COST OF CAPITAL

The chapter covers

Meaning of cost of capital Importance of cost of capital Classification of cost Computation of Cost of capital Computation of specific cost

Cost of Debt Cost of Preference share Cost of Equity share Overall cost of capital

Meaning of Cost of Capital

The cost of capital to a firm is the minimum return, which the suppliers of capital require.

For a firm it is a price for obtaining cash. In other words, COC means that rate which is paid for the use of capital.
Each source of funds has different cost,such as cost of equity share capital, cost of preference share capital, cost of debt, cost of retained earning.

The cost of capital to a company is the minimum required rate of return that it must Earn on its investments in order to satisfy the various categories of investors, whoHave made investments in the form of shares, debentures & term loans.

SOURCE OF FINANCE: 1. Equity share capital; Preference share capital; Debt amount if it is new organization. 2. In case of existing organization in addition to above Reserve & Surplus also the one source.

WHAT IS COST OF CAPITAL?

It is the Rate of Return that the company must pay to the suppliers of capital. It is the minimum rate of return that a project must yield in order to keep the existing value of the firm intact. In operational terms, COC refers to the Discounting Rate.

DEFINITON OF COC
Economists define COC in 2 senses: COC in terms of cost of generating funds to finance a project. COC in terms of opportunity cost of the fund to the firm. In the first category, it refers to borrowing rate Combined Cost of Capital.(i.e., Explicit Cost)

Meaning of Cost of Capital

From the view point of investor:- COC is the reward for the amount he is investing which could have otherwise been used for consumption or for investment at some other place.

The corporations cost of capital is the rate of return that must be earned on investment projects. It is the discount rate that should be used when calculating the present value of cash flows from an investment.

The rate of return required by investors is also a measure of the cost of capital to the corporation who issued the securities.

For example:
Assume that Carnival Cruise Lines, Inc. has bonds outstanding that are priced to provide investors a yield of 8 percent. It follows that if Carnival wanted to raise new funds by selling more bonds, they would need to pay investors 8 percent. Thus, 8 percent is Carnivals cost of debt capital.

Importance of Cost of Capital

As determination of the COC is very important in the area of financial management :Capital Budgeting Capital Structure Decision Dividend Policy Decision Helpful in Evaluation of financial efficiency of Top mgt. Helpful in comparative Analysis of various sources of finance

IMPORTANCE OF COST OF CAPITAL

Plays a crucial role in Capital Budgeting decision.
Has an important bearing on the acceptance or
rejection of an investment project.

Serves as a Screening Tool. Provides useful guidelines in determining optimum

Capital Structure of a company by adjusting the Financial Plan.

IMPORTANCE OF COST OF CAPITAL

(Contd)

Investors feelings about the expected

income of company and risks inherent in it are reflected in the COC of a company.

Leasing Decisions, Dividend Decisions,

Working Capital Policies, Redemption are some other where COC plays its role.

Bond fields

CALCULATION OF COST OF CAPITAL

As you know, each source involves some cost. So, cost of
each capital component must be ascertained and then the combined cost of capital must be worked out.

STEPS IN CALCULATING COST OF CAPITAL

1. Determine the type of funds to be raised and

their share in their total capitalization. 2. Determine the cost of each type of funds.

3. Calculate the combined Cost of Capital of the company by assigning weights to each type of funds in terms of its proportion to total funds.

CALCULATION OF INDIVIDUAL COST OF FUNDS

Cost has to be worked out for, Short-Term Debt Long Term Debt Irredeemable Debt Redeemable Debt Preference Shares Equity Shares Retained Earnings

Classification of Cost
Specific or component cost :- refers to
the cost of individual components of capital viz. equity share, preference share,debentures, retained earning.

Combined cost/WACC :- refers to the

combined cost (or weighted avg COC) of the various individual components.It is also called the average /weighted cost of capital or overall cost of capital.

Classification of Cost
Explicit and Implicit cost :- Explicit
cost is the one which is attached with the source of capital explicitly or apparently while implicit cost is the hidden cost which is not incurred directly.

