54732cost of capital-final
TRANSCRIPT
-
8/7/2019 54732Cost of Capital-Final
1/28
Amity School Of Business
1
Amity School Of Business
BBA Semister four
Financial Management-II
Ashish Samarpit Noel
-
8/7/2019 54732Cost of Capital-Final
2/28
Amity School Of Business
Cost Of Capital Cost of Capital is the cost of raising
capital and using it. In other words it is
evaluation of the required rate of return tofirms investors.
Signifiance:-
Evaluating Investment decision
Designing a firms debt policy
Appraising the financial performance of topmanagement
2
-
8/7/2019 54732Cost of Capital-Final
3/28
Amity School Of Business
3
Factors determining the cost of capital General economic conditions
Demand for and supply of capital within the economy
and the level of expected inflation
Market conditions
A firms operating and financing decisions
Business Risk-Companys investment decisions
Financial Risk-Use of Debt
-
8/7/2019 54732Cost of Capital-Final
4/28
Amity School Of Business
4
Project cost of capital & Companys cost ofcapital
The project cost of capital is the minimum
required on funds committed to a project, which
depends on the riskiness of its cash flows.
The company cost of capital is the overall or
average, required rate of return on theaggregate of investment projects.
-
8/7/2019 54732Cost of Capital-Final
5/28
Amity School Of Business
5
Explicit and Implicit Costs Explicit Cost
Discount rate that equates the PV of
incremental cash inflows to the PV ofincremental cash outflows
Implicit Cost/Opportunity Cost Rate of return of the foregone opportunity,
E.g. Retained Earnings
-
8/7/2019 54732Cost of Capital-Final
6/28
Amity School Of Business
6
Weighted Average Cost of Capital (WACC)vs. Specific Costs of Capital
The cost of capital for each source of capital is known as
specific or component cost of capital
The component costs are combined according to the
weights of each component capital to obtain weighted
average cost of capital or overall cost of capital
-
8/7/2019 54732Cost of Capital-Final
7/28
Amity School Of Business
7
Tax Adjustment
The interest paid on debt is tax deductible
The higher the interest charges, lower would be the
amount of tax payable by the firm
As a result, the after-tax cost of debt to the firm will besubstantially lower than the investors required rate of
return
After-tax-cost of debt = kd(1-T)
Where T is the corporate tax rate
Loss making firms will not have after tax cost of debt
In Calculation of WACC after-tax-cost of debt is to be
used
-
8/7/2019 54732Cost of Capital-Final
8/28
Amity School Of Business
8
In case of preference capital, payment of dividends is notlegally binding
The cost of preference capital is a function of thedividend expected by the investors
Irredeemable Preference Shares If Preference shares are perpetual,
where, kp is the cost of preference shares
PDIV is the expected preference dividend
P0 is the issue price of preference shares
Cost of Preference
Capital
0P
PDIVkp !
-
8/7/2019 54732Cost of Capital-Final
9/28
Amity School Of Business
9
Redeemable Preference Share
Cost of Redeemable Preference Shares can be
computed as:
The cost of preference share is not adjusted for taxes because
preference dividend is paid after the corporate taxes have been
paid
Since interest is tax deductible & Preference dividend is
not, the cost of preference is substantially higher than
the after tax cost of debt
n
p
n
n
t
t
p
t
k
P
k
PDIVP
)1()1(10
!
!
-
8/7/2019 54732Cost of Capital-Final
10/28
Amity School Of Business
10
Cost of Equity Capital Equity capital can be raised internally by retained
earnings or the firm can distribute dividends & raise
capital by new issue of equity shares
In both the cases the shareholders are providing funds to
the firms to finance their capital expenditures
Equity shareholders required rate of return would be
same
Difference between cost of retained earnings & cost of
external equity would be floatation costs
-
8/7/2019 54732Cost of Capital-Final
11/28
Amity School Of Business
11
Is equity CapitalF
ree of Cost? Equity capital involves opportunity cost; ordinary
shareholders provide funds to the firm in
expectation of dividends and capital gains
The shareholders required rate of return
equates the PV of the expected dividends with
the market value of shares
Two difficulties in measurement:
Difficult to estimate expected dividends
Future earnings & Dividends are expected to grow
-
8/7/2019 54732Cost of Capital-Final
12/28
Amity School Of Business
12
Cost of Internal Equity: Dividend Growth Model
The opportunity cost of retained earnings is therate of return foregone by equity shareholders
1. Normal Growth: The cost of Equity is equal to
the expected dividend plus capital gain rate
gP
DIke !
