fm+chapter+viii+–+cost+of+capital.ppt+class

8/8/2019 FM+Chapter+VIII++Cost+Of+Capital.ppt+class

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Prepared by

Dr.P.R,Kulkarni

10/25/2010 1Dr.P.R.Kulkarni


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` The cost of capital is an important element as a basic

input information in capital investment decision.

` The cost of capital is used as a discount rate to

calculate NPV.` when IRR is calculated, the viability of the project is

based IRR comparison with the cost of capital.

` It provides a yardstick to measure the worth of

investment proposal and thus perform the role accept

reject criteria.

10/25/2010Dr.P.R.Kulkarni 2


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` It is also referred as cut off rate, target rate. Hurdle

rate, minimum required rate of return, standard return

and so on.

` The cost of capital as an operational is related to firmsobjective of wealth maximization.

` The share holders wealth will decline if the actual

return is less than the cost of capital.



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` The term cost of capital is defined as the rate of return on investment

projects necessary to maintain the market price of the firms unchanged.

` The firm raises the funds from various sources. Each components of capital

has its cost.

` For example equity capital has a cost so as also preference shares` The cost of each sources or component is called specific cost of capital.

` When these specific cost are combined to arrive at overall cost of capital, it

is referred as weighted cost of capital.

` It presents the rate of return which the company must earn to pay to

supplier of capital to justify their use.` It is the discount rate which is used to discount the estimated future cash

inflows so as to determine their net present value.



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` Risk-less Component ( r )

` Business Risk Component (b)

` Financial Risk Component (f)

` Cost of Capital k = r + b + f` Business risk measures the variability in operating

profits (earning before interest and taxes) due to change

in sale.

` Financial risk is the risk of being unable to coverrequired financial obligations such as interest and

preference dividends



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` Explicit Cost : An explicit cost refers to the discountrate which equate the present value of cash inflows

with the present value of cash outflows. It is nothing

but internal rate of return on cash flows.

` Implicit cost :Implicit cost in nothing but opportunitycost. In a availment of a particular investment

opportunity, alternative investment opportunities are

scarified.

` Marginal cost :Marginal cost is the incremental cost foradditional funds raised. It is defined as the cost of

obtaining rupee of new capital.



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Capital Budgeting:

represents a long-term investment decision

involves the planning of expenditures for a project with a lifeof many years

usually requires a large initial cash outflow with the

expectation of future cash inflows

uses present value analysis

emphasizes cash flows rather than income



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` The cost of capital concept is of vital significance inthe financial decision making.

` It is used as a discount or cut-off rate for evaluating

investment projects.` It is also used for designing the firms debt-equity

mix.

` It is used as a standard for appraising the financialperformance of top management.

` The cost of capital also play useful role in dividenddecision and investment in current assets.



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` The required return is the same as the appropriate discount rateand is based on the risk of the cash flows.

` We need to know the required return for an investment before

we can compute the NPV and make a decision about whetheror not to take the investment.

` We need to earn at least the required return to compensate ourinvestors for the financing they have provided



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` SOURCES OF FINANCEDebentures, Term Loans, Preference Capital, Equity

Capital &Retained Earnings.

` COST OF CAPITALIs the minimum rate of return a company must earn

on its investment in order to satisfy the investors.A companys cost of capital is the weightedarithmetic average of the cost of various sources offunds.



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1) Total capital base is 500L. Debt Equity ratio 1:1. Post tax

cost ofDebt & Equity is 7% & 18% respectively.

Solution:

The Weighted average cost of capital to the company

= 250 * 0.07 + 250 * 0.18

500 500

=12.5%

Assumptions:

Risk in new project is not significantly different from existingRisk in new project is not significantly different from existing

biz.biz.

Firm will continue to pursue same financing policies.Firm will continue to pursue same financing policies.



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` A company raises debt finance through Varity of

instruments like debentures, bonds, bank loans and

commercial papers.

` The debentures or bonds may be issued at par or atdiscount or premium. The contractual or coupon rate

of interest forms the basis for calculating the cost of

any form of debt.

` The cost of the debt is the weighted average rate ofdifferent kinds of debt employed by it.



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` The weighted average rate of debt is calculated using

the market values and yield to maturity of various debt

instruments.

` Note that we use the yields to maturity or current ratesas they reflect the rate at which the firm can raise the

new debt.



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` A company decide to sell a new issue of 7 yeas 15 % bonds ofRs 100 each at par. If company realizes the full face value of

Rs 100 bond and will pay Rs 100 principal to bondholders at

maturity. The cost of debt is equal to:

` Kd =

` Kd = 15 100 = 15 %

` Tax adjustment

` The interest paid on debt is tax deductible The higher the

interest charges, the lower will be the amount of tax payable

by firm

Po

Interst



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with stock with debt

` EBIT 400,000 400,000

` - interest expense 0 (50,000)

` EBT 400,000 350,000

` - taxes (34%) (136,000) (119,000)

` EAT 264,000 231,000

Now, suppose the firm pays Rs.50,000 in dividendsNow, suppose the firm pays Rs.50,000 in dividends

to the stockholders.to the stockholders.



