cf_3_cost_of_capital_09

8/7/2019 CF_3_Cost_of_capital_09

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Topics Covered ------

Overview of cost of capital

Cost of Debt and Preference

Cost of Equity

Determining the Proportions

Weighted Average Cost of CapitalCost of capital_09


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------Topics Covered

Floatation Costs and the WACC

Divisional and Project Cost of Capital

Cost of Capital in Practice

Cost of capital_09 2


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Cost of Capital--

The cost of capital of any investment (project,

business, or company) is the rate of return the

the capital were invested elsewhere in an

investment (project, business, or company) of

comparable risk.



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--Cost of Capital

The cost of capital reflects expected

return.

The cost of capital represents an

opportunity cost.



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Why Cost of Capital is Important

We know that the return earned on assets

depends on the risk of those assets. The return

to an investor is the same as the cost to the

company.

The cost of capital provides us with an indication

of how the market views the risk of our assets.

Knowing the cost of capital can also help us

determine our required return for capital

budgeting projects.



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Required Return

The required return is the same as theappropriate discount rate and is based on therisk of the cash flows.

We need to know the required return for an

make a decision about whether or not to take theinvestment.

We need to earn at least the required return tocompensate our investors for the financing theyhave provided.



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Weighted Average Cost of Capital

(WACC)

WACC = weke + wpkp + wdkd(1 tc)

we = proportion of equity

ke = cost of equitywp = propor on o pre erence

kp = cost of preference

wd= proportion of debtkd= pre-tax cost of debt

tc= corporate tax rate



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Company Cost of Capital and Project

Cost of Capital--

The company cost of capital (WACC) is the rate

of return expected by the existing capital.

investment which is same as that of the

existing firm.



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--Company Cost of Capital and Project

Cost of Capital

The project cost of capital is the rate of return

expected by capital providers for a new

project the company proposes to undertake.



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Cost of Debt

The cost of debt is the required return on our

companys debt.

We usually focus on the cost of long-term debt

or bonds.

The required return is best estimated by

computing the yield to maturity on the existing

debt.

The cost of debt is not the coupon rate.



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Cost of Debt

n I F

P0 = +t= 1 (1 + kd)

t (1 + kd)n

P0 = current price of the debenture

I= annual interest payment

n = number of years left to maturity

F= maturity value

kd is computed through trial-and-error. A very

close approximation is:I+ (F P0)/n

0.6P0 + 0.4FrD =



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e.g.:

Face value = Rs. 1,000

Coupon rate = 12%

Period to maturity = 4 years

Current market rice = Rs.1040

The approximate yield to maturity of this

debenture is :

120 + (1000 1040) / 4

kd= = 10.7 percent

0.6 x 1040 + 0.4 x 1000Cost of capital_09 12


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Cost of Preference

Given the fixed nature of preference dividend

and principal repayment commitment, the cost

o pre erence s s mp y equa o s y e .



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e.g.:

Face value : Rs.100

Dividend rate : 11 percent

Maturity period : 5 years

Market price : Rs. 95

Approximate yield :

11 + (100 95) / 5

= 12.37 percent

0.6 x 95 + 0.4 x 100



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Cost of Equity

The cost of equity is the return required by

equity investors given the risk of the cash

.

Equity finance comes by way of

(a) retention of earnings , and(b) issue of additional equity capital



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Note:

Irrespective of whether a firm raises equity

finance by retained earnings or issuing

,

the same. The only difference is in floatation

cost.



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Approaches to Estimate Cost of Equity

Security Market Line Approach

Bond Yield Plus Risk Premium Approach

Dividend Growth Model Approach

Earnings-Price Ratio Approach



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Security Market Line Approach

ke = rf+ e [E(km) rf]

Where,

re

= required return on the equity of the

rf= risk-free rate

e

= beta of the equity of the company

E(km) = expected return on the market

portfolio



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e.g.:

rf= 7%, e = 1.2, E(km) = 15%

ke = 7 + 1.2 [15 7] = 16.6%



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Inputs for the SML--

While there is disagreement among finance

practitioners, the following would facilitate as a

guideline:

The risk-free rate may be estimated as the

yield on long-term bonds that have a

maturity of 10 years or more.



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-- Inputs for the SML

The market risk premium may be estimated

as the difference between the average return

on the market portfolio and the average risk-

free rate over the past 10 to 30 years.

The beta of the stock may be calculated by

regressing the monthly returns on the

market index over the past 60 months or so.



