Cost of Capital

The Cost of Capital

Cost of capital of a firm is defined as the cost of
obtaining the funds, i.e. the average rate of return
that the investors in a firm expect. It is also
referred as the minimum rate of return expected
by its investors. The cost of capital is the
minimum rate of return which a firm requires as a
condition for undertaking an investment. When
we talk about the cost of capital, we are talking
about the required rate of return on invested
funds. It is also referred to as a hurdle rate
because this is the minimum acceptable rate of
return.

Significance of the cost of
capital


Evaluating Investment Decisions
Designing A Firms Debt Policy,
Appraising The Financial Performance Of Top
Management.

Investment Decisions
The primary purpose of measuring the
opportunity cost is its use as a financial standard
for evaluating the investment projects. In the net
present value method, an investment project is
accepted if it has a positive net present value.
The projects net present value is calculated by
discounting its cash flows by the cost of capital.

DESIGNING A FIRM DEBT
POLICY

The debt policy of a firm is significantly influence
by the cost consideration. In designing the
financing policy, that is, the proportion of debt and
equity in the capital structure, the firm aims at
maximizing the overall cost. The cost of capital
can also be useful in deciding about the methods
of financing at a point of time.

PERFORMANCE APPRAISAL

The cost framework can be used to evaluate the
financial performance of top management. Such
an evaluation will involve a comparison of actual
profitability of the investment projects undertaken
by the firm with the projected overall cost of
capital, and the appraisal of the actual costs
incurred by management in raising the required
funds. The capital cost also plays a useful role in
dividend decision and investment in current
assets.
The Concept of the Opportunity Cost
FACTORS AFFECTING COST OF
CAPITAL

Controllable Factors
Capital Structure Policy
Investment Policy
Operating and Financing Decisions
Uncontrollable Factors
Level of Interest Rates
Tax Rates
General Economic Conditions
Market Conditions


COMPUTATION OF COST OF
CAPITAL

Computation of cost of specific source of finance.

Computation of weighted average cost of capital


Computation of cost of specific source of
finance
Cost of Debt It is the after tax cost of long- term
funds through borrowing. Debt may either be
Irredeemable or redeemable.

Cost of Irredeemable debt
Cost of irredeemable debt before tax
K
db
= I/NP x 100
Where
K
db
= Cost of debts before tax
I = Annual interest charges
NP = Net proceeds

Cost of Irredeemable debt after tax
Cost of irredeemable debt after tax
K
da
= I(1-t) /NP x 100
Where
K
da
= Cost of debts after tax
I = Annual interest
charges
NP = Net proceeds

Cost of Redeemable debt before tax

Cost of redeemable debt before tax

Kdb = I+ 1/n(RV-NP) x 100
(RV+NP)
Where

I= Interest
n= number of years in which debts is to be recovered
RV= redeemable value of debentures
NP= net proceeds from issue of debentures


Cost of Redeemable Debt after tax

Kda = I (1-t) + 1/n(RV-NP) x 100
(RV+NP)
Where,
I= Interest
n= number of years in which debts is to be recovered
RV= redeemable value of debentures
NP= net proceeds from issue of debentures
t= tax rate

Numericals
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.
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.
A Ltd. Issues Rs. 50,000 8% debentures at a
discount of5%. The tax rate is 50%. Compute the
cost of debt capital.
B Ltd. Issues Rs. 1,00,000 9% debentures at a
premium of 10%. The cost of floatation are 2%.
The tax rate applicable is 60%. Compute cost of
debt-capital.
Numericals
A Company issues Rs. 10,00,000 10%
redeemable debentures at a discount of 5%. The
cost of floatation amount to Rs. 30,000. The
debentures are redeemable after 5 years.
Calculate before-tax and after-tax cost of debt
assuming a tax rate of 50%.
A 5-year Rs. 100 debenture of a firm can be sold
at a net price of Rs. 96.50. The coupon rate of
interest is 14 per-cent per annum, and the
debenture will be redeemed at 5 per cent
premium on maturity. The firms tax rate is 40 per
cent. Compute the after-tax cost of debenture.
Cost of Preference Share Capital

It may be defined as the dividend expected by the
preference
share holders.
Cost of irredeemable preference capital :-
K
p
= D/NP x 100
Where
K
p
= cost of preference capital
D = annual preference dividend
NP = Net proceeds of preference share
capital

Cost of Redeemable Preference Capital

Kpr = D+ 1/n(RV-NP) x 100
(RV+NP)
Where
Kpr = cost of redeemable preference capital
D = annual preference dividend
n = number of years
RV = redeemable value of preference share
capital
NP = net proceeds of preference share capital



Practical Questions
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
At par
At a premium of 10%.
At a discount of 5%.
A Company issues 10,000 10% Preference
shares 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 Preference Share Capital
Kpr = D+ 1/n(RV-NP) x 100
(RV+NP)

Where
Kpr = cost of redeemable preference capital
D = annual preference dividend
n = number of years
RV = redeemable value of preference share
capital
NP = net proceeds of preference share capital