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with stock with debt

` EBIT 400,000 400,000

` - interest expense 0 (50,000)

` EBT 400,000 350,000

` - taxes (34%) (136,000) (119,000)

` EAT 264,000 231,000

` - dividends (50,000) 0

` Retained earnings 214,000 231,000



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` After-tax cost Before-tax cost Tax

of Debt of Debt savings

` 33,000 = 50,000 - 17,000

OR

` 33,000 = 50,000 ( 1 - .34)

` Or, ifwe want to look at percentage costs:



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After-tax Before-tax

cost of debt % cost of debt x tax

Debt rate

Kd = kd (1 - T)

0.066 = 0.10 (1 - .34)



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nP = I (1-t) + _F

t=1 (1+Kd)t (1+Kd)n

where;I = annual Interest cost per debenture, t = tax rate,F= redemption price per debt, P = net amt realized per debt, n =maturity period.

Approximation:Kd = I(1-t) + (F+P)/n

(F + P)/2



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` When the difference between the redemption price & net amountcan be written off evenly over the life of the debentures, and theamount so written - off is allowed as tax deductible expense, then

the cost of debenture.

Kd = I (1 t) + (F P)*(1 t)n .

(F + P)2

where;I = Interest, t = tax rate, F =redemption price per debt,P = net amt realized per debt, n = maturity period.



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2) A ltd. Issued non convertible debentures for Rs400L. Face valueRs.100, carries rate of interest of 14% annually. Debenture isredeemable at a premium of 5% after 10 yrs.

If A ltd realized Rs 97 per debenture and corporate tax is 50 %what is the cost of debenture to company ?

Solution:I= 14, T = .50, P = 97, F = 105 & n = 10.

Kd = 14(1- 0.05) + (105 97)/10(105 + 97)/2

= 7.7%



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` The cost of term loans

= i (1-t)

Where,

i = interest rate & t = tax rate

Interest on term loans is tax deductible.



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` No Obligation` Fixed dividend rate and Preferential right`

If not paid-- Firm cant pay to ordinary shareholders-- It is cumulative in nature-- No voting rights-- Difficulty in raising fresh capital

` Dividend not tax deductible it is paid after tax` Irredeemable and Redeemable



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` The preference share may be treated as perpetual

security if it is irredeemable.

` The cost (kd ) =

` where D id the dividend Price is the issue price

` The cost of preference share is not adjusted for taxes

because preference dividend is paid after the corporatetaxes have been paid.

)( poPirce

Dividend



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` The cost of redeemable preference share (kp) is defined as thatdiscount rate which equate the proceeds from preference capital issueto the payment associated with the same (dividend payment and

principal payment)

` Formula for Cost of Redeemable preference capital

D + F-P-------

n

Kp = ----------------F+P

-------2

nn

tt

kp

F

kp

DP

!

! 111



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The terms of the preference share issue made by XYZ are

as follows:

Each preference share has a face value of Rs 100 and

carries dividend rate of 14 % payable annually. Theshare is redeemable after 12 years at par. If the net

amount realized per share is Rs 95.

what is the cost of the preference share ?



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` Measuring the rate of return by the equity shareholder isdifficult and complex exercise.

` The dividend stream receivable by the equityshareholder is not specified by nay legal contract.

` Cost of equity is highest among all other sources offinance

` Equity shares implicitly a return in terms of dividendexpected and hence carry cost.

` Calculation

Dividend approach

Capital asset pricing model (CAPM)



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` Start with the dividend growth model formula and

rearrange to solve for KE

gPe

DKe

gke

DPe

!

!

1

1



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` Suppose that your company is expected to pay a dividend 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. What is the cost of

equity?

%1.11111.051.25

50.1!!!

ER



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` One method for estimating the growth rate is to use the

historical average

Year Dividend Percent Change

2000 1.23 -

2001 1.30

2002 1.36

2003 1.43

1999 1.50

(1.30 1.23) / 1.23 = 5.7%

(1.36 1.30) / 1.30 = 4.6%

(1.43 1.36) / 1.36 = 5.1%

(1.50 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%



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Cost of equity is reflected by the following equation

Ki = Rf+ i (Rm - Rf)

where, Ki = rate of return required on security i

Rf= risk-free rate of returni = beta of security i

Rm= rate of return on market portfolio



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` Suppose the risk free return is 6 %, the market risk

premium (Rm - Rf) is 9 % and beta ( ) of share is 1.54, thecost of capital is :

` K = 0.06 +0.09 1.54 = 0.1986 = 20 %



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` A firms internal equity consists of its retained earnings.

` The opportunity cost of the retained earnings is the rate

of return foregone by equity shareholders.

