Amity School of Business

Amity School of Business

BBA, 4 th
Semester
Financial Management 2

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 Amity School of Business

Module 3
Cost of Capital

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 Outline of the Module Amity School of Business
• Meaning of Cost of Capital.
• Factors effecting the cost of capital.
• Cost Measurement:
- Cost of Internal Equity.
- Cost of External Equity.
-Cost of Debt.
-Cost of equity by CAPM.
-Cost of Preference Shares.
-Dividend growth Model ( 2 stage)
• Book Value v/s Market values.
• Weighted Average cost of capital.

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What sources of long-term capital do firms
use? Amity School of Business
Amity School of Business
 Cost of Capital Amity School of Business

 For Investors the rate of return on a security is a

benefit of investing.
 For Financial Managers that same rate of return is a
cost of raising funds that are needed to operate the
firm.

In other words, the cost of raising funds is the firm’s

cost of capital.
 Factors determining the cost of capital
Amity School of Business

• General economic conditions:

– Demand for and supply of capital within the
economy and the level of expected inflation.

• Market conditions.

• A firm’s operating and financing decisions:

– Business Risk-Company’s investment decisions.
– Financial Risk-Use of Debt.

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 Cost of Internal Equity
Amity School of Business

 Since the stockholders own the firm’s retained earnings, the cost
is simply the stockholders’ required rate of return.
 If managers are investing stockholders’ funds, stockholders will
expect to earn an acceptable rate of return.
 Difference between cost of retained earnings & cost of external
equity would be floatation costs.
 Is Equity Share Capital free of cost?
Amity School of Business

 Equity capital involves opportunity cost; ordinary shareholders

provide funds to the firm in expectation of dividends and
capital gains.

 The shareholder’s required rate of return equates the PV of the

expected dividends with the market value of shares.

 Two difficulties in measurement:

• Difficult to estimate expected dividends.
• Future earnings & Dividends are expected to grow.

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 Amity School of Business

Cost of Equity
 Cost of Equity - Capital Asset Pricing Model
Amity School of Business

 The CAPM is a model that provides a framework to determine

the required rate of return on an asset and indicates the
relationship between return and risk of the asset
 Assumptions:
 Market Efficiency
 Risk Aversion
 Homogeneous expectations
 Single time period
 Risk-free rate
 Risk has two parts:
 Unsystematic Risk (Diversifiable)
 Systematic Risk (Cannot be reduced)
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 Cost of equity - CAPM
Amity School of Business

• Capital Asset Pricing Model (CAPM)

Ke  R f  B( Rm  R f )
Where,
– Rf= The risk free rate: The yields on the Government Treasury
securities are used
– Rm – Rf = Market Risk Premium: Measured as the difference
between the long term arithmetic averages of market return and
the risk-free rate (same for all securities)
– Β=The beta of the firm’s share: The sensitivity of a security’s
return vis-à-vis the market return which reflects its risk is the beta
(systematic risk)

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 Cost of Internal Equity: Dividend Growth Model
Amity School of Business

The opportunity cost of retained earnings is the rate of return

foregone by equity shareholders:
1. Normal Growth: The cost of Equity is equal to the expected
dividend plus capital gain rate

DIV1
ke  g
P0
Where,
– ke = cost of equity
– DIV1 = DIV0(1+g)
– g= expected growth in dividends
– Po = price of the stock at the beginning of the year.
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 Cost of Internal Equity: Dividend Growth Model
(Gordon model) Amity School of Business

Can be written as follows:

DIV1
Po 
ke  g
 These equations are based on the following assumptions:
– Market price of shares is a function of expected dividends.
– The Dividend is positive.
– The dividends grow at a constant rate & g = ROE X Retention Ratio.
– The dividend payout ratio is constant.
 Also called as GORDON’s model.
 Implies the opportunity cost for the shareholders, if these earnings were to
be distributed as dividends.

