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i Explain the general concept of the opportunity cost of capital

i Distinguish between the project cost of capital and the firm¶s
cost of capital
i Learn about the methods of calculating component cost of
capital and the weighted average cost of capital
i Illustrate the cost of capital calculation for a real company


èhat is p
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i áiewed from all investors¶ point of view, the firm¶s

cost of capital is the rate of return required by them
for supplying capital for financing the firm¶s
investment projects by purchasing various
securities.
i Compensation for TIME and RISK
i The rate of return required by all investors will be
an 
 
 
 

 
 



*

i The ’
 

  ’

  is the minimum
required rate of return on funds committed to the
project, which depends on the riskiness of its cash
flows. ±Individual project
i m  
 

  ’
  will be the overall, or
average, required rate of return on the aggregate of
investment projects
 


 
 


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i Evaluating investment decisions

i Designing a firm¶s debt policy

i Appraising the financial performance of top

management


 
 


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i The opportunity cost is the rate of return foregone

on the next best alternative investment opportunity
of x
.

u
 
 

  

  

 
 


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i Rate of return required by shareholders on

securities of comparable RISK
i Company must pay same to attract capital
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i The required rate of return (or the opportunity cost of capital)

of shareholders is market-determined.

i In an all-equity financed firm, the equity capital of ordinary

shareholders is the only source to finance investment projects,
the firm¶s cost of capital is equal to the opportunity cost of
equity capital, which will depend only on the 
  of
the firm.


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i Creditors have a priority claim over the firm¶s assets and

cash flows.
i The firm is under a legal obligation to pay interest and
repay principal.
i There is a probability that it may default on its obligation
to pay interest and principal.
i Corporate bonds are riskier than government bonds since
it is very unlikely that the government will default in its
obligation to pay interest and principal.


i èhat is average cost of capital ?

i èhat is Marginal cost of capital ?
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i The cost of capital of each source of capital is known as


’
 , or ’

- 

  ’
 .
i The overall cost is also called the 0
    


 ’
  (èACC).
i Relevant cost in the investment decisions is the   
 or
the  
 
.
i Marginal cost is the new or the incremental cost that the firm
incurs if it were to raise capital now, or in the near future.
i The


  
 that was incurred in the past in raising
capital is not relevant in financial decision-making.
   '
' 
  


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i Investors¶ required rate of return should be adjusted

for taxes in practice for calculating the cost of a
specific source of capital to the firm.
i m     ‰


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i Sometimes a firm may like to compute the

³current´ cost of its existing debt.

i In such a case, the cost of debt should be

approximated by the current market yield of the
debt.
  
*

i A firm is currently earning Rs 100,000 and its share is selling

at a market price of Rs 80. The firm has 10,000 shares
outstanding and has no debt. The earnings of the firm are
expected to remain stable, and it has a payout ratio of 100 per
cent. èhat is the cost of equity?
i èe can use expected earnings-price ratio to compute the cost
of equity. Thus:





' *

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i 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
i Equation requires the following three parameters
to estimate a firm¶s cost of equity:
 The risk-free rate (Rf)
 The market risk premium (Rm ± Rf)
 The beta of the firm¶s share (›)
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i Suppose in the year 2002 the risk-free rate is 6 per

cent, the market risk premium is 9 per cent and beta
of L&T¶s share is 1.54. The cost of equity for L&T
is:

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i p
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 ’’
 




  



 ’


 The only condition for its use is that the company¶s share is
quoted on the stock exchange.
 All variables in the CAPM are market determined and
except the company specific share price data, they are
common to all companies.
 The value of beta is determined in an objective manner by
using sound statistical methods. One practical problem with
the use of beta, however, is that it does not probably remain
stable over time .
 è  
 
 
 


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i The following steps are involved for calculating the firm¶s èACC:
 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 èACC.
k o
k d (1 T) d ´ k d e

k o
k d (1 T) ´ k e
´  ´ 

i èACC is in fact the weighted marginal cost of capital (èMCC);

that is, the

 
 

x  

x 
 


 x x



0&1
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i A simple practical approach to incorporate risk differences in

projects is to adjust the firm¶s èACC (upwards or
downwards), and use the 
  to evaluate the
investment project:

i Companies in practice may develop policy guidelines for

incorporating the project risk differences. One approach is to
divide projects into broad risk classes, and use different
discount rates based on the decision maker¶s experience.


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i ›or example, projects may be classified as:

 Low risk projects
discount rate < the firm¶s èACC
 Medium risk projects
discount rate = the firm¶s èACC
 High risk projects
discount rate > the firm¶s èACC