Cost of Capital

Meaning

The projects 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. The firms cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects.

Basic Aspects on the Concept of Cost of Capital

The above definitions indicates that the following three basic aspects of the concept of cost of capital. They are

Rates of Return - Cost of Capital is not a Cost as

such in fact it is the rate of return that a firm requires to earn from its investment projects.

Minimum Rate of Return cost of capital of any

firm is that minimum rate of return that will at least maintain the market value of the shares.

Cost of Capital Comprises of Three Components (1)

The risk less cost of the particular type of financing (rj) The business risk premium, (b) and The financial risk premium (f)

Symbolically cost of capital may be represented as Ko = rj + b + f

Importance / Significance of Cost of Capital

Designing Optimal Corporate Capital Structure

Investment Evaluation / Capital Budgeting

Financial Performance Appraisal

Flotation Costs

A new issue of debt or shares will invariably involve flotation costs in the form of legal fees, administrative expenses, brokerage or underwriting commission

Approaches to Calculate of Cost of Equity (Ke)

(i) Dividends capitalisation approach Ke = D / CMP or NP Where: Ke = cost of equity D = Dividends per share CMP = Current market price per share, NP = Net proceed per share This method assumes that investor give prime importance to dividends and risk in the firm remains unchanged and it does not consider the growth in dividend.

Earnings Capitalisation Approach (E/MP Approach)

Ke = E / CMP or NP Where Ke = cost of equity E = earnings per share CMP = current market price per share NP = net proceeds per share

Dividend Capitalisation plus growth rate approach

Computation of cost of equity capital based on a fixed dividend rate may not be appropriate, because the future dividend may grow. The growth in dividends may be constant perpetually or may vary over a period of time. It is the best method over dividend capitalisation approach, since it considers the growth in dividends.

Cost of Capital Under Constant Growth Rate Perpetually

The formula for computation of cost of equity under constant growth rate is : Ke =(D/NP or CMP) + g Where: Ke = cost of equity capital D = dividends per share, NP = net proceeds per share, CMP = current market price per share, g = growth rate (%)

Cost of Capital Under Variable Growth Rate

Compound growth rate in dividends can be computed with the following formula.

gr = Do (1 + r) n = Dn

where: gr = growth rate in dividends Do = first year dividend payment,

(1 + r) n

= present value factor for nth year

Dn = last year dividend payment

Bond Yield Plus Risk Premium Approach

According to this approach the rate of return required by the equity shareholder of a company is equal to Ke = yield on long-term bonds + risk premium

Capital Asset Pricing Model Approach (CAPM)

Capital Asset Pricing Model (CAPM) was developed by William F. Sharpe. This is another approach that can be used to calculate cost of equity. From cost of capital point of views, CAPM explains the relationship between the required rate of return, or the cost of equity capital and the non-diversifiable or market risk of the firm that is beta ().

Symbolically, Ke = Rf + (Rmf Rf) Where: Ke = cost of equity capital Rf = the rate of return required on a risk free security (%) = the beta coefficient Rmf = market return

COST OF RETAINED EARNINGS (Kre)

Retained earnings is one of the internal sources to raise finance. Retained earnings are those / part of earnings that are retained by the form of investing in capital budgeting proposals instead of paying them as dividends to shareholders The opportunity cost of retained earning is the rate of return the shareholders forgoe by not putting his/her funds elsewhere, because the management has retained the funds

The opportunity cost can be computed with the following formula

Kre = Ke { (1 Ti) / (1 Tb)} x 100 Where: Ke = cost of equity capital [(D / NP )+ g]

Ti = tax rate Tb = cost of purchase of new securities / brokerage commission D = expected dividend per share NP = net proceeds of equity share / market price g = growth rate in (%)

Cost of Preference Shares

Preference share is one of the types of shares issued by companies to raise funds from investors. Preference share is the share that has two preferential rights over equity shares, (i) preference in payment of dividend, from distributable profits, (ii) preference in the payment of capital at the time of liquidation of the company.

Cost of Irredeemable Preference Share / Perpetual Preference Share:

The share that cannot be paid till the liquidation of the company are called as irredeemable preference shares. The cost is measured by the following formulas.

Kp (without tax) =D/MP or NP Where: Kp = cost of preference share D = dividend per share MP = market price per share NP = net proceeds

Cost of irredeemable preference stock (with dividend tax) Kp (with tax) =D (1 + Dt)/MP or NP where Dt = tax on preference dividend

Cost of redeemable Preference Share

Kp={D+(f+d+pr-pi)/N}/(RV+NP)/2 D=dividend per share f=Flotation cost(Rs) d=Discount on issue of preference share (Rs) Pr=Premium on redemption of preference shares(Rs) Pi=Premium on issue of preference share (Rs) N=Term of preference shares. Rv=Redeemable value of preference shares Np=Net proceeds realized.

Cost of Debentures
Cost of Irredeemable Debt / Perpetual debt

Perpetual debt provides permanent funds to the firm, because the funds will remain in the firm till liquidation. Computation of cost of perpetual debt is conceptually relatively easy. Cost of perpetual debt is the rate of return that lender expect (i.e., fixed interest rate). The coupon rate or the market yield on debt can be said to represent an approximation of cost of debt. Bonds / debentures can be issued at (i) par / face value, (ii) discount and (iii) premium.

The following formulae used to compute cost of debentures or bond. (i) Pre-tax cost = Kdi = I/P or NP x 100 (ii) post-tax cost = IKd = I (1 - t)/ P or NP x 100 Where: rate I = interest, P = principle amount or face value,N P = net proceeds,t = tax

Cost of redeemable Debt

Kd={I(1-t)+(f+d+pr-pi)/N}/(RV+NP)/2 I= Intrest (Rs) t=Tax rate f=Flotation cost(Rs) d=Discount on issue of debt (Rs) Pr=Premium on redemption of debt(Rs) Pi=Premium on issue of debt (Rs) N=Term of debt. Rv=Redeemable value Np=Net proceeds realized.

Computation of weighted average Cost of Capital (WACC)

The term cost of capital (Ko) means the overall composite cost of capital, defined as the weighed average of the cost of each specific type of fund. It is also known as composite cost or weighted average cost of capital (WACC) Steps of finding WACC Determination of the type of funds to be raised and their individual share in the total capitalisation of the firm Computation of cost of each type of funds.

Assigning weights to specific costs. Multiplying the cost of each of the sources by the (appropriate) assigned weights. Adding the total weighted cost to get over all cost of capital.

WACC=(ke x we)+ (kd X wd) =ke X{E/(D+E)}+ kd X {D/(D+E)} ke cost of equity kd cost of debt we-proportion of equity in the financing mix wd-proportion of debt in the financing mix D=Value of debt (Rs) E=Value of equity (Rs)

Marginal cost of capital (MCC)

Companies may rise additional funds for expansion .The cost of additional funds is called marginal cost of capital. The weighted average cost of new or incremental capital is known as the marginal cost of capital