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Cost of Capital

Equity Preference Share Debentures Risk- Government Bonds like RBI relief bonds free security
Equity
Preference
Share
Debentures
Risk-
Government
Bonds like RBI
relief bonds
free
security
Equity Preference Share Debentures Risk- Government Bonds like RBI relief bonds free security

Cost of Capital

The firm’s cost of capital is the rate of return required to all the suppliers capital for financing the firm’s investment projects by purchasing various securities.

The rate of return required

by

all

investors

will be an overall rate of return a weighted

rate of return.

WACC Vs. Specific Cost of Capital

The project’s 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. Suppose:

Cost of Equity = 11%

Cost of Debt = 6%

Project A: Expected rate of return = 10% & Financed by Debt.

Project B: Same Risk return class Financed by Equity

It can also be thought of a rate of return required by the all the capital providers.

The cost of capital is the rate of return that a firm must earn to maintain the market value of the

stock. It is considered as a hurdle rate.

The cost of capital is estimated at a given point of time.

COST OF DEBT

Current Yield = Coupon / Current Market Price

Yield to Maturity

Debt Issued at Par

k

i

d  

INT

P 0
P
0

Dutch Corporation, a major hardware manufacturer, is

contemplating selling Rs.10 million worth of 20-year, 9% coupon bonds with a par value of Rs.1,000.

The similar types of bonds offered by other companies

offering 10% coupon rate. Because current market interest rates are greater than 9%, the firm must sell

the bonds at discount. The issue price is Rs.980.

Further the floatation costs are 2% of the face value of

the bond. The net proceeds to the firm from the sale of

each bond would be Rs.960.

Calculate the cost of the bond.

Before-Tax Cost of Debt

Approximating the Cost

K d =

90: 1000 −960

20

960+1000

2

=

  • 92 = 9.4%

980

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 the firm.

As a result of these interest tax shield, the after tax cost of

debt to the firm will be substantially less than the investors required rate of return.

After-tax cost of Debt = K d (1-t)

Find the after-tax cost of debt for Dutch Corp. assuming it has a 40% tax rate:

k d = 9.4% ×(1-0.40) = 5.6%

This suggests that the after-tax cost of raising debt capital for Dutch is 5.6%.

COST OF PREFERENCE CAPITAL

Irredeemable Preference Share

k p

PDIV

P 0
P
0

Dutch Corporation is contemplating the issuance of a 10% preferred stock that is having a face value of Rs.87per share. The cost of issuing and selling the stock is expected to be Rs.5 per share. The dividend is Rs.8.70 (10% x Rs.87). The net proceeds price (N p ) is Rs.82 (Rs.87 Rs.5). K P = D P /N p = Rs.8.70/Rs.82 = 10.6%

Example

Example 11

COST OF EQUITY CAPITAL Using CAPM

As per the CAPM, the required rate of return on

equity is given by the following relationship:

k

e

R

f

(R

m

R )

f

j

Equation requires the following three parameters to estimate a firm’s cost of equity:

The risk-free rate (R f ) The market risk premium (R m R f ) The beta of the firm’s share ()

Example

Dutch Corporation’s investment advisor indicates that the firm’s beta is 1.5 and the

market return R m is equal to 11%. The 364-days T-bill rate is hovering around 7%.

As per CAPM, the cost of equity share is

kRRR

e

f

(

m

f

)

K e = 7 + 1.5 (11 7 ) = 13%

COST OF EQUITY CAPITAL

Cost of External Equity: The Dividend Growth Model

DIV

1

P

0

k e

g

Dutch Corporation's shares are currently trading in the market at Rs.50 per share. The

firm expects to pay a dividend of Rs.4 per share in the next year. The annual growth rate

of dividend is coming at 5 percent p.a. The cost of equity capital would be

K e

.4

= .50 + 0.05 = 0.08 + 0.05 = 13%

Example

Example 16
Example 16

THE WEIGHTED AVERAGE COST OF CAPITAL

The following steps are involved for calculating the firm’s WACC:

Calculate the cost of specific sources of funds

Multiply the cost of each source by its proportion in the capital structure.

Add the weighted component costs to get the WACC.

kk

(1

o



d

)

Tw

d

kw

ee

  • D k

E

kk

(1

o



d

T

)

DE

e

DE

WACC of Dutch

Sources of Capital

Weights

Cost

Weighted Cost

Long Term Debt

0.40

5.6%

2.2%

Preferred Stock

0.10

10.6%

1.1%

Equity Shares

0.50

13%

6.5%

Total

1.00

 

9.8%

WACC Book Value Approach

Source

Amount

Proportion (%)

After tax Cost (%)

Weighted Cost

Equity Capital

45,00,000

45

18

8.1

Reserve &

15,00,000

15

18

2.7

Surplus

Pref. Capital

10,00,000

10

11

1.1

Debenture

30,00,000

30

8

2.4

 

100,00,000

 

WACC

14.3%

The Company issued 4,50,000 shares @ Rs.10 per share

WACC Market Value Approach

Source

Amount

Proportion (%)

After tax Cost (%)

Weighted Cost

Equity Capital

90,00,000

69.2

18

12.5

Pref. Capital

10,00,000

7.7

11

0.8

Debenture

30,00,000

23.1

8

1.8

 

130,00,000

 

WACC

15.1%

The current market price per share is Rs.20.

Book Value Versus Market Value Weights

Managers prefer the book value weights for calculating WACC

Firms in practice set their target capital structure in terms of book values.

The book value information can be easily derived from the published sources.

The

book

value

debt-equity

ratios

are

analysed

by

investors to evaluate the risk of the firms in practice.

Book Value Versus Market Value Weights

The use of the book-value weights can be seriously

questioned on theoretical grounds;

The book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values

Book Value Versus Market Value Weights

Market-value

weights

are

theoretically

superior to book-value weights:

They reflect economic values and are not influenced by accounting policies.

They are also consistent with the market-determined

component costs.

The difficulty in using market-value weights:

The

market

frequently.

prices

of

securities

fluctuate

widely

and

A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.