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Bond yield plus Risk Premium Approach

Yield on the

long-term bonds

of the firm

Cost of equity =Risk

+ premium

Should the risk premium be 2%, 4% orn% ?

There seems to be no objective way of doing it.



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Dividend Growth Model Approach--

If the dividend per share grows at a constantrate ofgpercent.

D1

P0 = k

D1So, ke = + g

P0



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-- Dividend Growth Model Approach

Thus, the expected return of equity

shareholders, which in equilibrium is

also the required return, is equal to thev en y e p us e expec e grow

rate.



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e.g.:

Suppose that a company is expected to pay adividend of Rs. 1.50 per share next year. There

has been a steady growth in dividends of 5.1%

per year and the market expects that to

continue. The current price is Rs. 25.Compute the cost of the equity.



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Getting a handle overg

Analysts forecasts of growth rate.

Average annual growth rate in the preceding

.

(Retention rate) (Return on equity)



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Advantages and Disadvantages of

Dividend Growth Model

Advantage

easy to understand and use

Disadvantages

Only applicable to companies currently payingdividends

Not applicable if dividends arent growing at areasonably constant rate

Extremely sensitive to the estimated growthrate (an increase in g of 1% increases thecost of equity by 1%)



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e.g.:

Suppose the company has a beta of 1.5. Themarket risk premium is expected to be 9% and

the current risk-free rate is 6%. We have used

analysts estimates to determine that the market

and our last dividend was Rs. 2. Our stock is

currently selling for Rs. 15.65. What is the cost of

equity?



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Solution:

Using SML: ke = 6% + 1.5(9%) = 19.5%

Using DGM: ke = [2(1.06) / 15.65] + .06= 19.55%



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Earnings-Price Ratio Approach--

Cost of equity = E1 / PO

where,

=

PO = the current market price



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--Earnings-Price Ratio Approach

This approach provides an accurate measurein the following two cases:

When the EPS is constant and the dividend

payout ratio is 100 percent.

When retained earnings earn a rate of

return equal to the cost of equity.



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Weighted Average Cost of Capital

We can use the individual costs of capitalthat we have computed to get our average

cost of capital for the firm.

This average is the required return on therm s assets, ase on t e mar et s

perception of the risk of those assets.

The weights are determined by how much

of each type of financing is used.



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Determining the Proportions or Weights--

The appropriate weights are the target capital

structure weights stated in market value terms.

The primary reason for using the target capitalstructure is that the current capital structure may

not reflect the capital structure expected in future.



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--Determining the Proportions or Weights

Market values are superior to book values

because in order to justify its valuation the

firm must earn competitive returns for

s are o ers an e o ers on e

current (market) value of their investments.



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e.g.:Suppose you have a market value of equity equal to Rs.

500 million and a market value of debt Rs. 475 million.

What are the capital structure weights?

V = Rs. 500 million + Rs. 475 million = Rs. 975 million

we = E/V = 500 / 975 = .5128 = 51.28%

wd = D/V = 475 / 975 = .4872 = 48.72%



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e.g.:

Source of Capital Proportion Cost Weighted Cost

(A) (B) [AxB]

Equity 0.60 16.0% 9.60%Preference 0.05 14.0% 0.70%

Debt 0.35 8.4% 2.94%

Note: Assuming tax rate @ 30%. WACC = 13.24%



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Weighted Marginal Cost of Capital Schedule--

The procedure for determining the weighted

Marginal cost of capital involves the

following steps:

1. Estimate the cost of each source of

financing for various levels of its use

through an analysis of current marketconditions and an assessment of the

expectations of investors and lenders.Cost of capital_09 38


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--Weighted Marginal Cost of Capital Schedule--

2. Identify the levels of total new financing

at which the cost of the new components

would change, given the capital structure

policy of the firm. These levels, calledrea ng po n s, can e es a s e us ng

the following relationship:



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where, BPj is the breaking point on account of

BPj =TFj

wj

--Weighted Marginal Cost of Capital Schedule--

nanc ng source , j s e o a new nanc ng rom

source j at the breaking point, and wj is the

proportion of financing source j in the capital

structure.



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3. Calculate the WACC for various ranges of total

financing between the breaking points.

--Weighted Marginal Cost of Capital Schedule

4. Prepare the weighted marginal cost of capital

schedule which reflects the WACC for each level

of total new financing.



