Cost of Capital

Key Concepts and Skills

Know how to determine a firms cost of debt [Kd] Know how to determine a firms cost of Preference equity capital [Kp] Know how to determine a firms cost of equity capital [Ke] Know how to determine a firms overall cost of capital Understand pitfalls of overall cost of capital and how to manage them

 The Cost of Capital: Some Preliminaries The Costs of Debt and Preferred Stock The Cost of Equity The Weighted Average Cost of Capital Divisional and Project Costs of Capital Flotation Costs and the Weighted Average Cost of Capital

Why Cost of Capital Is Important We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company Our cost of capital provides us with an indication of how the market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects

Required Return
The required return is the same as the appropriate discount rate and is based on the risk of the cash flows We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment We need to earn at least the required return to compensate our investors for the financing they have provided

Cost of Capital
Sources of Capital Component Costs WACC (weighted Average Cost of Capital) Adjusting for Flotation Cost Adjusting for Risk Sources of Capital Long term Capital Long term Debt Common Stock Preferred Stock

Retained Earnings

New Common Stock

 WACC = Wd.Kd (1-t) + Wp.Kp + Wc.Kc

W = Firms capital structure weights K = Cost of each component

Note: Our analysis must be on after calculation of tax.

Therefore Kd needs adjustment, because Interest is tax deductible. We should focus on todays Marginal Costs( for WACC).

Cost of Debt (Kd)

Cost of Debt (Kd) Irredeemable Par Kd= Discount I P-f I P-f Premium I Pf Par I+ R-P+f N R+P-f 2 Kd = I (1-t) + R-P+F N R +P-f
2

Redeemable Premium I = Interest (always on Par value) P = Issue Price (par, discount, premium) f = flotation cost n = no.of.years R = Redeemable (Par, Premium) t= tax rate

After Tax Kd = I (1-t) P-f

Cost of Preference Capital (Kp)

Cost of Preference Capital (Kp) Irredeemable Par Kd= Discount Pd P-f Pd P-f Premium Pd Pf Par Pd + R - P + f N R+P-f 2 Redeemable Premium

Pd = Preference Dividend (always on par value) = Preference Capital x Preferred Dividend Rate

P = Issue Price ( Par, Premium, Discount) ; R = Redeemable Value ( Par, Premium)

f = Flotation Cost N = No.of.years

Cost of Equity [Ke] Existing Shares Dividend model New Shares

Ke = Div P Note: Dividend = Paidup capital x R / 100 Earnings Model

Ke = Div Pf

Ke = EPS Ke = EPS P Pf EPS = Earnings Available to Equity Share Holders No.of.Equity Shares When Growth Rate is given + g should added to the formula

Cost of Retained Earnings [Kr]

Kr = D / [P-f] + G Kr = Cost of retained Earnings D = Expected Dividend P = issue price f = flotation cost

Computation of WACC
1 Sources of Funds 2 3 4 5=3x4 Amount Proportion Cost of Source Weighted Cost

WACC

Cost of Debt - Irredeemable Debentures

Problem: 1 X Ltd. Issues Rs.50,000 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital.
Solution: Kd (before tax) = I Pf = 4.000 50,000 0 = 8%

Kd (after tax)

I (1-t) Pf

4,000 (1-.50) 50,000 - 0

2000 50,000

4%

Problem:2 Y Ltd. Issues Rs.50,000 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute Cost of debt capital. P = Issue Price = 50,000 + 10% of 50,000 = 50,000 + 5000 = 55.000 I = Interest (always on face value) i.e. 50,000 x 8% = 4000. f= Flotation cost ( is not given ) = 0 ; Kd (before tax)= I Pf = t = tax rate 60%. 4000(1-.60) 55000 - 0 Pf

4,000 = 7.27%. Kd (after tax) = I(1-t) 55000-0

= 2.91%

Problem: 3 A Ltd. Issues Rs.50,000 8% debentures at a discount of 5%. The tax rate is 50%. Compute Cost of debt Capital. Solution: Kd [before tax] = I Pf Kd [after tax] = I (1-t) Pf

