Cost of preferred stock = dividend price - flotation cost

Baker Corporation has preferred stock that sells for $100 per share and pays an annual dividend of $10.50. If the flotation costs are $4 per share, what is the cost of new preferred stock? $10.50 KP ! ! .1094 ! 10.94% $100 - 4

Unlike debt and pref. shares, equity shares do not carry a fixed cost. Hence, there is no single model of computation of cost of equity which is acceptable to all.

 Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends Investors could buy other securities, and earn a return. Thus, there is an opportunity cost if earnings are retained

 There are a number of methods used to determine the cost of equity We will focus on two Dividend growth Model CAPM

 Estimating the cost of equity: the dividend growth model approach According to the constant growth (Gordon) model, D1 P0 = RE - g Rearranging RE = P0 D1 +g

Percentage Year Dividend Change 1990 1991 1992 1993 1994 $4.00 4.40 4.75 5.25 5.65 -

Dollar Change

10.00% 7.95 10.53 7.62

$0.40 0.35 0.50 0.40

Average Growth Rate (10.00 + 7.95 + 10.53 + 7.62)/4 = 9.025%

This model has drawbacks: Some firms concentrate on growth and do not pay dividends at all, or only irregularly Growth rates may also be hard to estimate Also this model doesnt adjust for market risk Therefore many financial managers prefer the capital asset pricing model (CAPM) - or security market line (SML) - approach for estimating the cost of equity

kj ! Rf  ( Rm  Rf )
Cost of capital Risk-free return Co-variance Average rate of return of returns against on common stocks the portfolio (WIG) (departure from the average)
B < 1, security is safer than WIG average B > 1, security is riskier than WIG average

The Capital Asset Pricing Model (CAPM) can be used to estimate the required return on individual stocks. The formula: K j ! R f  F j K m  R f where Kj Rf Fj Km = = = = Required return on stock j Risk-free rate of return (usually current rate on Treasury Bill). Beta coefficient for stock j represents risk of the stock Return in market as measured by some proxy portfolio (index)

Suppose that Baker has the following values: = 5.5% Rf Fj = 1.0 Km = 12%

Then, using the CAPM we would get a required return of

K j ! 5.5  1.0  - 5.5 ! 12% 12

 Advantage: Evaluates risk, applicable to firms that dont pay dividends Disadvantage: Need to estimate
Beta the risk premium (usually based on past data, not future projections) use an appropriate risk free rate of interest

 WACC weights the cost of equity and the cost of debt by the percentage of each used in a firms capital structure WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
(E/V)= Equity % of total value (D/V)=Debt % of total value (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be considered because interest on corporate debt is deductible

ABC Corp has 1.4 million shares common valued at $20 per share =$28 million. Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the market. Total market value of both equity + debt thus =$32.65 million. Equity % = .8576 and Debt % = .1424 Risk free rate is 4%, risk premium=7% and ABCs =.74 Return on equity per SML : RE = 4% + (7% x .74)=9.18% Tax rate is 40% Current yield on market debt is 11%

WACC = (E/V) x RE + (D/V) x RD x (1-Tc) = .8576 x .0918 + (.1424 x .11 x .60) = .088126 or 8.81%

Weighted average cost of capital, WACC will be one single number that will take into Account the expectations of all suppliers of capital. This may be used as a hurdle rate That must be overcome if the project is to be accepted. Crossing of this hurdle rate Will imply that all capital suppliers are satisfied with the benefits of the project.

Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations.

Net Income (NI) Theory Net Operating Income (NOI) Theory Traditional Theory Modigliani-Miller (M-M) Theory

This theory was propounded by David Durand and is also known as Fixed Ke Theory. According to this theory a firm can increase the value of the firm and reduce the overall cost of capital by increasing the proportion of debt in its capital structure to the maximum possible extent.

It is due to the fact that debt is, generally a cheaper source of funds because: (i) Interest rates are lower than dividend rates due to element of risk, (ii) The benefit of tax as the interest is deductible expense for income tax purpose.

The Kd is cheaper than the Ke. Income tax has been ignored. The Kd and Ke remain constant.

This theory was propounded by David Durand and is also known as Irrelevant Theory. According to this theory, the total market value of the firm (V) is not affected by the change in the capital structure and the overall cost of capital (Ko) remains fixed irrespective of the debt-equity mix.

The split of total capitalization between debt and equity is not essential or relevant. The equity shareholders and other investors i.e. the market capitalizes the value of the firm as a whole. The business risk at each level of debtequity mix remains constant. Therefore, overall cost of capital also remains constant. The corporate income tax does not exist.

This theory was propounded by Ezra Solomon. According to this theory, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the debt proportion in its capital structure to a certain limit. Because debt is a cheap source of raising funds as compared to equity capital.

This theory was propounded by Franco Modigliani and Merton Miller. They have given two approaches

In the Absence of Corporate Taxes When Corporate Taxes Exist

According to this approach the V and its Ko are independent of its capital structure. The debt-equity mix of the firm is irrelevant in determining the total value of the firm. Because with increased use of debt as a source of finance, Ke increases and the advantage of low cost debt is offset equally by the increased Ke. In the opinion of them, two identical firms in all respect, except their capital structure, cannot have different market value or cost of capital due to Arbitrage Process.

Perfect Capital Market No Transaction Cost Homogeneous Risk Class: Expected EBIT of all the firms have identical risk characteristics. Risk in terms of expected EBIT should also be identical for determination of market value of the shares Cent-Percent Distribution of earnings to the shareholders No Corporate Taxes: But later on in 1969 they removed this assumption.

M-Ms original argument that the V and Ko remain constant with the increase of debt in capital structure, does not hold good when corporate taxes are assumed to exist. They recognised that the V will increase and Ko will decrease with the increase of debt in capital structure. They accepted that the value of levered (VL) firm will be greater than the value of unlevered firm (Vu).