Cost of Capital

The Cost of Capital

Cost of capital of a firm is defined as the cost of obtaining the funds, i.e. the average rate of return that the investors in a firm expect. It is also referred as the minimum rate of return expected by its investors. “The cost of capital is the minimum rate of return which a firm requires as a condition for undertaking an investment.” When we talk about the “cost” of capital, we are talking about the required rate of return on invested funds. It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return.

Significance of the cost of capital

Evaluating Investment Decisions Designing A Firms Debt Policy, Appraising The Financial Performance Of

Top Management.

Investment Decisions The primary purpose of measuring the

opportunity cost is its use as a financial standard for evaluating the investment projects. In the net present value method, an investment project is accepted if it has a positive net present value. The projects net present value is calculated by discounting its cash flows by the cost of capital.

DESIGNING A FIRM DEBT POLICY 

The debt policy of a firm is significantly influence by the cost consideration. In designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at maximizing the overall cost. The cost of capital can also be useful in deciding about the methods of financing at a point of time.

PERFORMANCE APPRAISAL 

The cost framework can be used to evaluate the financial performance of top management. Such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected overall cost of capital, and the appraisal of the actual costs incurred by management in raising the required funds. The capital cost also plays a useful role in dividend decision and investment in current assets.

The Concept of the Opportunity Cost 

FACTORS AFFECTING COST OF CAPITAL

Controllable FactorsCapital Structure PolicyInvestment PolicyOperating and Financing Decisions

Uncontrollable FactorsLevel of Interest RatesTax RatesGeneral Economic ConditionsMarket Conditions

COMPUTATION OF COST OF CAPITAL

Computation of cost of specific source of finance.

Computation of weighted average cost of capital

Computation of cost of specific source of finance

Cost of Debt – It is the after tax cost of long- term funds through borrowing. Debt may either be Irredeemable or redeemable.

Cost of Irredeemable debt Cost of irredeemable debt before tax

Kdb= I/NP x 100 Where Kdb = Cost of debts before tax

I = Annual interest charges NP = Net proceeds

Cost of Irredeemable debt after tax Cost of irredeemable debt after tax

Kda= I(1-t) /NP x 100 Where Kda = Cost of debts after tax

I = Annual interest charges

NP = Net proceeds

Cost of Redeemable debt before tax

Cost of redeemable debt before tax

Kdb = I+ 1/n(RV-NP) x 100 ½(RV+NP)

Where

I= Interest n= number of years in which debts is to be recoveredRV= redeemable value of debenturesNP= net proceeds from issue of debentures

Cost of Redeemable Debt after tax

Kda = I (1-t) + 1/n(RV-NP) x 100 ½(RV+NP)

Where,I= Interest n= number of years in which debts is to be

recoveredRV= redeemable value of debenturesNP= net proceeds from issue of debenturest= tax rate

Numericals X Ltd. Issues Rs. 50,000 8% debentures at par.

The tax rate applicable to the company is 50%. Compute the cost of debt capital.

Y Ltd. Issues Rs. 50,000 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute cost of debt capital.

A Ltd. Issues Rs. 50,000 8% debentures at a discount of5%. The tax rate is 50%. Compute the cost of debt capital.

B Ltd. Issues Rs. 1,00,000 9% debentures at a premium of 10%. The cost of floatation are 2%. The tax rate applicable is 60%. Compute cost of debt-capital.

Numericals A Company issues Rs. 10,00,000 10%

redeemable debentures at a discount of 5%. The cost of floatation amount to Rs. 30,000. The debentures are redeemable after 5 years. Calculate before-tax and after-tax cost of debt assuming a tax rate of 50%.

A 5-year Rs. 100 debenture of a firm can be sold at a net price of Rs. 96.50. The coupon rate of interest is 14 per-cent per annum, and the debenture will be redeemed at 5 per cent premium on maturity. The firm’s tax rate is 40 per cent. Compute the after-tax cost of debenture.

Cost of Preference Share Capital

It may be defined as the dividend expected by the preferenceshare holders.Cost of irredeemable preference capital :-

Kp = D/NP x 100Where

Kp = cost of preference capitalD = annual preference dividendNP = Net proceeds of preference

share capital

Cost of Redeemable Preference Capital

Kpr = D+ 1/n(RV-NP) x 100 ½(RV+NP)

Where Kpr = cost of redeemable preference capital D = annual preference dividend n = number of years RV = redeemable value of preference share

capital NP = net proceeds of preference share

capital  

Practical Questions A Company issues 10,000 10% Preference

Shares of Rs. 100 each. Cost of issue is Rs. 2 per share. Calculate cost of preference capital if these shares are issued

At parAt a premium of 10%.At a discount of 5%.

