1

COST OF CAPITAL

LA

COST OF CAPITAL

A companys cost of capital is the average cost of the various capital components Average rate of return required by investors who provide capital to the company

Reflects the business risk of existing assets and the capital structure currently employed
Also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard return Return that an investor receives from a security is the cost of that security to the company that issues it Cost of capital as an operational criterion is related to the firms objective of wealth maximisation
2

LA

COST OF CAPITAL

Cost of capital is used for evaluating investment projects, for determining the capital structure, for assessing leasing proposals, for setting rates that regulated organisations like electric utilities can charge to their customers etc. Important because of its practical utility as an acceptancerejection decision criterion Minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged Cost of each source or component of capital is called specific cost of capital

LA

PROJECTS COST OF CAPITAL

Opportunity cost of capital for a project is the discount rate for discounting its cash flows Projects cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows Firm represents the aggregate of investment projects undertaken by it Firms cost of capital can be used to evaluate new investments if two conditions are satisfied:

Risk characterizing the project is not significantly different from

the risk characterizing the existing investments of the firm Firm will continue to pursue the same financing policies
4

LA

AVERAGE COST OF CAPITAL

Weighted average cost of capital, composite cost of capital, combined cost of capital Companys cost of capital is the weighted average cost of various sources of finance used by it viz. equity, preference and debt

Suppose that a company uses equity, debt and preference and debt in the following proportions: 50,10 and 40. If the component costs of
equity, preference and debt are 16%, 12% and 8% respectively, what will be the weighted average cost of capital?

Consider a firm that employ equity and debt in equal proportions and whose cost of equity and debt are 14% and 6% respectively. Calculate cost of capital. Further if the firm invests Rs 100 million, say on a project which earns a rate of return of 12%, what is the return on equity funds employed in the project?

LA

EXPLICIT AND IMPLICIT COST OF CAPITAL

Explicit cost of any source of capital is the discount rate that equates the PV of cash inflows that are incremental to the taking of the financing opportunity with the PV of the incremental cash outflows Explicit cost is the rate of return of the cash flows of the financing opportunity or the internal rate of return that the firm pays to procure financing What is the explicit cost of an interest free loan, a loan bearing interest, sale of an asset, retained earnings? Opportunity costs are referred to as implicit cost of capital Implicit costs Rate of return associated with the best investment opportunity for the firm and its shareholders that would be foregone, if the projects presently under consideration by the firm were accepted Explicit cost arises when funds are raised, implicit costs arises when funds are used
6

LA

COST OF PERPETUAL DEBT

Coupon interest rate or market yield on debt can be said to represent an approximation of the cost of debt Nominal / coupon rate of interest on debt is the before-tax cost of debt Effective cost of debt is the tax-adjusted rate of interest, the before-tax cost of debt should be adjusted for the tax effect ki = I / SV and kd = 1/SV (1-t) Where ki = Before-tax cost of debt kd = After-tax cost of debt I = Annual interest payment SV = Sale proceeds of the bond / debenture T = tax rate

A company has 10% perpetual debt of Rs 1,00,000. The tax rate is 35%. Determine cost of capital (before tax as well as after tax) assuming the debt is issued at (i) par (ii) 10 discount and (iii) 10% premium
7

LA

COST OF REDEEMABLE DEBT

Here, account has to be taken, in addition to interest payments, of the repayment of principal A company issues new 10% debentures of Rs 1000 face value to be redeemed after 10 years. The debenture is expected to be sold at 5% discount. It will also involve floatation costs of 5% of face value. The companys tax rate is 35%. What would the cost of debt be? Illustrate the computations using (i) trial and error approach and (ii) shortcut method A company issues 11% debentures of Rs 100 for an amount aggregating Rs 1,00,000 at 10% premium, redeemable at par after 5 years. The companys tax rate is 35%. Determine the cost of debt using the short cut method. A company has issued 10% debentures aggregating Rs 1,00,000. The floatation cost is 4%. The company has agreed to repay the debentures at par in 5 equal annual installments starting at the end of year 1. The companys rate of tax is 35%. Find the cost of debt.
8

LA

COST OF EXISTING DEBT

Current cost of existing debt Cost of debt to be approximated by the current market yield
of the debt Suppose that a firm has 11% debentures of Rs 1,00,000

(Rs 100 face value) outstanding at 31 December 19X1 to be matured on December 31, 19X6. If a new issue of debentures could be sold at a net realisable price of Rs 80 in the beginning of 19X2, find the cost of existing debt.

LA

COST OF PREFERENCE SHARES

Cost of irredeemable preference shares: kp kp = Dp / [P0(1-f)] = Dp (1 + Dt) / [P0(1-f)] kp Dp P0 f Dt = = = = = Cost of preference capital Constant annual dividend payment Expected sales price of preference shares Floatation costs as a percentage of sales price Tax on preference dividend

Where

A company issues 11% irredeemable preference shares of the face value of Rs 100 each. Floatation costs are estimated at 5% of the expected sales price. (a) What is the kp if preference shares are issued at (i) par value (ii) 10% premium and (iii) 5% discount? (b) Also compute kp in these situations assuming 13.125% dividend tax.

LA

10

COST OF PREFERENCE SHARES

Explicit cost of redeemable preference shares is

the discount rate which equates the net proceeds

of the sale of preference shares with the present

value of future dividends and principal repayments ABC Ltd has issued 11% preference shares of the face value of Rs 100 each to be redeemed after 10

years. Floatation costs are estimated at 5% of the

expected sales price. Determine the cost of

preference shares.
LA 11

COST OF EQUITY CAPITAL

Equity shares implicitly involve a return in terms of dividends expected by the investors and therefore carry a cost Cost of equity capital is relatively the highest among all sources of funds Equity shares involve the highest degree of financial risk

ke may be defined as 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 of shares

Two approaches to calculate the cost of equity capital (i)

Dividend approach (ii) Capital asset pricing model approach

LA

12

DIVIDEND APPROACH / DIVIDEND VALUATION

MODEL

Cost of equity capital is the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share

Two elements of calculation of ke: Net proceeds from sale of a share / current market price of a share here adjustments for floatation costs and discount / premium are necessary and Dividends and capital gains expected on the share here expected dividend under different growth assumptions to be taken into account

LA

P0 ke D1 P0 g

= =
= = =

D1 / (ke g) (D1 / P0) + g Expected Dividend per share Net proceeds per share / current market price Growth in expected dividends
13

DIVIDEND APPROACH / DIVIDEND VALUATION

MODEL

G = b.r , where b = retention rate and r = rate of return Formula under different growth assumptions of dividends
Suppose that dividend per share of a firm is expected to be Re 1 per share next year and is expected to grow at 6% per

year perpetually. Determine the cost of equity capital, assuming the market price per share is Rs 25.

LA

14

DIVIDEND APPROACH / DIVIDEND VALUATION

MODEL

From the under-mentioned facts determine the cost of equity shares of company X:

i. ii. iii.

Current market price of a share = Rs 150 Cost of floatation per share on new shares Rs 3 Dividend paid on the outstanding shares over the past five years
Year 1 2 3 4 5 6 Dividend per share (Rs) 10.50 11.02 11.58 12.16 12.76 13.40

iv. v.

Assume a fixed dividend payout ratio. Expected dividend on the new shares at the end of the current year is Rs 14.10 per share.

LA

15