0
1
Where,
ke = cost of equity
DIV1 = DIV0(1+g)
g= expected growth in dividends
-
8/7/2019 54732Cost of Capital-Final
13/28
Amity School Of Business
13
Cost of Internal Equity: Dividend Growth Model
Can be written as follows:
These equations are based on the following assumptions:
Market price of shares is a function of expected dividends
The Dividend is positive
The dividends grow at a constant rate & g = ROE X Retention
Ratio
The dividend payout ratio is constant
Also called as GORDONs model
Implies the opportunity cost for the shareholders, if these
earnings were to be distributed as dividends
gk
DIVP
e
o
! 1
-
8/7/2019 54732Cost of Capital-Final
14/28
Amity School Of Business
14
2. Supernormal Growth When dividends grow at different rates, thedividend valuation model is used as follows:
Where, gs = super-normal growth rate for n years
& gn is the growth rate beginning in the year n+1,
perpetually
3. Zero growth:
nenen
tn
t
t
e
s
kX
gkDIV
kgDIVP
)1(1
1)1( 1
1
00
!
!
0
1
P
DIVke !
-
8/7/2019 54732Cost of Capital-Final
15/28
Amity School Of Business
15
Cost of External Equity: Dividend GrowthModel
The firms external equity consists of funds raised
externally through public or rights issue
The minimum rate of return required by equity
shareholders to keep the market price of share
same is the cost of equity
Cost of retained earnings is lesser than the cost ofexternal equity
-
8/7/2019 54732Cost of Capital-Final
16/28
Amity School Of Business
COST OF EXTERNAL EQUITY (No Flotation Cost)
DIVIDEND GROWTH MODEL
Consists of funds raised externally through public or rights issue
The minimum rate of return required by equity shareholders to keep
the market price of share same is the cost of equity
Firm can induce existing or potential shareholders to purchase new
shares when it promises rate of return which is equal to
ke = Div1 + g
PoWhere
Div1 = Expected dividend = Div0 (1+g)
P0 = Current market price
g = Expected growth rate in dividend = RoE x Retention Ratio
-
8/7/2019 54732Cost of Capital-Final
17/28
Amity School Of Business
COST OF EXTERNAL EQUITY (With Flotation Cost)
DIVIDEND GROWTH MODEL(2)
New issues of ordinary shares are generally sold at a price less than
the prevailing market price
Hence cost of equity can be calculated as
ke = Div1 + g
Pn
Where
Div1 = Expected dividend = Div0 (1+g)
Pn = Issue price of new equity = Issue Price Floatation cost
g = Expected growth rate in dividend = RoE x Retention Ratio
-
8/7/2019 54732Cost of Capital-Final
18/28
Amity School Of Business
18
Cost of Debt
Cost of Debt Based on the interest/coupon rate
Before tax cost of debt is the rate of return required by
the lenders
1. Debt Issued At Par
where,
kd is the cost of debt
I is the coupon rate of interest
B0 is the issue price of the bond
INT is the amount of interest
0B
INTikd !!
-
8/7/2019 54732Cost of Capital-Final
19/28
Amity School Of Business
19
The before tax cost of debt can be calculated using the
following equation:
where,
Bn is the repayment of debt on maturity
B0 is the issue price of the bond
This equation can be solved for kd by trial & error &
interpolation
01
I T(1 ) (1 )
n
t n
t nt
d d
BBk k!
!