A Company issues 10,000 10% Preference shares of Rs. 100 each redeemable after 10 years at a premium of 5%. The cost of issue is Rs. 2 per share. Calculate the cost of Preference capital

Cost of Preference Share Capital

Kpr = D+ 1/n(RV-NP) x 100 ½(RV+NP)

Where Kpr = cost of redeemable preference capital D = annual preference dividend n = number of years RV = redeemable value of preference share

capital NP = net proceeds of preference share capital  

COST OF EQUITY SHARE CAPITAL

It is the minimum rate of return that a firm must earn on the equity-financed portion of an investment project in order to leave unchanged the market price ofthe share.Dividend yield method Ke = DPS/NP*100 (For new issue)

Ke = DPS/MP*100 (For existing shares) Where

DPS= Dividend per share MP= Market price per share NP =Net Proceeds

COST OF EQUITY SHARE CAPITAL

Dividend yield plus growth in dividend method

Ke = D1/MPx100+g or

Ke = D0 (1+g) /MPx100+gWhere

D1= Dividend at the end of the yearD1= Dividend at the end of the yearMP= Market price per shareNP =Net Proceeds g = Rate of growth in dividend

Earning yield methodKe = EPS/MPx100

Where Ke = Cost of equity capitalEPS = Earnings per shareMP = Market price per share`

Earning yield plus growth in earning method

Ke = EPS/MPx100 + g Where

Ke = Cost of equity capitalEPS = Earnings per shareMP = Market price per

share`g = Rate of growth in EPS

Capital Asset Pricing Model - Approach

As per this approach, return on any security depends upon the level of risk attached to the security. More risk, more returns. CAPM describes the relationship between risk and expected return and that is used in the pricing of risky securities. CAPM calculates the cost of equity through the following formula. CAPM calculates the cost of equity through the following formulas.

Ke=kf+β(Km-kf)Where,

Ke = cost of equity share capitalKf = cost of any risk free asset β = coefficients of systematkic riskKm = cost of market portfolio

Realized yield method-This approach is based on the premise that actual returns earned by the investors in the past will be repeated in the future. According to this approach, cost of equity capital should be determined on the basis of returns actually realized by the investors on their equity shares. Past record of dividends for a particular period should be considered while calculating cost of equity capital. This approach given us good cases where companies are earnings good and stable profits.

Cost of Retained EarningsThe cost of retained earnings is the earning foregone by shareholders. The firm is implicitly required to earn on the retained earnings at least equal to the rate that would have been earned by the shareholders if these earnings were distributed to them. As per the external yield criteria. As per external yield criteria returns expected from investing these retained earnings somewhere else i.e. outside the company are compared with the investment in company’s own project. So it is said that the cost of retained earnings is equal to cost of equity capital. However, this also is not true

Cost of Retained EarningsCost of retained earnings is always less

than the cost of equity capital because while raising equity capital one has to bear brokerage cost and while declaring dividend on equity capitals, corporate dividends tax has to be paid.

Cost of Retained EarningsSo the cost of retained Earning is ,

kr = ke(1-t)(1- β) kr = ke(1-t)(1- β)

Where, kr = Cost of retained earningske = Cost of equity capitalT = tax rate applicable to shareholdersβ = brokerage cost

Numerical on EquityA Company issues 1000 equity shares of Rs. 100

each at a premium of 10%. The company has been paying 20% dividend to equity shareholders fir the past five years and expects to maintain the same in future also. Compute the cost of equity capital. Will it make any difference if the market price of equity shares is Rs. 160?

A Company plans to issue 1000 new shares of Rs. 100 each at par. The flotation costs are expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares.

If the current market price of an equity is Rs. 150, calculate the cost of existing equity share capital.

Numerical on EquityThe shares of a company are selling at Rs. 40 per share

and it had paid a dividend of Rs. 4 per share last year. The investor’s market expects a growth rate of 5 per cent per year. Compute the equity cost of capital If the anticipated growth rate is 7 per cent per annum,

calculate the indicated market price per share.

A Firm is considering an expenditure of Rs. 60 lakhs for expanding its operations. The relevant information is as follows:

Number of existing equity shares 10 lakhsMarket Value of Equity Shares 60Net Earnings 90 lakhsCompute the cost of existing equity share capital and of new

equity capital assuming that new shares will be issued at a price of Rs. 52 per share and the costs of new issue will be 2 per share.

WEIGHT AVERAGE COST OF CAPITAL

The Weighted average cost of capital (WACC) means overall cost of capital or combined cost of capital is defined as weighted average cost of capital. The weighted average cost of cost of capital is calculated by aggregating the product of weights of each kind of source of fund and its respective specific cost.

WEIGHTED AVERAGE COST OF CAPITAL

Formula (WACC)Kw = wd * kd + wp * k p + we * ke

Wd = proportion of long-term debt in capital structure

Wp = proportion of preferred equity in capital structure

We= proportion of common equity in capital structure

NotesThe weights sum to 1.

Finding the Weights

The weights that we use to calculate the WACC will obviously affect the result

Therefore, the obvious question is: “where do the weights come from?”

There are two possibilities:Book-value weightsMarket-value weights

Book-value Weights

One potential source of these weights is the firm’s balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity

We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

Market-value Weights

The problem with book-value weights is that the book values are historical, not current, values

The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate

Calculation of market-value weights is very similar to the calculation of the book-value weights

The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital

A Firm has the following capital structure and after tax costs for the different sources of funds used.

Calculate the weighted average cost of capital using book value weights

The firm wishes to raise further Rs.6,00,000 for the expansion of the projects as below.

Debt 3,00,000Preference Capital 1,50,000Equity Capital 1,50,000

Sorces of Funds

Amount Proportion After tax Cost (%)

DebtPreference CapitalEquity Capital

4,50,0003,75,0006,75,00015,00,000

302545100

71015