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COST OF CAPITAL

Meaning
The Cost of capital to a firm is the minimum
return, which the suppliers of capital require.
It is a price of obtaining capital and it is a
compensation for time and risk.

What types of long-term


capital
do
firms
use?

Long-term debt
Preferred stock
Common equity

Capital Components
Capital

components are sources of


funding that come from investors.
Accounts payable, accruals, and deferred
taxes are not sources of funding that
come from investors, so they are not
included in the calculation of the cost of
capital.

Project cost & Firms


The projects cost is the minimum
cost
acceptable rate of return
committed to the project.

on

funds

The firms cost of capital will be the


overall, or average, required rate of return
on the aggregate of investment projects.

Significance of Cost of Capital


It is useful as a standard for:
- evaluating investment decision
- designing a firms debt policy and
- appraising the financial performance of
top Mgmt.

The Concept of Opportunity


Cost of Capital
The opportunity cost is the rate of return

foregone on the next best alternative


investment opportunity of comparable
risk.
Risk Difference:
Investors will require different rates of
return on various securities since they
have risk different.

Required rate of return


Return
Equity Shares
Preference Shares
Corporate Bonds
Government Bonds
Risk Free Security

Risk

Computation of Cost of
Capital
(A) Specific source of finance
(B) Weighted Average cost of capital (WACC)

(A) Specific source of finance:


1) Cost of Debt:
Is the rate of interest payable on debt.

Cost of Debt
(i) Debenture at Par: (before tax)
i
Kdb = --------P
where, Kdb = before cost of debt
i = Interest
P = Principle
(ii) Debt raised at Premium or Discount:
i
Kdb = --------NP
NP = Net proceeds

Cost of Debt
(iii) After tax cost of debt:
i
Kda = ------ (1-t) OR Kda = Kdb(1-t)
NP
where, Kda = After tax cost of debt
(iv) Cost of Redeemable debt (at par): The
debt is issued and redeemed after a
certain period at par during the life time of
a firm.
i + (P NP)/n
Kdb = ------------------(P + NP) / 2
P = proceeds at par NP = Net proceeds

(v) Cost of Redeemable debt (at premium): The


debentures are to be redeemed at a premium
i.e., the amount more than the face value after
the expiry of a certain period.
Cost before Tax:
Kdb

I + (RV NP)/n
= ----------------------(RV + NP) / 2

RV = redeemable
NP = Net proceeds
n = no. of years debt is redeem
Cost of debt after Tax:
Kda = Kdb(1-t)

(2) Cost of Preference capital:


A fixed rate of dividend is payable on preference
shares.
(i) Cost of PC at par:
D
D = Dividend
Kps = --------P = PS capital proceeds
P
(ii) If PS issued at premium or discount or
when cost of floatation cost are incurred:
D
Kps = -------NP

(iii) Redeemable PS :
D + (MV NP)/n
Kps = ------------------(MV + NP) / 2
MV = Maturity Value
NP = Net proceeds
(3) Cost of Equity Share Capital:
Is the
maximum rate of return that the company must
earn as equity financed portion of its investments
in order to leave unchanged the market price of
its stock

Different methods for cost of equity:

(i) Dividend yield method or dividend/price


ratio method:
Cost of equity is the discount rate that equates
the present value of expected future dividends
per share with the Net proceeds (or Current
market price) of a share.
Ke

D
= --------NP or MP

NP = Net proceeds per year


MP = Market price per share

(ii) Dividend yield plus growth method:


When the dividend of the firm are expected to
grow at a constant rate & the dividend pay-out
ratio is constant.
D1
Do (1+g)
Ke = --------- + G = -------------- + G
NP
NP
D1 = Expected dividend per share
at the end of the year
G = Rate of growth in dividends
NP = Net proceeds per share
D0 = Previous years dividend

In case of cost of existing equity share capital

is to be calculated, the NP should be changed


with MP (Market Price)
D1
Ke = --------- + G
MP
MP = Market price (current)

Cost of Equity using Capital


The values of an equity share is a function
Asset Pricing Model (CAPM):
of cash inflows expected by the investors
and the risk associated with cash inflows.
It is calculated by discounting the future
stream of dividends at the required rate of
return called the capitalisation rate.

CAPM .

