COST OF CAPITAL

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The Concept of the Opportunity Cost of Capital

The cost of capital of a firm is the minimum rate of return expected by its investors. It is the weighted average cost of various sources of finance used by a firm Cost of capital is the minimum rate of return expected by the investors which will maintain the market value of shares at its present level. Cost of capital of a firm or the minimum rate of return expected by its investors has a direct relation with the risk involved in the firm. Generally, higher the risk involved in a firm, higher is the cost of capital

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The Concept of the Opportunity Cost of Capital

Significance of the cost of capital 1. As an acceptance Criterion in Capital budgeting 2. As a determinant of Capital Mix in capital Structure decisions 3. As a Basis for evaluating the financial performance 4. As a basis for taking other financial decisions

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The Concept of the Opportunity Cost of Capital

Controversy regarding cost of capital 1. Traditional approach 2. Modigliani and Miller approach Traditional approach/Relevant
A firms cost of capital depends upon the method and level of financing or its capital structure. By changing its debt equity mix it can change its cost of capital

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The Concept of the Opportunity Cost of Capital

Controversy regarding cost of capital

2. Modigliani and Miller approach/Irrelevant According to this approach the corporations total cost of capital is constant and it is independent of the method and level of financing.

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Computation of cost of capital

Computation of specific costs : 1. Computation of cost of debt 2. Computation of cost of preference shares 3. Computation of cost of equity 4. Computation of Cost of retained earnings.

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Cost of Debt

a. Debt issued at par b. Debt issued at premium or discount c. Cost of redeemable debt

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Debt

Redeemable

irredeemable

At par

At premium

At Discount

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a. Cost of debt issued at par

It is the explicit interest rate adjusted further for the tax liability of the company kd = (1-T)R Where kd = cost of debt t = tax rate r = interest rate Eg. Compute the cost of debt for a company issuing debentures at 9% and the tax rate is 50%

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a. Cost of debt issued at par

Eg. Compute the cost of debt for a company issuing debentures at 9% and the tax rate is 50% Cost of debt = 4.5%

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b. Debt issued at a premium or discount.

In case the debt is issued at a premium or a discount the cost of debt should be calculated based on net proceeds realised on account of issue of such debentures or bonds. Formula Kd = I (1-T) Np Kd = before tax cost of debt, I = coupon rate of interest (the amount of interest) Np = Net proceeds of loans or debentures T = Tax rate

 1. A company issues 10% irrredeemable debentures of Rs.1,00,000. The company is in the 55% tax bracket. Calculate the cost of debt (before as well as after tax). If the debentures are issued at a. Par b. Premium10% c. Discount10%

 A. Issued at par
Kd

= 10,000

(1-.55) =
1,00,000 10

(.45) = 4.5%

 A. Issued at discount
Kd

= 10,000

1 (.45) = 5% 9

(1-.55) = ( 1,00,000-10,000)

 A. Issued at premium
Kd

= 10,000

1 (.45) =4.1% 11

(1-.55) = ( 1,00,000+10,000)

c. Cost of redeemable debt.

If the debt is redeemable after the expiry of a fixed period the effective cost of debt can be calculated using two methods.

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Calculation of cost of debt using Trial and Error method

Cost of debt at a discount or a premium Eg. A 7 year 15% bond is sold below par for Rs.94. How much is the cost of debt 94 = 94 = 15(pvfa 7, Kd) + 100(pvf 7, Kd) by trial and error method , Kd = 16.5%

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Short cut method:

Kd = Ans = 16.4%

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Short cut method:

int = interest n= no of years f = future value /maturity value Np or B0 = Issue price of debt salvage value - floatation cost any other commisson mentioned

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Tax Adjustment cost of debt

The interest paid on debt is tax deductible. The higher the interest charges the lower will be the amount of tax payable by the firm Thereby the after tax cost of debt of the firm will be less than the investors required rate of return. After tax cost of debt = Kd (1-T) Where T is the corporate tax rate.

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Tax Adjustment cost of debt In the previous eg the cost of debt was 16.4% Whereas the after tax cost of debt will be If the tax rate is 35%

16.4%(1-35%) = 10.73%

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Tax Adjustment cost of debt

Tax benefit will be available only for profitable firms In the calculation of weighted average cost of capital the after tax cost of debt should be taken.

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cost of debt A firm issues debentures of Rs.1,00,000 and realises Rs.98,000 after allowing 2% commission to brokers. The debentures carry an interest rate of 10%. The debentures are due for maturity at the end of the 10th year. You are required to calculate the effective cost of debt before tax.

