COST OF CAPITAL

CHAPTER
13
CONTENTS
Introduction
Opportunity Cost of Capital
WACC Preview
Cost of Debt
Cost of Redeemable Debt
Cost of Perpetual Debt
Post Tax Cost of Debt
Cost of Preferred Capital

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2
CHAPTER 13
CONTENTS
Cost of Equity
Dividend capitalization Approach
Earning Based Approach
CAPM Based Approach
Cost of External Equity
Assigning Weights
Marginal Cost of Capital
WACC as Discount Rate & Risk
Pure Play Approach-
Unlevering & Relevering Beta
Factors Affecting Cost of Capital

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CHAPTER 13
COST OF CAPITAL
INTRODUCTION
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.
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4
CHAPTER 13
OPPORTUNITY COST OF CAPITAL
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.
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5
CHAPTER 13
WACC
Besides opportunity cost the cost of capital must also
consider
1. Business risk 2. Financial risk
There are predominantly two suppliers of capital
1. Debt 2. Equity
WACC is a composite figure reflecting cost of each
component multiplied by the weight of each component.
WACC = w
e
x r
e
+ w
p
x r
p
+ w
d
x r
d


w
e
= Proportions of equity r
e
= Cost of equity
w
p
= Proportion of pref capital r
p
= Cost of preference capital
w
d
= Proportion of Debt r
d
= Cost of debt
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CHAPTER 13
COST OF PERPETUAL DEBT
Cost of debt is determined by equating the cash
flows of the instrument to its market price.
Cost of perpetual debt, r
d
is

Most debts are repayable in the specified time
interval. Is debt perpetual?
Where a firm decides to maintain a fixed
component of debt by replacing one debt with
another, it becomes the case of perpetual debt.




CHAPTER 13 COST OF CAPITAL
7
o
t
d
d
t
o
P
C
= r or
r
C
= P
COST OF DEBT
3
d
3
d
2
d
d
) r 1 (
105
) r 1 (
6 . 0 x 11
) r 1 (
6 . 0 x 11
r 1
6 . 0 x 11
95

CHAPTER 13 COST OF CAPITAL

8
Cost of redeemable debt is determined by
equating the cash flows of the instrument to its
market price.
Cost of redeemable debt is
Post tax cost of debt = r
d
(1-T)
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

N
1 t
N
d
t
d
t
o
) r (1
R
) r (1
C
P

COST OF DEBT
ISSUE EXPENSES
To mobilise debt one has to incur
floatation cost which increases the cost
of debt
WHICH DEBTS TO CONSIDER
While computing the cost of debt the
claims of the suppliers of long-term debt
are only considered.
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CHAPTER 13
COST OF PREFERENCE
CAPITAL
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, r
p
is determined by
equating its cash flows to market price. No
adjustment for tax is required.
COST OF CAPITAL
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N
1 t
N
p
t
p
t
o
) r (1
R
) r (1
D
P
CHAPTER 13
COST OF EQUITY CAPITAL
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.
Does this mean that cost of equity is zero?
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CHAPTER 13
TYPES OF EQUITY CAPITAL
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
And external equity may have cost differential on
account of
Floatation cost associated with raising fresh equity,
Inability to deploy external equity instantaneously,
Underpricing of fresh issue.
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CHAPTER 13
APPROACHES
COST OF EQUITY
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.
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CHAPTER 13
DIVIDEND CAPITALIZATION
APPROACH
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.




For constant growth of dividend at g



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14
Yield Dividend
P
D
r or ;
r
D
P Then
D ...... D D D . i.e constant is dividend if
......... ..........
) r (1
D
) r (1
D
) r (1
D
) r (1
D
P
0
e
e
0
3 2 1
4
e
4
3
e
3
2
e
2
e
1
0

g +
P
D
= r or ;
g - r
D
= P then
......... ..........
) r + (1
g) + (1 D
+
) r + (1
g) + (1 D
+
) r + (1
g) + (1 D
+
) r + (1
D
= P
0
1
e
e
0
4
e
3
1
3
e
2
1
2
e
1
e
1
0
CHAPTER 13
COST OF EQUITY
PE APPROACH
0
1
e
e
1
0
e
1
e
1
0
P
E
= r or
r
E
= P k; = b when And
bxk - r
b) - x(1 E
=
g - r
D
= P
CHAPTER 13 COST OF CAPITAL
15
Earnings based approach, as manifested by Dividend
capitalization Approach equates the value as