Required rate of return depends upon the


element
of
risk
associated
with
investment in shares.
CAPM derives the;
Relationship between the expected return and risk

of individual securities and portfolios in the market


Risk

and

Return

are

the

characterstics of every investment.

two

important

CAPM .

A portfolio risk does not fall below a certain


level, irrespective of how wide diversification is,
because
Total Risk = Unsystematic + Systematic
Risk
Risk
Unsystematic (Diversifiable / Business) risk:
-

It arises like (i) a development of a new


product, (ii) emergence of a new competitor. It is
also called as business risk

CAPM .
Systematic risk (Undiversifiable / Market) risk:
Risk of a stock represents that portion of its
risk which is attributable to economy-wide
factors like growth rate of GDP, interest rate,
inflation

rate,

currency

exchange,

natural

disasters (flood, earth quake) etc.


These market risk affects all firm at a
greater degree.

Investor cannot avoid the

risk arising from them.

The risk of a well-diversified portfolio


depends on the market risk of the
securities included in the portfolio
Measurement
of
Beta
recognition of two points;

requires

the

A rate of return for risk-free investment. This rate of

risk is given a Beta value of Government Treasury


Bills are often sited as risk-free investments
with a Beta value of zero.
A rate of return for investments carrying the market

rate of risks.
value of 1.

This rate of risk is given a Beta

CAPM .
Risk premium =
i ( Market return of a diversified portfolio risk
free return )
OR
i (Rm Rf)
Cost of equity, acc. to CAPM will ;

Ke = Rf + i (Rm Rf)
Where,

Ke
Rf
i
Rm

=
=
=
=

Cost of equity capital


Risk free rate of return
Beta co-efficient of the firms
Market return of a diversified

portfolio
portfolio

Example:

- The return on risk-free investment (i.e, =0) is


6%
- The return on securities carrying market risk
(i.e., b = 1) is 10% p.a.
- Then the premium for a Beta of 1 is 4% p.a.
( 10% - 6% )
Suppose,
- A security with a Beta value of 0.7 would offer
a return of ;
= 6% + (0.7 x 4%) = 6% + 2.8%
= 8.8% p.a.

(4) Cost of Retained Earnings:


Retained earnings accrue to a firm only because of
some sacrifice made by the shareholders in not
receiving the dividends out of the available profits.
Cost of retained earnings is the rate of return which
the existing shareholders can obtain by investing
the after-tax dividends in alternative opportunity of
equal qualities.

D
Kr = ------ + G
NP
Kr = Cost of retained earnings
D = Expected dividend
NP = Net proceeds of share value
G = Rate of growth
To make adjustment in the cost of retained
earning for tax and costs of purchasing new
securities, the following formulae may be
adopted;

(B) Weighted Average Cost of


Capital
(WACC):
Is the average cost of the costs of various
sources of financing.
It is also known as
composite cost of capital. The weights may be
given on the basis of book value or market
value weights.
Usually market value weights are preferred,
because it represent real or true value to the
investment.
Kw = Cost of specific X Weight, specific
source of finance

proportion of finance

Weighted Marginal cost of


capital:
Is the cost of additional funds to be raised,
called marginal cost of return.
It is the
weighted average cost of new capital
calculated by using the marginal weights.
Steps:
1. Estimate the cost of each source of financing
for various levels of its use through an analysis
of current market conditions.

Steps..
2. Identify the levels of total new financing at which
the cost of the new components would change,
given the capital structure policy of the firm. These
levels, called breaking points,
TFj
BPj = ------Wj
Where BPj = breaking point on account of
financing source j
TFj = total new financing from source j
at the breaking point
Wj = proportion of financing source j in the
capital structure

Steps.

3. Calculate the WACC for various ranges of total


financing between the breaking points.
4. Prepare the weighted marginal cost of capital
schedule which reflects the WACC for each
level of total new financing.

Cost of Capital in practice:


Nature of Industry
Practice
Electrical : Profitability based on equity
dividend rate is 10%
Tea
: Three sources equity,debt & reserves
Ke = last yr. dividend paid
Kd= different int. rates
Kr = taken as 18%
Shipping : Normal Debt-Equity ratio 3:1
Ke = 18% Kd = 8% Avg=10.5%
Leasing : Currently Debt Equity 5:1
Pre tax Kd 18%
Pre tax dividend Ke = 40%
Avg . 21.7%