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cost of debt

Solution
A firm issues debentures of Rs.1,00,000 and realises Rs.98,000 after allowing 2% commission to brokers. The debentures carry an interest rate of 10%. The debentures are due for maturity at the end of the 10th year. You are required to calculate the effective cost of debt before tax.

Answer : 10.30%

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Cost of Preferred Stock

Reminders
Preferred stock generally pays a constant dividend each period Dividends are expected to be paid every period forever

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Cost of Preference Capital Kp = DP Kp = DP NP MP Kp = Cost of Preference share capital DP = Fixed Preference dividend NP = Net Proceeds of Preference Shares Cost of redeemable preference shares Kp = DP + (P NP)/n (P + Np)/2 P = Par value of preference shares at maturity
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Example: Cost of Preferred Stock

Your company has preferred stock that has an annual dividend of Rs.3. If the current price is Rs.25, what is the cost of preferred stock? RP = 3 / 25 = 12%
Here NP = MP
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Cost of preference shares

A company raised preference share capital of Rs.1,00,000 by issue at 10% preference shares of Rs.10 each. Calculate the cost of preference capital when they are issued at i. 10% premium and ii. 10% discount.

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Cost of preference shares

A company raised preference share capital of Rs.1,00,000 by issue at 10% preference shares of Rs.10 each. Calculate the cost of preference capital when they are issued at i. 10% premium
Kp = 9.09% ii. 10% discount Kp = 11.11%

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Cost of redeeemable preference shares

A company issues 10% redeemable preference shares for Rs.1,00,000 redeemable at the end of 10th year from the year of their issue. The underwriting cost came to 2% calculate the effective cost of preference share capital.

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Solution
Using the formula for redeemable preference shares. Dp = 10,000, P= 100000 Np= 98000 KP = 10.3%

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Cost of Equity

The cost of equity is the maximum rate of return the co must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock.
Ke = expected return by share holders

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Models of working cost of equity

Dividend price approach Dividend yield plus growth in div method Earning price approach (E/P approach) Realised yield approach

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Dividend price (D/P) approach

According to this approach the cost of equity is the rate of expected dividends which will maintain the present market price of the equity shares

Where D = Expected Dividend per shaare Np = Net proceeds Net proceeds or current market price
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Dividend price (D/P) approach

Where D = Expected Dividend per share Mp = market price

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Dividend yield method or Dividend price ratio method

1. A company offers for public subscription equity shares of Rs.10 each at a premium of 10%. The company pays 5% of the issue price as underwriting commission. The rate of dividend expected by the equity shareholders is 20%. you are required to calculate the cost of equity capital. Will your cost of capital be different if it is to be calculated on the present market value of the equity shares, which is Rs.15/-

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Dividend price (D/P) approach

Solution Under Net proceeds method Cost of equity = 19% Where d= 2 Np = 11 - .55 = 10.45 2/10.45 =19%

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Dividend price (D/P) approach

Solution Under market price method cost of equity = 13.33% Where d= 2/15 = 13.33%

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The Dividend Growth Model Approach

According to this approach, the cost of equity is determined on the basis of the expected dividend rate plus the rate of growth in dividend.
Ke = cost of equity D = dividend per equity

+ g

NP = net proceeds

g = growth in expected dividend

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The Dividend Growth Model Approach

The current market price of an equity share of a company is Rs.90. The current dividend per share is Rs.4.50. In case the dividends are expected to grow at the rate of 7% calculate the cost of equity capital.

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The Dividend Growth Model Approach

The current market price of an equity share of a company is Rs.90. The current dividend per share is Rs.4.50. In case the dividends are expected to grow at the rate of 7% calculate the cost of equity capital.

Solution: Ke = (4.50/90 ) +.07 = 12%

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The Dividend Growth Model Approach

Problem 2: A company plans to issue 1000 new shares of Rs.100 each at par. The floatation 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. b. If the current market price of an equity share is Rs.150, calculate the cost of existing equity share capital.

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The Dividend Growth Model Approach

Problem 2:
A company plans to issue 1000 new shares of Rs.100 each at par. The floatation 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. b. If the current market price of an equity share is Rs.150, calculate the cost of existing equity share capital.

Solution: a. Ke = (10/100-5) + 5% = 15.53% b. Ke = (10/150) + 5% = 11.67%

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Earnings

price approach

According to this approach , it is the eps which determines the market price of the shares.

