FINANCIAL MANAGEMENT i, fi COST OF CAPITAL The cost of capital is important for three main reasons. The reasons are: (a). To maximize its value a firm must minimize the cost of all inputs including capital. (b). Proper capital budgeting (investment) decision requires an estimate of the cost of capital (c). Other decision making matters like leasing, bond refunding, working capital policy requires the estimates of the cost of capital. Component @ cost of capital: Generally, a firm raises its new funds as debt, Preference shares, new issue of common shares and Retained earnings. Firms try to keep the share of the ahave: sources in optimal proportions, (a). Cost of Deist(Kp): The relevant cost of new debt financing is the after-tax cost that takes into account the tax deductibility of interest. Kp = Ka(1-T) Where, ‘ Ko = Effective cost of debt. Ka = Contractual cost of debt T = Firms corporate tax rate. EXAMPLE: If a firm can borrow at an interest rate of 10% and it has a tax fate of 40%, then, Ky = Ky(4-T) = 10% (1 —0.4) = 0.06 or 6%. Reasons for tax adjustment: The value of the firm, which we want to maximize depends on after-tax flows. Since interest is a deductible expense for tax payments, it produces tax savings which reduces the net cost of debt. So, after- tax cost of debt is less than before-tax cost of debt. ie. Ko< Ky “* A firm carrying loss bears a zero tax rate. As the firm has nit to pay tax in this situation the cost of debt is not reduced. Therefore, Kp= Kg. (b). Cost of Preference Share (Kp): 2. D Where, Tn Kp= Pa Dp= Preferred dividend P, = Net issuing price of Preferred Share Example: A Preferred Stock pays a Tk.10 dividend per share and sells for Tk. 100 per share in the market. The issuing firm has to incurs aldtiderwiting (flotation) costéf' 2.5% of market price. So, Ke=5i95= 0.1025 or 10.25%FINANCIAL MANAGEMENT 2 (c). Cost of new issue of common share (Ke) : WYrat rate of return must be eared on funds by selling common stock in wide to satisfy the investors on such issues. Normally, common stockholders eynuest a current flow of income which should grow steadily over time. For a firm with a constant growth rate, pt Where, Ko +g D, = Dividend to be paid at the end of 4°" yeoar. eee « 19 = Current market price of common share Po(1-F) = Net price per share issued byimeissuer. F = Flotation costs. g = Growth rate c= Po(t-F) Example: A common share’s market price is Tk.20, pays @_dividend of Tk.2, Flotation cost is 10% of the market price of commortshare. ~The firm's growth rate is 5%. Where, So, Ke=— +g dend to be paid at the end of #°yyear. = 2 0 Lael ‘urrent market price of common s-hatite= se 2 +0.05 P,(1-F) = Net price per share reissued by the issuer 20(1 - 0/1) 20(1-0.10) 2 F = Flotation costs. = 0.10 =~ +005 g=0.05 18 =0.1110.05 = 0.161 Or, 16.1% (d). Cost of Retained Earnings (Ks): This (RE) is an intkenally generated fund of the firm for the purpose of reinvestment or creation of other different types of funds. Apparently, it might be thought of free of any const. But, common shareholders have the alternative investment opportunity elsewhere and opportunity of earnings. So, itis not cost free. D1 Ks = Pal +g Only flotation cost will not be incurred here. Investors exouedt to receive a dividend yield (B+ plus a capital gain yield (@).FINANCIAL MANAGEMENT 3 Composite Cost of Capital: ‘After computation of component costs, it is required to calculate the composite cost of capital giving due weight of each sources contribution into the total capital structure. The component costs are multiplied with their respective weight and added in order to get the Weighted Average cost of Capital (WACC) or the composite cost of capita. ¢.9 Sources of fund Weight Component | Weighted Cost z | Cost ah i 2 3 (2324) Source Amount La ae, Debt XX x x XX Preferred Share xX x x XX emimie Common} XX x a xXx Share XX x x XX Retained Earnings _[WAGG = XX The WACC is also called the marginal cost of capital as it is the cost of raising new/additional capital of the firm. PROBLEM: ‘X’ Co. has the following capital structure: 