`

The shareholders generally expect the dividend andcapital gain from their investment.

` The required rate of return of shareholders can be

determined from the dividend valuation model.



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gPe

DKe

gke

DPe

!

!

1

1



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Return req by investors Risk profile of Co.

Risk profile of Co. Return of bondholders

Return = Yield on long-term bonds + Risk premium

Risk premium = Operating Risk + Financial Risk

Equity investors exposed to higher risk

Example = Net profit margin, A = 5% , B = 10%



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According this approach Cost of equity = E1 / P

where , E1 = expected EPS for next year

P = Current market price per share

E1= multiplying current EPS (1+ growth rate)

Based on two parameters , Dividend Payout ratio & Rate of Return of the

firm

Results to be accurate in the following two scenario

1) When all the earnings are paid out as dividends, the rate of return

becomes irrelevantor,

2) The D/P ratio < 100% and Retained earnings are expected to earn rate of

return equal to cost of equity



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Once the components of the cost have been calculated , they

are multiplied by the weight of various sources of capital to

obtain a weighted average cost of capital (WACC).

`

The following steps are involved :1. Calculate the cost of specific sources of funds

2. Multiply the cost of each source by its proportion in the

capital structure.

3. Add the weighted component cost to get the WACC



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WACC = weke + wpkp + wdkd

Where,

we proportion of equityke cost of equity

wp proportion of preference

kp cost of preference

wd proportion of debtkd cost of debt



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Source of Finance Amount Rs Proportion % Cost %

Equity (Share Capital ) 4,50,000 45 18

Retained Earning 1,50,000 15 18

Preference Shares 1,00,000 10 11

Debt 3,00.000 30 8


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Source

1

Amount

2

Proportion

%

3

After T cost

%

4

Weighted cost

5=3x4

Equity share 450000 45 18 8.1

Retained Earning 150000 15 18 2.7

Preference share 100000 10 11 1.1

Debt 300000 30 8 2.4

100000 100 WACC 14.3 %



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source Amount After T cost After t cost Amount

Equity share 450000 .18 81000

Retained Earning 150000 .18 27000

Preference share 100000 .10 11000

Debt 300000 .30 24000

1000000 143000

WACC =143000 divided by 10,00000

=14.3



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` WACC increases with the level of financing.

` Suppliers of capital generally require a higher return

as they supply more capital.

` Schedule showing the relation between additional

financing and the WACC is referred to as the WMCC

Schedule.



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` Estimation of cost of individual source of finance for

various levels.

` Determining the range of total finance based on ratios.(Breaking Point)

` Calculation of WACC at different breaking Points.

` Listing the WACC at various levels of financing to get

the WMCC Schedule.



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` Breaking Point on Account of a Source =

Total new finance from that source at the breaking point

Proportion of that financing source in the capital

structure



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` ABC Ltd is planning to raise Equity, Preference and

Debt capital in the following proportion.

Equity : 0.40

Preference : 0.30

Debt : 0.30

1.00



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Source Range ofNew Financing from the

Source (Rs in Lakhs)

Cost %

Equity

Preference

Debt

0-15

15-25

25 & above

0-5

5 & above

0-20

20 & above

16

17

18

14

15

8

10



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Source Cost

%

Range ofNew

Finance

Breaking Point Range ofTotal

Finance

Equity

Preference

Debt

16

17

18

14

15

8

10

0-15

15-25

25 & above

0-5

5 & above

0-20

20 & above

15/0.4=37.5

25/0.4=62.5

-

5/0.3=16.67

-

20/0.3=66.67

-

0-37.5

37.5-62.5

62.5 & above

0-16.67

16.67 & above

0-66.67

66.67 & above



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Range Sources Pr oportion Cost % Weighted Cost

0-16.67 Equity

Preference

Debt

0.4

0.3

0.3

16

14

8

6.40

4.20

2.40

WACC 13.00

16.67-37.50 Equity

Preference

Debt

0.4

0.3

0.3

16

15

8

6.40

4.50

2.40

WACC 13.30

37.50-62.50 Equity

Preference

Debt

0.4

0.3

0.3

17

15

8

6.80

4.50

2.40

WACC 13.70



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Range Sources Pr oportion Cost % Weighted Cost

62.50-66.67 EquityPreference

Debt

0.40.3

0.3

1815

8

7.204.50

2.40

WACC 14.10

66.67 & above Equity

PreferenceDebt

0.4

0.30.3

18

1510

7.20

4.503.00

WACC 14.70



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Range ofTotal New Finance WMCC Schedule (%)

0-16.67

16.67-37.50

37.50-62.50

62.50-66.6766.67 & above

13.00

13.30

13.70

14.1014.70



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` Cost of Redeemable shares

D(1-t) + F-P

-------

n

Kp = -------------------

F+P

-------

2

10/25/2010 52Dr P R Kulkarni

fm+chapter+viii+–+cost+of+capital.ppt+class

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