2
. Debt Issued at Discount/Premium`
-
8/7/2019 54732Cost of Capital-Final
20/28
Amity School Of Business
20
Tax Adjustment
The interest paid on debt is tax deductible
The higher the interest charges, lower would be the
amount of tax payable by the firm
As a result, the after-tax cost of debt to the firm will besubstantially lower than the investors required rate of
return
After-tax-cost of debt = kd(1-T)
Where T is the corporate tax rate
Loss making firms will not have after tax cost of debt
In Calculation of WACC after-tax-cost of debt is to be
used
-
8/7/2019 54732Cost of Capital-Final
21/28
Amity School Of Business
21
Earnings Price Ratio & Cost of Equity The firms external equity consists of funds
raised externally through public or rights
issue
The minimum rate of return required by
equity shareholders to keep the market
price of share same is the cost of equity
-
8/7/2019 54732Cost of Capital-Final
22/28
Amity School Of Business
22
Cost of Equity & Capital Asset Pricing Model
The CAPM is a model that provides a framework to determine the
required rate of return on an asset and indicates the relationship
between return and risk of the asset
Assumptions:
Market Efficiency
Risk Aversion
Homogeneous expectations
Single time period
Risk-free rate Risk has two parts:
Unsystematic Risk (Diversifiable)
Systematic Risk (Cannot be reduced)
-
8/7/2019 54732Cost of Capital-Final
23/28
-
8/7/2019 54732Cost of Capital-Final
24/28
Amity School Of Business
24
Cost of Equity: CAPM Vs. Dividend-Growth
Model
The dividend-growth approach has limited
application in practice
The expected dividend growth rate, g, shouldbe less than the cost of equity, ke, to arrive at
the simple growth formula
Cant be used if a company is not payingdividends
Fails to deal with risk directly
-
8/7/2019 54732Cost of Capital-Final
25/28
Amity School Of Business
25
Cost of Equity: CAPM Vs. Dividend-Growth Model
CAPM has a wider application although it is based on
restrictive assumptions:
The only condition for its use is that the companys
share is quoted on the stock exchange All variables in the CAPM are market determined and
except the company specific share price data, they are
common to all companies
The value of beta is determined in an objective mannerby using sound statistical methods. One problem with
the use of beta is that it does not remain stable over
time
-
8/7/2019 54732Cost of Capital-Final
26/28
Amity School Of Business
26
Weighted Average Cost of Capital (WACC)
The following steps are involved for calculating the firms
WACC:
Calculate the cost of specific sources of funds
Multiply the cost of each source by its proportion in the capitalstructure.
Add the weighted component costs to get the WACC.
Weighted Marginal Cost of Capital (WMCC):
Marginal cost is the new or incremental cost of new capital(equity & debt) issued by the firm
New funds are raised at new costs according to the firms
target capital structure
WMCC is the WACC of new capital given the firms target
capital structure
-
8/7/2019 54732Cost of Capital-Final
27/28
Amity School Of Business
27
Book Value Versus Market Value Weights Managers prefer the book value weights for calculating
WACC:
Firms in practice set their target capital structure in terms ofbook values.
The book value information can be easily derived from the
published sources. The book value debtequity ratios are analysed by investors to
evaluate the risk of the firms in practice.
The use of the book-value weights can be seriously
questioned on theoretical grounds: First, the component costs are opportunity rates and are
determined in the capital markets. The weights should also bemarket-determined.
Second, the book-value weights are based on arbitraryaccounting policies that are used to calculate retained earningsand value of assets. Thus, they do not reflect economic values.
-
8/7/2019 54732Cost of Capital-Final
28/28
Amity School Of Business
28
Book Value Versus Market Value Weights
Market-value weights are theoretically superior tobook-value weights: They reflect economic values and are not influenced by
accounting policies
They are also consistent with the market-determined
component costs.
The difficulty in using market-value weights: The market prices of securities fluctuate widely and frequently. A market value based target capital structure means that the
amounts of debt and equity are continuously adjusted as the
value of the firm changes.