10% Debenture 8% Preference Share (Tk.100 par) Common Shares Total =Tk.1,00,000 The common share of Co. sells for Tk.20. it is expected that the Company will pay next year a dividend of Tk.3 per Common ‘Share which will grow at the rate of 5% for ever. Assume the marginal tax rate is 40%. REQUIRED: (). Compute the WACC of the existing capital structure (i). Compute the new WACC if the company raises an additional Tk.20,000 debt by issuing 8% bond, This would result in increasing the expected dividend on “Eamon Shape to Tk4 and leave the growth rate (g) unchanged. But the price of share will fall to Tk.16 per share. SOLUTION: (i). (a). Cost of debte £ Kp = Ka (1-1) = 0.40(1-.4) = 0.06 pe (0), Cost of Preferred Share 2 Ke= py = 700FINANCIAL MANAGEMENT 4 zyS0t, 3 3 1 +g +0.05=—-+ 0.08 Po(t-F) ~ 20(1-0) 20 = 0.15 + 0.05 = 0.20 (c). Cost of Common share Composite Cost of Capital WACC: 7 ets Sources Amount Weight | Component Weighted Cost J Cost 1 2 a 3 4(2x3=4) | DEBT 40,000 0.4 0.06 | 0.024 Preference Shares | 10,000 04 0.08 0.008 Common shares | 50,000 0.5 0.20 0.10 Ee ia 0.432 WACG = 13.2% Gi). Component Cost: (a). Cost of debt: 10% debenture: 0.10(1-0.4) = 0.06 8% Bond: 0.08(1-0.4) =\..;. 048 (b). Cost of Preferred Shares: 3 = 0.08 (6). Cost of Common Shares: #5 #0.05- 0.30 Composite Cost of Capital Sources ‘Amount | Weight Component Cost | Weighted | ee | Cost 1 2 Emmet) 4(2x3=4) Debt, 10%{Deb-| 40,000 0.3333 0.060 0.0200 one 20,000 0.1667 0.048 0.0080 8% (Bond) 10,000 0.0833 0.08 0.0067 Preference 50,000 | 0.4167 0.300 | 0.1250 Share 20,000 1.00 0.1597 Common Share hana aa WACC = 15.97%FINANCIAL MANAGEM! TIME VALUE OF MONEY What is it? Value of money changes (decreases) with the passage of time. Why? * General price level increases over time * Uncertain future * Transaction motive for holding money * Opportunity cost of investments. Interest rate (time preference rate) is the exchange rate between a sum of money at a future date & that sum of money at the present date. This exchange rate reflects the time value of money. e.g. if you deposit Tk.1000 at savings A/C for one (1) year @8% interest rate, you will be neutral between Tk.1000 today and Tk.1080 after one year. So, the rate of exchange or preference rate is 8%. One of the most important tools in time value of money analysis is the cash flow time line used to help us visualize when the cash flows. associated with a particular project occur and their values at different point in time. {EME e208 [0 4 sy Slee aioe 6 Cash Flow time | [__Present Cash Flows Future cash flows line | COMPOUNDING (Converting PV into FV): FV; EVs= PV (14); FV2 = PV (1#i)(14i) OR, PV (HH) FVn = PV (14i)¥ (This is the general equation of FVn compounded annually) FV in the table: FVIF is the future value of Tk.1 at the end of n year. So, FVIF is substituted for the term (1+i)" FV, = PVAFV DISCOUNTING (Converting FV into PV) [Lump -sum] In compounding we used FV,= PV ( 1+)? Solving for PV, we get PV = pp jis the discount factor used as the opportunity cost rate i.e. if the rate of return an investor could earn on alternative investments of similar riskFINANCIAL MANAGEMENT 6 PV in table: FV, (PVIFin) ANNUITY: It is a series of periodic payments/receipts of equal amounts. ‘Annuity may be of two types: (i). Ordinary (deferred); (i). Annuity due. Ordinary are more common in finance. FV of an Annuity (Ordinary): FV,= A(1+i)? +A (141) +A Example: [Tk. 100 for 3 years @ 5%] Or, FVq = 100(1.05)? + 100(1.05) + 100 = 315.25 (i). Annuity compound factor: e.g. Tk: @ 5% for 3 years = 1.1025 +1.05+1 =3.1525 (ji). Annuity discount factor: fo Amir A Sg AEE po ALT Pea Gay * Ta rp e.g. How much must be invested today to provide Tk.300 after 3 years or Tk.100 annuity in 3 years. 100 400, 100__ re 05)" * 440.05)" * (1+0.05)? = 95.20 +90.70+86.38 = 1k272.32 So,Tk.272.32 to be deposited now or Tk.100 annuity is 3 years to get Tk.300 after 3 years. * Perpetual Annuity: w When approaches to infty, then annuity PV factor ist 4 ee A ie. PVA =" [Annuity discount factor] In our example, a = Tk.2000 for Tk.100 to be received for ever.