P0 = MP/NP
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Earnings price approach

The entire capital employed by a company consist of one lakh equity shares of Rs.100 each. Its current earnings are Rs.10 lakhs per annum. The company wants to raise additional funds of Rs.25 lakhs by issuing new shares. The floatation costs are expected to be 10% of the face value of the shares. You are required to calculate the cost of equity capital presuming that the earnings of the company are expected to remain stable over the next few years.

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Earnings price approach

The entire capital employed by a company consist of one lakh equity shares of Rs.100 each. Its current earnings are Rs.10 lakhs per annum. The company wants to raise additional funds of Rs.25 lakhs by issuing new shares. The floatation costs are expected to be 10% of the face value of the shares. You are required to calculate the cost of equity capital presuming that the earnings of the company are expected to remain stable over the next few years.

Solution:
Ke = earnings/np = 10/90 = 11% 90 = 100 10% floatation cost

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Realized yield approach

According to this approach the cost of equity should be determined on the basis of return actually realised by the investors in a company on their equity shares.

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Realized yield approach

A purchased 5 shares in a company at a cost of 240 on jan 1 2005, he held them for 5 years and finally sold them in jan 2010 for 300 the amt of dividend received by him in each of these 5 years was as follows:you are required to calculate the cost of equity capital

2005
2006 2007

14
14 14.50

2008
2009

14.50
14.50

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Period

Dividend

Sales proceeds/ purchase (240)

Discount Present value factor@10%

0 1 14

240 .909 12.7

2
3 4 5 5

14
14.50 14.5 14.5 300

.826
.751 .683 .621 .621

11.6
10.9 9.9 9 186.3 240.4

 The purchase price of the 5 shares on Jan 1st 2005 was Rs.240. the present value of cash inflows amounts to 240.4. thus at 10% the present value of the cash inflows over a period of 5 years is equal to the cash outflow in the year 2005. The cost of equity capital can therefore, be taken as 10%

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Realized yield approach

The realised yield approach helps in determining the cost of equity provided the following conditions are satisfied 1. The company will fundamentally remain the same as regards risk 2. The shareholders continue to expect the same rate of return for bearing this risk 3. The share holders reinvestment opportunity rate is equal to the realised yield.

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COST OF RETAINED EARNINGS

The cost of retained earnings is the earnings forgone by the shareholders. The opportunity cost of retained earnings may be taken as the cost of the retained earnings.

Ke = cost of equity, t = income tax b = brokerage

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COST OF RETAINED EARNINGS

A firms Ke (return available to shareholders) is 15%, the average tax rate of shareholders is 40% and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings?

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COST OF RETAINED EARNINGS

A firms Ke (return available to shareholders) is 15%, the average tax rate of shareholders is 40% and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings?

Kr =15%(1-.4)(1-.02) Kr = 8.82%

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 Where B= brokerage cost T = tax rate

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WEIGHTED AVERAGE COST OF CAPITAL

STEPS IN CALCULATING THE FIRMS WACC:

1. Calculate the after tax 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 costs to get the WACC
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WEIGHTED AVERAGE COST OF CAPITAL

Methods of assigning weights 1. Book value method 2. Market value method.

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Weighted Average Cost of Capital

WACC = KD WD + KP WP + KE WE + KRWR WD = Proportion of long term debt in capital structure WP = Proportion of preferred stock in the capital structure WR = Proportion of common stock equity in the capital structure WD + WP + WE + WR = 1 KD = cost of debt KP =cost of preferred stock KE =cost of common stock equity KR = cost of retained earnings

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From the following capital structure of a company, calculate the overall cost of capital, using a. book value weights and b. market value.

Source Equity share capital Retained earnings Debentures

Book Value 45000 15000

Market Value 90000

Preference capital 10000 30000

10000 30000

The after-tax cost of different sources of finance is as follows: Equity share capital 14%, retained earnings 13%, preference share capital 10%, debentures 5%

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A. computation of weighted average cost of capital Book value weights

Source Amount Proportion After tax cost Weighted cost

1 Equity share capital Retained earnings Preference share cap Debentures

2 45000 15000 10000

3 .45 .15 .10

4 14% 13% 10%

5 = (3 *4) 6.30% 1.95% 1%

30000

.30

5%

1.50%

10.75%

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A. computation of weighted average cost of capital Market value weights

Source Amount Proportion After tax cost Weighted cost

1 Equity share capital Retained earnings Preference share cap Debentures

2 90000

3 .692

4 14%

5 = (3 *4) 9.688%

10000

.077

10%

.770%

30000

.231

5%

1.155%

11.613%

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