COST OF EQUITY SHARE
CAPITAL

It is the minimum rate of return that a firm must
earn on the equity-financed portion of an
investment project in order to leave unchanged
the market price of
the share.
Dividend yield method
Ke = DPS/NP*100 (For new issue)
Ke = DPS/MP*100 (For existing shares)
Where
DPS= Dividend per share
MP= Market price per share
NP =Net Proceeds

COST OF EQUITY SHARE
CAPITAL
Dividend yield plus growth in dividend
method
Ke = D
1
/MPx100+g
or
Ke = D
0
(1+g) /MPx100+g
Where
D
1
= Dividend at the end of the year
D
1
= Dividend at the end of the year
MP= Market price per share
NP =Net Proceeds
g = Rate of growth in dividend

Earning yield method
Ke = EPS/MPx100
Where
Ke = Cost of equity capital
EPS = Earnings per share
MP = Market price per share`

Earning yield plus growth in earning method

Ke = EPS/MPx100 + g
Where
K
e
= Cost of equity capital
EPS = Earnings per share
MP = Market price per share`
g = Rate of growth in EPS

Capital Asset Pricing Model -
Approach
As per this approach, return on any security depends upon the
level of risk attached to the security. More risk, more returns.
CAPM describes the relationship between risk and expected
return and that is used in the pricing of risky securities. CAPM
calculates the cost of equity through the following formula.
CAPM calculates the cost of equity through the following
formulas.

K
e
=k
f
+(K
m
-k
f
)
Where,
K
e
= cost of equity share capital
K
f
= cost of any risk free asset
= coefficients of systematkic risk
K
m
= cost of market portfolio

Realized yield method-
This approach is based on the premise that
actual returns earned by the investors in the past
will be repeated in the future. According to this
approach, cost of equity capital should be
determined on the basis of returns actually
realized by the investors on their equity shares.
Past record of dividends for a particular period
should be considered while calculating cost of
equity capital. This approach given us good cases
where companies are earnings good and stable
profits.
Cost of Retained Earnings
The cost of retained earnings is the earning
foregone by shareholders. The firm is implicitly
required to earn on the retained earnings at least
equal to the rate that would have been earned by
the shareholders if these earnings were
distributed to them. As per the external yield
criteria. As per external yield criteria returns
expected from investing these retained earnings
somewhere else i.e. outside the company are
compared with the investment in companys own
project. So it is said that the cost of retained
earnings is equal to cost of equity capital.
However, this also is not true
Cost of Retained Earnings
Cost of retained earnings is always less than the
cost of equity capital because while raising equity
capital one has to bear brokerage cost and while
declaring dividend on equity capitals, corporate
dividends tax has to be paid.

Cost of Retained Earnings
So the cost of retained Earning is ,
k
r
= k
e
(1-t)(1- )
k
r
= k
e
(1-t)(1- )
Where,
k
r
= Cost of retained earnings
k
e
= Cost of equity capital
T = tax rate applicable to shareholders
= brokerage cost

Numerical on Equity
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
fir the past five years and expects to maintain the
same in future also. Compute the cost of equity
capital. Will it make any difference if the market
price of equity shares is Rs. 160?
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 dividends is expected to
be 5%. Compute the cost of new issue of equity
shares.
If the current market price of an equity is Rs. 150,
calculate the cost of existing equity share capital.
Numerical on Equity
The shares of a company are selling at Rs. 40 per
share and it had paid a dividend of Rs. 4 per share last
year. The investors market expects a growth rate of 5
per cent per year.
Compute the equity cost of capital
If the anticipated growth rate is 7 per cent per annum,
calculate the indicated market price per share.

A Firm is considering an expenditure of Rs. 60 lakhs for
expanding its operations. The relevant information is as
follows:
Number of existing equity shares 10 lakhs
Market Value of Equity Shares 60
Net Earnings 90 lakhs
Compute the cost of existing equity share capital and of
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 2 per share.
WEIGHT AVERAGE COST OF
CAPITAL

The Weighted average cost of capital (WACC)
means overall cost of capital or combined cost of
capital is defined as weighted average cost of
capital. The weighted average cost of cost of
capital is calculated by aggregating the product of
weights of each kind of source of fund and its
respective specific cost.

WEIGHTED AVERAGE COST OF
CAPITAL

Formula (WACC)
Kw = wd * kd + wp * k p + we * ke

W
d
= proportion of long-term debt in capital
structure
W
p
= proportion of preferred equity in capital
structure
W
e
= proportion of common equity in capital
structure
Notes
The weights sum to 1.

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

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 quantity) of each
type of capital


A Firm has the following capital structure and after tax
costs for the different sources of funds used.
Calculate the weighted average cost of capital using
book value weights
The firm wishes to raise further Rs.6,00,000 for the
expansion of the projects as below.
Debt 3,00,000
Preference Capital 1,50,000
Equity Capital 1,50,000


Sorces of
Funds
Amount Proportion After tax Cost
(%)
Debt
Preference
Capital
Equity Capital
4,50,000
3,75,000
6,75,000
15,00,000
30
25
45
100
7
10
15