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 2. Supernormal Growth
Amity School of Business

 When dividends grow at different rates, the dividend valuation

model is used as follows:
t
n
DIV0 (1  g s ) DIVn 1 1
P0    X
t 1 1  k e  t
k e  g n (1  k e ) n

 Where, gs = super-normal growth rate for n years & gn is the

growth rate beginning in the year n+1, perpetually

3. Zero – growth:
DIV1
ke 
P0
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 Cost of External Equity: Dividend Growth
Model Amity School of Business
• The firm’s external equity consists of funds raised externally through public or
rights issue.

• The minimum rate of return required by equity shareholders to keep the market
price of share same is the cost of equity.

• Cost of retained earnings is lesser than the cost of external equity.

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 Cost of External Equity: Dividend Growth
Model Amity School of Business

• Cost of internal equity= Cost of external equity, when no

floatation cost is there (As per Dividend Growth Model).
• Cost of external equity with floatation costs:

DIV1
ke  g
Pn
Where,
– ke = cost of equity
– DIV1 = DIV0(1+g)
– g= expected growth in dividends
– Pn = Net price to the firm= Issue price – Floatations Costs.
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 Earnings Price Ratio - Cost of Equity (external equity)
Amity School of Business

 The firm’s external equity consists of funds raised externally

through public or rights issue.

 The minimum rate of return required by equity shareholders to

keep the market price of share same is the cost of equity.
E1
P0
Where,
E1 is the expected earning per share i.e. E0 (1 + g)
P0 is the current market price per share.

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 Earnings Price Ratio plus growth - Cost of Equity
(external equity) Amity School of Business

E1
g
P0

Where,
E1 is the expected earning per share i.e. E0 (1 + g)
P0 is the current market price per share.
G is the growth rate.

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 Cost of Equity: CAPM Vs. Dividend-Growth Model
Amity School of Business

 The dividend-growth approach has limited application in

practice
 The expected dividend growth rate, g, should be less than the
cost of equity, ke, to arrive at the simple growth formula.

 Can’t be used if a company is not paying dividends.

 Fails to deal with risk directly.

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 Cost of Equity: CAPM Vs. Dividend-Growth Model
Amity School of Business

 CAPM has a wider application although it is based on restrictive

assumptions:
 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 problem with the use
of beta is that it does not remain stable over time

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 Characteristics of Cost of debt
Amity School of Business

 Face value.
 Interest rate.
 Maturity.
 Redemption value.
 Market value.

For the issuing firm, the cost of debt is the rate of return required
by investors, adjusted for flotation costs (any costs associated
with issuing new bonds), and adjusted for taxes.
 Example: Tax effects of financing with
debt Amity School of Business

Equity Firm Debt Firm

EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
 Example: Tax effects of financing with debt
Amity School of Business

Equity Firm Debt Firm with stock

with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
 After-tax cost Before-tax cost Tax
of Debt
= of Debt -
Amity School of Business
Savings

33,000 = 50,000 - 17,000

OR
33,000 = 50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

After-tax Before-tax Marginal
Amity School of Business
% cost of % cost of x
1 tax
= -

Debt Debt
rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

 Cost of irredeemable/ perpetual Debentures
Amity School of Business

 No redemption during the life time of the company.

Kd = Int(1-t)
NP
Kd = cost of debt.
I = annual interest rate.
NP = net proceeds of debentures.
T = tax rate.

Net proceeds from the issue of debt (NP) = Face value + Premium
on issue (- issue on discount) – Floatation cost like
underwriting commission or Brokerage.
 Cost of Debt (redeemable debentures)
Present value method Amity School of Business

• Simply subtract the flotation costs (F) from the price of

the bonds, and calculate the cost of debt as usual:
I(1  t)
n
F
P 
t 1 (1  k d ) t
(1  k d ) n

where,
kd is the post-tax cost of debenture capital.
I is the annual interest payment
t is the corporate tax rate
F is the redemption price debenture
P is the net amount realized per debenture
and n is the maturity period.

Note that we still adjust this calculation for taxes.

 Cost of Preference share capital
Amity School of Business

Factors determining cost of preference share:

• Fixed dividend rate.
• Dividend distribution tax.
• Issue expenses like underwriting commission,
brokerage costs.
• Redemption: Par, Premium, Discount.