P = 50,000 5% of 50,000 = 50,000 2500 = 47,500; f = flotation cost = 0; t=.50

I = 50,000 x 8/100 = 4000

= 4000 47,500 0 = 8.42% 4,000 (1-.50) = 4.21% 47,500 0

Problem: 4 B Ltd. Issues Rs,1,00,000 9% debentures at a discount of 9%. The costs of flotation are 2%. The tax rate applicable is 60%. Compute cost of debt. Solution: Kd [before tax] = I Kd [after tax] = I (1-t) Pf Pf P = 1,00,000 - 9% of 1,00,000 = 1,00,000 9,000 =91,000 f = flotation cost (always on issue price ) i.e. 91,000 x 2% = 1,820 I = 1,00,000 x 9/100 = 9,000 9000 9000 (1-.60) 91,000 1820 91000 1820 =10.09% =4.03%

Cost of Debt - Redeemable Debentures Problem:1 A company issues Rs.10,00,000 10% redeemable debentures at a discount of 5%. The costs of flotation amount to Rs.30,000. The debentures are redeemable after 5 years. Calculate before tax and after tax cost of debt assuming tax rate of 50%. Solution: P = 10,00,000 5% of 10,00,000 = 10,00,000 50,000 = 9,50,000 f= 30,000 ; t=50% ; R=10,00,000 ; n = 5 ; I = 10,00,000 x 10% = 1,00,000

Kd = I + R- P+ f
N R + P f 2

100,000 + 10,00,000 950000 + 30000

5 10,00,000 + 950,000 - 3000 2

100,000 + [80000 / 5] 19,20,000 / 2

= 116000 = 12.08% 960,000

After tax = Kd (1-t) = 12.08 (1-.50) = 6.04%

Assignment Problems
1 . X.Ltd issues 50,000 8% Debentures of Rs.1 each at a Premium of 10%. The costs of flotation are 2%. The rate of tax applicable to the company is 60%. Compute the cost of debt capital. Ans. 2.96% 2. A company issues 5.000 12% debentures of Rs.100 each at a discount of 5%.The commission payable to underwriters and brokers is Rs.25,000. The debentures are redeemable after 5 years. Compute the after tax cost of debt assuming a tax rate of 50%. Ans: 6.66%

3. X ltd. Issues Rs.50,000 4% debentures at par. The tax rate applicable to the company is 40%. Compute Cost of debt Capital.
4. B Ltd issues Rs.2,00,000 9% debentures at a premium of 5%. The costs of flotation are 2%. The tax rate applicable is 60% Compute cost of debt. 5. A company issues Rs.20,00,000 5% redeemable debentures at premium of 5%. The costs of flotation amount to be Rs.30,000. The debentures are reedemable after 5 years. Calculate cost of debt assuming tax rate of 50%.

Cost of Preference Share Capital [Kp]

Preference Share Capital (always after tax)
Irredeemable Redeemable Pd + [ R P + f] n [ R + P f]

Kp =

Pd Pf

2
Pd = Preference Divided = Preference Share Capital x Dividend Rate P = Issue Price ( Par, Discount, Premium) ; f =flotation cost R = Redeemable Value ( Par, Premium) n= number of years

Problem 1 : A Company issues 10,000 10% preference shares of Rs.100 each. Cost of issue is Rs. 2 per share. Calculate cost of preference capital if these shares are issued (a) At Par, (b) at a premium 10% and (c ) at a discount of 10%. Ans . 10.2%, 9.26% , 10.75%

Problem 2: A company issues 10,000 10% preference shares of Rs.100 each redeemable after 10years at a premium of 5%. The cost of issue is Rs.2 per share. Calculate the cost of preference capital. Ans . 10.54%

Problem 3: A company issues 1,000 7% preference shares of Rs.100 each at a premium of 10% redeemable after 5 years at par. Compute the cost of preference capital. Ans: 4.76%