Example of explicit and Implicit cost

Eg. debt capital :- the interest is explicit cost. if the company increase debt then investment in the company becomes risky investors will expect more return These increased expectations of the investor may be considered to be implicit cost of debt capital.

Classification of Cost
Historical and Future Cost :Historial cost means the cost that has been paid in the past for financing a specific project. Future cost is the estimated cost to be incurred to finance a project.Future cost is important for taking financial decision.

Computation of Cost of Capital

It includes:Computation of cost of specific source of finance. - Cost of Debt - Cost of Preference share capital - Cost of Equity share capital - Cost of Retained Earnings Computation of weighted average cost of capital

Cost of Debt
Debt fund can be in the form of debentures or loans from financial institution. Debt can be of 2 types:Irredeemable or perpetual Debt Redeemable Debt

Cost of Irredeemable Debt

Calculation of Irredeemable Debt, before tax :Kd = Int NP where
Kd = Cost of Debt before tax Int = Interest NP = Net Proceeds

Example of Cost of Debt, before tax:X Ltd. issues Rs 15 lakh, 8% debentures (a) at par, (b) at a discount of 7 % and ( c) at a premium of 10% You are required to calculate the cost of Debt to the company.

Cost of Irredeemable debt, after tax

Int(1- t) * 100 NP Example:- X Ltd has 8% perpetual debt of Rs 20 Lakh. The tax applicable to the company is 40%. Determine the cost of capital after tax assuming the debt is issued (a) at par, (b) at 10% discount,and at 10% premium

Formula:Kda =

Example of Cost of Irredeemable Debt

X Ltd.issues 40,000, 8% debentures of Rs 100 each and incurred the following expenditure: Underwriting Commission 2% of issue price Brokerage 0.5% of issue price Printing and other expense Rs 20,000 Calculate cost of Debt assuming debt is issued At 10% premium At 10% discount Tax rate is 40%

Cost of Redeemable Debt

Before tax :Kdb = Int +1/n( RV NP ) *100 (RV+ NP) After tax :Kda = kdb X (1-t)

Example of Redeemable debt

A company issues Rs 5,00,000 , 10% redeemable debentures redeemable at par after 5 years .The cost of Floatation amount to 4% of face value. Tax rate is 35% You are required to calculate before tax and after tax cost of debt if debentures are issued at par,at a discount of 10%, at a premium of 5%

Example
A company issues 20,000, 7.5% debentures of Rs. 100 each at a discount of 2% t be redeemed after 10 years at a premium of 5% .The cost of floatation amount to Rs 50,000.. Calculate cost of debt assuming tax rate at 40%

Cost of Preference Share Capital

2 types of Preference share capital is there: Irredeemable Preference share Redeemable Preference share Formula of computing cost (irredeemable) Kp = D / NP
share where:Kp = cost of preference D = Dividend NP = Net proceed

Redeemable Preference share

Formula of computing:Kpr = D+ (MV-NP)/ n ( MV + NP ) where:Kpr= cost of redeemable preference Share D = Dividend MV = Market value n = no of years

Example of preference share

A company issues 10,000, 10% preference share of Rs 100 each. Cost of issue is Rs 2 per share. Calculate cost of preference capital if these are issued at par, at a premium of 10 % , at a discount of 5%.

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

Cost of Common Stock

Is Equity Capital free of cost ??????????

Cost of Common Stock

There are 2 sources of Common Equity: 1) Internal common equity (retained earnings), and 2) External common equity (new common stock issue)

Do these 2 sources have the same cost?

Cost of Equity share capital

The cost is difficult to measure, as the rate of return fluctuates every year Its not legally binded to pay dividend to equity share holder. As the future earning and dividend are expected to grow overtime.

Cost of Equity
The cost of equity can be computed with the following methods: Dividend yield method Dividend yield method plus growth in dividend Earning yield method Earning yield method plus growth in earning CAPM Approach

Dividend Yield Method

It is also known as Dividend/ Price method. This method is based on the assumption that when an investor invests in the equity shares of a company he expect to get a payment at least equal to the rate of return prevailing in the market. This method is suitable only when the

company has stable earnings and stable dividend policy.