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 Cost of Preferred Stock (irredeemable)
Amity School of Business

kp = D1
Po
Where
Kp = Cost of Preference shares.
D1 = Expected Dividend on preference share.
Po = Price of the share

From the firm’s point of view:

kp = D1
NPo
Where
NPo = price - floatation costs.
 Example: Cost of Preferred stock
Amity School of Business

If Prescott Corporation issues preferred stock, it will pay

dividend of Rs.8 per year and should be valued at Rs.75 per
share. If flotation costs amount to Rs.1 per share, what is
the cost of preferred stock for Prescott?
kp = D1
NPo
Where
NPo = Price - floatation costs.
= 8
74
=10.81%
 Amity School of Business

COST OF REDEEMABLE PREFERENCE SHARES:

present value method/hit & trial method
 Cost of redeemable preference shares will be computed as follows
n
PDIVt Pn
P0   
t 1 (1  k p ) t
(1  k p ) n

where,
– kp is the cost of preference shares
– PDIV is the expected preference dividend
– P0 is the issue price of preference shares
– Pn is the price at which preference share is redeemed

 The cost of preference share is not adjusted for taxes because preference
dividend is paid after the corporate taxes have been paid
 Since interest is tax deductible & Preference dividend is not, the cost of
preference is substantially higher than the after tax cost of debt
 The Weighted Cost of Capital
Amity School of Business

We must first calculate the costs of the individual financing

sources:

 Cost of Debt.
 Cost of Preferred Stock.
 Cost of Common Stock.
 Explicit and Implicit Costs
Amity School of Business

 Explicit Cost
-Discount rate that equates the PV of incremental cash inflows
to the PV of incremental cash outflows

 Implicit Cost/Opportunity Cost

-Rate of return of the foregone opportunity, E.g. Retained
Earnings

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 Weighted Average Cost of Capital (WACC)
Amity School of Business

 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.

 Weighted Marginal Cost of Capital (WMCC):

ko = ke we + kd (1-T) wd + kp wp
 Marginal cost is the new or incremental cost of new capital
(equity & debt) issued by the firm.
 New funds are raised at new costs according to the firm’s target
capital structure.
 WMCC is the WACC of new capital given the firm’s target
capital structure.

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 Amity School of Business

Example: Dunlop Technologies Ltd. has the following capital

structure in terms of book values and market values:
Source Book Value (Rs.) Market Value
(Rs.)
Paid-up equity Capital 20,00,000 40,00,000
Reserves and Surplus 30,00,000 -
Preference capital 10,00,000 12,00,000
Debentures 40,00,000 42,00,000
The cost of various sources of finance used by the firm is as follows:

Cost of
Sources Capital
Equity 12.5%
Debentures 11.4%
Preference capital 7.64%
 Solution: Amity School of Business

(a) WACC using market value weights

Source Proportion
40,00,000
Equity (We) = 0.4255
94,00,000
12,00,000
94,00,000 0.1277
Preference Capital (Wp)=
42,00,000
94,00,000
Debenture Capital (Wd = 0.4468

Weighted average cost of capital using market value weights

= weke + wpkp + wdkd
= (0.4255) 12.50 + (0.1277) 11.40 + (0.4468) 7.64
= 11.39%.
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Solution: (a) WACC using book value weights
Amity School of Business

Source Proportion
Equity (we) = 20,00,000 0.20
100,00,000
30,00,000
100,00,000 0.30
Retained Earnings (wr) =
10,00,000
100,00,000
Preference Capital (wp)= 0.10
40,00,000
100,00,000 0.40
Debenture Capital (wd) =

Weighted average cost of capital using market value weights

= weke + wpkp + wrkr + wdkd
=(0.20) 12.5 + (0.30) 12.5 + (0.10) 11.40 + (0.40) 7.64
= 11.57% 38
 Book Value Versus Market Value Weights
Amity School of Business

 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.

 The use of the book-value weights can be seriously questioned

on theoretical grounds:
 First, the component costs are opportunity rates and are determined in
the capital markets. The weights should also be market-determined.
 Second, 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.

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 Book Value Versus Market Value Weights
Amity School of Business

 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 prices of securities fluctuate widely and frequently.
 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.
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