Assignment Problems Problem 1 : (a) A company issues 1000 10% preference shares of Rs.100 each at a discount of 5%. Cost of raising capital are Rs.2,000. Compute the cost of preference share capital. Ans: 10.75% Problem 2 : Assume that the firm pays tax at 50%. Compute the after tax cost of capital of a preferred share sold at Rs.100 with a 9% dividend and a redemption price of Rs.110, if the company redeems it in five years. Ans: 10.47%

Cost of Equity
The cost of equity is the return required by equity investors given the risk of the cash flows from the firm Business risk Financial risk There are two major methods for determining the cost of equity Dividend growth model SML or CAPM

The Dividend Growth Model Approach

Start with the dividend growth model formula and rearrange to solve for RE

D1 P 0 RE g D1 RE g P 0

Dividend Growth Model Example

Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity?

1.50 RE .051 .111 11.1% 25

Example: Estimating the Dividend Growth Rate

One method for estimating the growth rate is to use the historical average
Year 2000 2001 2002 2003 1999 Dividend 1.23 1.30 1.36 1.43 1.50 Percent Change (1.30 1.23) / 1.23 = 5.7% (1.36 1.30) / 1.30 = 4.6% (1.43 1.36) / 1.36 = 5.1% (1.50 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

Cost of Equity [Ke] Existing Shares Ke = Dividend P or MP Dividend = Paid up capital x Rate MP= Market Price Ke = EPS P or MP 100
Earnings Model
Dividend Model

New Shares Ke = Dividend Pf

P = Issue Price (at par, premium discount) Ke = EPS Pf

EPS = Earnings available to Equity Share Holders

Number of Equity Shares Note: When growth rate is given + g to added to the formula

Problem No.1: A company issues 1000 equity shares of Rs.100 each at a premium of 10%. The company has been paying 20% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs.160.

Ke :

Dividend Pf

Dividend MP

Dividend = 100 x 20% = 20.

20 110 0

= 18.18%

20 160

= 12.5%

Problem: A company plans to issue 1000 new shares of Rs.100 each at Par. The flotation costs are expected to be 5% of the share price. The company pays a dividend of Rs.10 per share initially and the growth in dividend is expected to be 5%. Compute the cost of new issue of equity shares. If the current market price of an equity share is Rs.150, calculate the cost of existing equity share capital.
Ke : Dividend Pf +g Dividend MP +g

10 100 5

+ .05

= 15.53%

10 150

+ .05 = 11.67%

Problem on Earnings Yield Method:

A firm is considering an expenditure of Rs.60,00,000 for expanding its operations. The relevant information is as follows:
Number of existing equity shares = 10 lakhs Market Value of existing share = Rs.60 Net Earnings = Rs.90 lakhs Compute the cost of existing equity share capital and the new equity capital assuming that new shares will be issued at a price of Rs.52 per share and the costs of new issue will be Rs. 2 per share. Solution: Cost of existing equity share capital =EPS = 90/10 = Rs.9 ; Ke = 9 / 60 x 100 = 15% Cost of new Equity capital : Ke = EPS / P f = 9 / 52 2 = 18%

The SML Approach

Use the following information to compute our cost of equity
Risk-free rate, Rf Market risk premium, E(RM) Rf Systematic risk of asset,

RE R f E ( E ( RM ) R f )

Example - SML
Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?
RE = 6.1 + .58(8.6) = 11.1%

Since we came up with similar numbers using both the dividend growth model and the SML approach, we should feel pretty good about our estimate

Advantages and Disadvantages of SML

Advantages
Explicitly adjusts for systematic risk Applicable to all companies, as long as we can estimate beta

Disadvantages
Have to estimate the expected market risk premium, which does vary over time Have to estimate beta, which also varies over time We are using the past to predict the future, which is not always reliable

Example Cost of Equity

Suppose our company has a beta of 1.5. The market risk premium is expected to be 9% and the current risk-free rate is 6%. We have used analysts estimates to determine that the market believes our dividends will grow at 6% per year and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity?

Using SML: RE = 6% + 1.5(9%) = 19.5% Using DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%