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ABC Ltd. Wishes to use equity, preference and debt capital in the

following proportions:Equity: 0.45 , Preference: 0.05, Debt: 0.50

As per the estimates of ABC Ltd., the cost of each of its three

sources of financing for various levels of usage are as follows:

Source Target proportions Range of new financing(Rs. in cr.) Cost (%)

Equity 45% 0 - 10 15.00

e.g.:

.

30 & above 18.00

Preference 5% 0 1 14.50

1 & above 15.00

Debt 50% 0 - 15 7.50

15 40 8.0040 & above 8.40

Compute the breaking points for each source of finance and corresponding

ranges of new financing.



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We have,

Source Cost (%) Range of new Breaking Points Range of total new

financing (in cr.) (Rs. in cr.) financing (in cr.)

Equity 15.00 0 - 10 10/0.45= 22.22 0 22.22

16.50 10 30 30/0.45 = 66.67 22.22 66.67

18.00 30 & above ---------- 66.67 & above

Solution--

Preference 14.50 0 1 1/0.05 = 20.00 0 20.00

15.00 1 & above ---------- 20.00 & above

Debt 7.50 0 15 15/0.50 = 30.00 0 30.00

8.00 15 40 40/0.50= 80.00 30.00 80.00

8.40 40 & above ----------- 80.00 & above



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Range of total new Source Proportions Cost (%) Weighted Cost (%)

financing (Rs. In cr.)

0 20.00 Equity 0.45 15.00 6.750

Preference 0.05 14.50 0.725

Debt 0.50 7.50 3.750

WACC = 11.225

20.00 22.22 Equity 0.45 15.00 6.750Preference 0.05 15.00 0.750

--Solution--

Debt 0.50 7.50 3.750

WACC = 11.250

22.22 30.00 Equity 0.45 16.50 7.425

Preference 0.05 15.00 0.750

Debt 0.50 7.50 3.750

WACC = 11.925



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Range of total new Source Proportions Cost (%) Weighted Cost (%)

financing (Rs. In cr.)

30.00 66.67 Equity 0.45 16.50 7.425

Preference 0.05 15.00 0.750

Debt 0.50 8.00 4.000

WACC = 12.175

--Solution--

. . . . .

Preference 0.05 15.00 0.750

Debt 0.50 8.00 4.000

WACC = 12.850

80.00 & above Equity 0.45 18.00 8.100Preference 0.05 15.00 0.750

Debt 0.50 8.40 4.200

WACC = 13.050



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---

Thus, the weighted marginal cost of capital schedule will

be as follows:

Range of Total New Financing (Rs. In cr.) Weighted Cost (%)

0.00 -- 20.00 11.225

--Solution

20.00 22.22 11.250

22.22 - 30.00 11.925

30.00 66.67 12.175

66.67 80.00 12.850

80.00 & above 13.050



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Divisional and Project Cost of Capital --

Using WACC for evaluating investments

whose risks are different from those of the

overall firm leads to poor decisions. In such

,

compared with the risk-adjusted required

return, as calculated by the security market

line.



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--Divisional and Project Cost of Capital

Multidivisional firms that have divisions

characterised by differing risks may calculate

separate divisional costs of capital. Two

purpose:

The pure play approach

The subjective approach



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Pure Play Approach

Find one or more companies that specializein the product or service (that we are

considering)

Compute the beta for each company and

Use that beta along with the CAPM to find

the appropriate return for a project of that

risk Often difficult to find pure play companies



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Subjective Approach

Consider the projects risk relative to the firmoverall.

If the project is riskier than the firm, use a

discount rate greater than the WACC.

If the ro ect is less risk than the firm use adiscount rate less than the WACC.

One may still accept projects that one

shouldnt and reject projects one should

accept, but ones error rate should be lower

than not considering differential risk at all.



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Divisional and Project Costs of Capital

Using the WACC as our discount rate is onlyappropriate for projects that are the same riskas the firms current operations

If we are lookin at a ro ect that is NOT of thesame risk as the firm, then we need todetermine the appropriate discount rate forthat project

Divisions also often require separatediscount rates



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Floatation Costs--

Floatation or issue costs consist of items

like underwriting costs, brokerage

expenses, fees of merchant bankers etc.

is to adjust the WACC to reflect the

floatation costs:



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--Floatation Costs

WACCRevised WACC =

1 Floatation costs

Note: A better approach is to leave the WACC

unchanged but to consider floatation costs

as part of the project cost.



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cf_3_cost_of_capital_09

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