Cost of Equity Share Capital

Formula of computing Cost of Equity:- (Dividend yield method)
Ke = DPS/ MP * 100

where:ke = cost of equity DPS= Dividend Per share MP = Market Price

Example of Equity Share Capital

Equity capital of a company consists of 5,00,000 equity shares of Rs 10 each issued at a premium of Rs 2.5 per share.The average rate of dividend paid by the company has been Rs 3 per share .The market value of the share is Rs 25.Calculate the cost of equity capital.

Dividend yield plus growth in dividend method

This method takes care of the future growth in the rate of dividend .hence, when dividend are expected to grow at constant rate,we compute cost by:Ke = DPS/ MP *100+G Ex:- X Ltd pays a dividend of Rs 12 per share initially and the growth in dividend is expected to be 5 % . Compute the cost of equity share if the current market price of an equity share is Rs 150.

Earning Yield Method

Formula:Ke = EPS/ MP * 100 Example:- A company plans to incur an expenditure of Rs 80 lakhs for expanding its operations. The relevant operation is as follows:No of existing share = 20 lakhs Net earning = Rs 160 lakhs Market value of existing share = 40 s Compute the cost of equity capital.

Earning yield plus growth in Earning Method

Formula:Ke= EPS/ MP *100 + G Ex:- The current market price of the equity share of a company is Rs 60 per share .The expected earning per share after one year is Rs 9 per share .Thereafter EPS is expected to grow constantly at 4% per annum .Find out the cost of equity capital.

Capital Assets Pricing Model or CAPM Approach

Ke = Rf + b (Km Rf) where:Rf = risk free return b = beta coeff.
return Ex :- Calculate the cost of equity capital where the beta factor (Risk) is 1.5. Risk free rate of interest on Government Securities is 8% . Return on market portfolio is 12% Km= req return on market

The Weighted Average Cost of Capital

We now need a general way to determine the minimum required return Recall that 40% of funds were from debt. Therefore, 40% of the required return must go to satisfy the debtholders. Similarly, 10% should go to preferred shareholders, and 50% to common shareholders This is a weighted-average, which can be calculated as:

WACC w d k d w p k p w cs k cs

Weighted Cost of Capital

The weighted cost of capital is just the weighted average cost of all of the financing sources.

Calculating RMMs WACC

Using the numbers from the RMM example, we can calculate RMMs Weighted-Average Cost of Capital (WACC) as follows:
WACC 0.40(0.07) 010(010) 050(012) 0.098 . . . .

Note that this is the same as we found earlier

Finding the Weights

The weights that we use to calculate the WACC will obviously affect the result Therefore, the obvious question is: where do the weights come from? There are two possibilities:

Book-value weights Market-value weights

Book-value Weights
One potential source of these weights is the firms balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

Book-value Weights (cont.)

The following table shows the calculation of the book-value weights for RMM:

Source Long-term Debt Preferred Equity Common Equity Grand Totals

Total Book Value $400,000 $100,000 $500,000 $1,000,000

% of Total 40% 10% 50% 100%

Market-value Weights
The problem with book-value weights is that the book values are historical, not current, values The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate Calculation of market-value weights is very similar to the calculation of the book-value weights The main difference is that we need to first calculate the total market value (price times

Calculating the Market-value Weights

The following table shows the current market prices:

Source Debt Preferred Common Totals

Price per Units Total Market % of Unit Value Total $ 905 400 $362,000 31.15% $ 100 1,000 $100,000 8.61% $ 70 10,000 $700,000 60.24% $1,162,000 100.00%

WACC 0.31150.07 0.0861010 0.60240.12 01027 10.27% . .

Market vs Book Values

It is important to note that market-values is always preferred over book-value The reason is that book-values represent the historical amount of securities sold, whereas market-values represent the current amount of securities outstanding For some companies, the difference can be much more dramatic than for RMM Finally, note that RMM should use the 10.27 WACC in its decision making process

The Costs of Capital

As we have seen, a given firm may have more than one provider of capital, each with its own required return In addition to determining the weights in the calculation of the WACC, we must determine the individual costs of capital To do this, we simply solve the valuation equations for the required rates of return