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 as

bxk - r
b) - x(1 E
=
g - r
D
= P
e
1
e
1
0
COST OF EQUITY
CAPM 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, r
f
the market return, r
m
and
, as measure of risk
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CHAPTER 13
COST OF EQUITY
CAPM APPROACH
,the primary determinant of risk governs
the cost of equity.
r
e
= r
f
+ x (r
m
r
f
)
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Cost of Equity
r
e


r
m


Risk Premium
(r
m
-r
f
)
r
f





= 1 Risk,
CHAPTER 13
COST OF EQUITY
DDM VS 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.
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CHAPTER 13
COST OF
INTERNAL AND EXTERNAL EQUITY
There are three major differences in the
INTERNAL and EXTERNAL equity
Existence of flotation cost
Under utilisation of external equity
Under 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).

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g +
P
D
f) - (1
1
=
f) - (1
equity internal of Cost
= equity external for r
0
1
e
CHAPTER 13
ASSIGNING WEIGHTS
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.
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CHAPTER 13
BOOK VALUE VS MARKET VALUE
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.
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CHAPTER 13
MARGINAL COST OF CAPITAL
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.
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CHAPTER 13
OPTIMAL CAPITAL BUDGET
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.
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CHAPTER 13
WACC AND RISK
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.
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CHAPTER 13
PURE PLAY APPROACH
ADJUSTING FOR 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 unlevering and then
re-adjusting for the proposed capital structure of the
project, called relevering.
The value of so arrived is used in calculating the WACC.
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CHAPTER 13
PURE PLAY APPROACH
ADJUSTING FOR RISK

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CHAPTER 13
Equity of Value Market E Debt of Value Market D
beta observed the firm; levered for equity of Beta
debt of Beta firm unlevered the of Beta
Where
.
E D
E

E D
D

L
d u
L d u

E T) - D(1
E

E T) - D(1
T) - D(1

L d u

D/E} x T) - (1 + {1

= or

E + T) - (1 x D
E
=
L
u
L u
PURE PLAY APPROACH
ADJUSTING FOR RISK
While using beta of the pure play firm it must be unlevered
for the financial leverage to reflect only the business risk
and then re-levered for the proposed capital structure of
the project.
Assume that observed beta of Pure-play firm is 1.2. Besides
reflecting the business risk the observed beta also
represents the financial risk. This has to be unlevered i.e.
converted into of equity as if it were all equity financed.
If the debt equity ratio based on market values is 1:5 and
its marginal tax rate is 30% the beta of pure play firm is

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CHAPTER 13
0526 . 1
5 / 1 7 . 0 1
20 . 1
D/E} x T) - (1 {1

or

E T) - (1 x D
E

L
u
L u

x
RE-LEVERING
This now needs to be relevered with the proposed
financing pattern of the project. This can be done by
incorporating debt equity ratio (D*/E*) and tax rate
(T*) of the proposed project.
If new project is proposed with debt equity ratio of
2:5 and with tax rate of 35% the beta of the project is
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1.3262 0.65x2/5) 1.0526(1 } /E D x ) T - (1 {1
* * *
U
*
L

WACC
After incorporating the business risk and leverage in its
beta, the cost of equity may be calculated using CAP-M
r
e
= r
f
+ x (r
m
r
f
)
Using the risk free return r
f
of 6% and market return of r
m

of 16% the cost of equity is 19.262%.
r
e
= r
f
+ x (r
m
r
f
) = 6 + 1.3262 x (16 6) = 19.262%
Finding WACC, the discount rate; The WACC is given by
WACC = w
e
x r
e
+ w
d
x r
d

The cost of equity is arrived at by using 19.262%.
Assuming the pre-tax cost of debt at 8%, WACC for with
debt at 40% of equity (debt equity ratio at 2:5) would be
5/7 x 19.26% + 2/7 x 8% x (1 35%) = 15.244%

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