prof p. krishna

8/8/2019 Prof P. Krishna

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Financial Management

Topic 4

Cost of Capital



Introduction

Introduction

Opportunity Cost of Capital

WACC Preview

Cost of Debt

* Cost of Redeemable Debt

* Cost of Perpetual Debt

* Post Tax Cost of Debt

* Historical Yields and Current Yields



* Treating Floatation Cost and Issue at Premium/Discount

* Which Debts to Consider

Cost of Capital



CONTENTS

Cost of Preferred Capital

Cost of Equity

*Dividend Capitalization Approach

* Earning Based Approach

* CAPM Based Approach

* Cost of External Equity

Assigning Weights

* al

Contents



Marginal Proportions

* Book Value Vs. Market Value Proportions

Marginal Cost of Capit

Contents



WACC as Discount Rate & Risk

Pure Play Approach-

* Unlevering & Relevering Beta

* Factors Affecting Cost of Capital

Optimal Capital Budget



Cost of capital is an extremely important input requirement for capital budgeting

decision.

Without knowing the cost of capital no firm can evaluate the desirability of the

implementation of new projects.

Cost of capital serves as a benchmark for evaluation.

Introduction



The basic determinant of cost of capital is the expectations of the suppliers of capital.

The expectations of the suppliers of capital are dependent upon the returns that

could be available to them by investing in the alternatives.

The returns provided by the next best alternative investment is called opportunity

cost of capital. This could serve as basis for cost of capital.

Opportunity Cost of Capital



Besides opportunity cost the cost of capital must also consider

1. Business risk 2.Financial risk

There are be many suppliers of capital; predominantly two

1.Debt 2.Equity

WACC is a composite figure reflecting cost of each component multiplied by the

weight of each component.

WACC = wex re+ wpx rp+ wdx rdwe= Proportions of equityre= Cost of equity

wp= Proportion of pref capitalrp= Cost of preference capital

wd= Proportion of Debt rd= Cost of debt

WACC



Cost of redeemable debt is determined by equating the cash flows of the instrument

to its market price

Cost of perpetual debt, rd is Po=Ct or rd= Ct

r d Po

Cost of redeemable debt is Post tax cost of debt is

N

Po = Ct + R___ Post tax cost of debt = rd (1-T)

t=1 (1+ r d ) t ( 1+ r d ) N

For a bond paying 11% coupon annually and redeemable after three years at Rs 105

that sells for Rs 95 the cost of debt is 10.12% given by

95= 11 X 0.6 + 11 X 0.6 + 11 X 0.6 + 105

1 + rd (1+rd)2

(1+rd)3

( 1+rd)4

Cost of Debit



To mobilize debt one has to incur floatation cost which increase the cost of debt

While computing the cost of debt the claims of the suppliers of long-term debt are

only considered.

Cost of Debit



Preference capital is in between pure debt and equity that explicitly states a fixed

dividend.

The dividend has claim prior to that of equity holders.

But unlike interest on the debt the dividend on preference capital is not tax

deductible

Cost of preference capital , rp is determined by equating its cash flows to market

price. There is no adjustment of tax.

Introduction



Cost of equity capital is most difficult to determine because

* It is not directly observable

* There is no legal binding to pay any compensation and

* It is not explicitly mentioned

This does not mean that cost of equity is zero

Equity capital is classified as

1) Internal: the profits that are not distributed but retained by the firm in funding

the growth, is referred as internal equity and

2) External: equity capital raised afresh to fund, is called external equity

Cost of Equity Capital



Cost of equity is determined by

* Dividend Capitalization approach

* CAPM based approach.

Both approaches are driven by market conditions and measure the cost of equity in

an indirect manner

The price to be used in any of the model is the market determined

Approaches Cost of Equity



Dividend capitalization approach determines the cost of equity by equating the

stream of expected dividends to its market price. For constant dividend cost of equity

is equal to dividend yield

Dividend Capitalization Approach



Earnings based approach, as manifested by Dividend Capitalization Approach

equates the value

Under the special case when the firm uses the earnings at the same rate as

expected by shareholders earnings based approach measures the cost of equity

Cost of Equity PE Approach



CAPM based determination of cost of equity considers the risk characteristics that

dividend capitalization approach ignores.

Determinants of cost of equity under CAPM based approach include three

parameters;

* the risk free rate, rf

* the market return, rmand

* , as measure of risk

Cost of Equity CAPM Approach



, the primary determinant of risk governs the cost of equity.

re= rf+ x (rmrf)

Cost of Equity CAPM Approach



CAPM based determination of cost of equity is regarded superior as

* it relies on the market information and

* incorporates risk

* it need not know the dividend policy.

Dividend capitalization approach

* does not consider risk of the dividend

* has assumption of constant pay out ratio.

Cost of Equity DDM Vs CAPM Approach



There are three major differences in the INTERNAL and EXTERNAL equity Existence

of flotation costUnder utilization of external equityUnder pricing of fresh capital If

floatation cost is 5% of the issue price and cost of internal equity determined either

through DDM or CAP-M is 16% then the cost of fresh equity shall be 16.84%

(16/0.95).

Cost of Internal and External Equity



After cost of each component is determined they need to be multiplied by the

respective proportions to arrive at WACC.

The proportions may be based on

1) marginal

2) book value or

3) market value

The weights based on the target capital structure are most appropriate though the

current capital structure may not conform.

Assigning Weights



The weights for computation of WACC can either be based on book values or market

values

Though book value weights appear convenient and practical it lacks conviction

ignoring current trends.

Use of market value based weights is technically superior reflecting the current

expectations of investors.

Book Values Vs Market Values



WACC as discount rate, implies that acceptance of projects do not alter the existing

capital structure.

When project is large compared to the existing operations, the capital structure as

well as the cost of each component would more likely increase.

Lenders tend to raise cost with the quantum, so could be the case with equity

suppliers.

In such cases WACC is inappropriate as hurdle rate. Marginal (incremental) cost of

capital is more appropriate.

Marginal Cost of Capital



In practice Marginal Cost of Capital must be used in determination of the optimal

capital budget.

Marginal cost of capital governs the value addition.

Incremental benefits must exceed incremental cost.

The capital expenditure level at which incremental benefits are equal to the

incremental cost is Optimal capital budget.

Optimal Capital Budget



The discount rate for the project must be appropriate to its risk.

In most cases WACC adequately represents the risk since most projects selected by

the firms belong to the line of activity.

Where project has substantially different risk profile blind use of WACC as discount

rate may cause

1.erroneous acceptance of riskier project due to lower discount rate or

2.erroneous rejection of less risky project due to higher discount rate.

WACC and RISK



Risk-adjusted WACC must be used as discount rate for the cash flow.

Most popular method to incorporate such risk is called a pure-play approach,

* identifying a firm that most resembles the risk profile of the new project.

* beta of the firm is adjusted for its leverage to find an all equity beta, called

unleveringand then

* re-adjusting for the proposed capital structure of the project, called relevering.

* The value of so arrived is used in calculating the WACC

Pure Play Approach (Adjusting for Risk)

prof p. krishna

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