Cost of Capital Learning Objectives Concept and importance of cost of capital. Cost of capital of debt and equity capital. Cost of retained earnings. Role of the cost of capital in decision making. Weighted average cost of capital. 6.1 Concept of Cost of Capital In the preceding chapter we discussed various techniques and concepts for evaluating investment alternatives. In discussion of discounted cash flow techniques of capital budgeting, the term of cost of capital has been widely used, especially in case of NPV and Profitability Index. It has also been observed that cost of capital plays vital role in accept-reject decisions criterion. A cost of capital is shown in percent value. Now question arises, how to determine cost of capital, and what does it actually represent. In earlier discussion on sources of finance, we have also learnt that there are various types of sources of finance, e.g., long-term, short-term, equity and debt securities Let’s take the example of debt to understand the concept of cost of capital. A company issues debt security at 10% interest per annum is under two obligations, first, to pay interest, and second, pay-back principal amount on the maturity of debt It means, raising and using debt is not free, rather it bears some cost, i., interest and122 || Finance for Non-Finance Executives principal amount. The raised funds (from debts) will be used to make investments in capital assets in order to generate revenues. Now company is required to generate revenues, at least, equal or more than ten percent. The required percentage of return is ‘rate of return’ or cost of capital. In this chapter, we will learn various types of cost of capital 6.2 Meaning and Definition of Cost of Capital The role of cost of capital is very important in decision making process of financial management. The cost of capital is used for two purposes, simultaneously, firstly, a comparison of alternative sources of funds may be made to select one which has least cost and maximum contribution to wealth maximisation, secondly, to evaluate investment proposals, as it provides a benchmark to yield a minimum return. A few definitions on cost of capital are given below: J.C. Van Horne, “Cost of capital is a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave un-changed the market price of the stock Lawrence J. Gitman, “The cost of capital is the rate of return a firm must earn on its investments for the market value of the firm to remain unchanged. It can also be thought of as the rate of return required by the market suppliers of capital in order to attract needed financing at a reasonable price”. H. Kent Baker and Gary E. Powell, “The cost of capital is the rate that the firm has to pay, explicitly or implicitly, to investors for their capital or the minimum rate of return required by the suppliers of capital, thus, ignoring taxes and flotation costs, the cost of capital represents two sides of the same coin — the cost to issuers is the return to investors”. I. M. Pandey, “The project's cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows”. J. Berk, Peter D., and A. Thampy, “Cost of capital is the expected return available on securities with equivalent risk and term to a particular investment”. Hunt, William and Donaldson, “Cost of capital may be defined as the rate of that must be earned on the net proceeds to provide the cost elements of the burden at the time, they are due”. Hampton, John J., “Cost of capital is the rate of return the firm requires from investment in order to increase the value of the firm in the market place”. From the above definitions, the following characteristics of the cost of capital may be drawn. Cost of capital is a rate of return, generally, expressed in percent value. 2. It is the minimum required rate of return to offset the affect of risk associated with business, and to maintain profitability in order to maximise the wealth of shareholders.Cost of Capital | 123 3. Cost of capital has role in maintaining market value of the firm. The value of a firm will decline if firm uses capital at a higher cost than its return on assets 4. Arranging source of finance at rate of return (called cost of capital), and allocating them in investments are the two sides of same coin. The amount so invested must yield return equal to or more than a rate at which sources are arranged to fund such investments. 5. Cost of capital involves implicit as well as explicit cost, therefore, it takes future risk and business risk into account 6.3 Importance of Cost of Capital in Financial Management The cost of capital has a central role in financial management because it provides a way to link investment and financing decisions of a firm. An interrelationship exists between capital budgeting and cost of capital, For example, to determine the size of the capital budget, managers need information about both the returns on investment opportunities and the cost of capital. It helps in two ways, first, assist in identify the discount rate to be used to evaluate proposed capital investments, second, to serve as guideline in developing capital structure and evaluating financial alternatives. The key usages of cost of capital in financial management are discussed below. 1. Cost of Capital in Capital Budgeting: The cost capital is the fundamental requirement of capital budgeting technique especially based on discounted cash flows. The acceptance and rejection of a proposal depends upon cost of capital associated with it. A proposal with higher rate of return have lesser net present value in comparison of another proposal with lesser cost of capital, therefore, more chances to reject the proposal with higher cost of capital. Since, the cost of capital represents to minimum rate of return to be earned on an investment, thus, a costly source of finance expects higher rate of return from assets to be funded from such source of finance. Net present value, profitability index, discounted payback period method and many more are based on cost of capital to discount the cash flows. Hence, the cost of capital is very useful in capital budgeting decision. 2. Cost of Capital in Determination of Capital Structure: Every source of fund has own features, few are costly in comparison of others, some are easily available etc. A firm, commonly, uses both equity and debt as a mix in its total financing. The cost of debt is considered at lower rate in comparison to equity At the same, there is tax advantage on debt security but not on equity capital Therefore, an optimum mix of debt and equity is helpful in determination of average cost of capital. In designing an optimal capital structure, the management has to keep in mind the objective of maximising the value of the firm which makes cost of capital important in financial planning of the firm. 3. Cost of Capital and Financial Performance of the Firm: The average cost of capital of a firm represents risk and return of the firm, A firm with high cost of capital exposed to high rate of risk, and impacts firm’s profitability. If the124 || Finance for Non-Finance Executives actual profitability of a proposal is more than the projected and actual cost of capital, the performance may be said to be satisfactory, vice-versa Cost of Capital and Financial Decisions: Cost of capital has more usages in financial decision making, e.g.. in valuation of retained earnings, dividend policy, capitalization or profit also. Cost of capital involves business risk as well as financial risk, therefore, it recognises the time value of money in optimum manner. Moreover, cost of capital also takes explicit and implicit cost into account, thus, opportunity cost is also considered in financial decision making when the decision is taken on the basis of cost of capital. Cost of Capital and External Users: Cost of capital is useful in decision making for internal as well as external users. A potential investor, banking institution, short-term lender, creditors also interested to know the cost of capital of the firm. A firm with higher cost of capital, generally, operates at higher risk thus lender may have less favour to advance money to such firm. Sometimes, government also provide financial assistance to companies in danger, but of national or social importance, due to high cost of capital by way of announcing special packages 6.4 Components of Cost of Capital The prime components of cost of capital are: (i) cost, and (ii) capital. A combination of different types of capital and cost components determine cost of capital which may vary from case to case. A detail classification of components of cost of capital is displayed in figure 6.1 Components of Cost of Capital Capital Before tax or ater tax Historical, Future, Average t 1 Flotation, Marginal Cost External Internal Explicit and Implicit Cost Equity Retained Eamings Capital eee Preference Depreciation as coma Source of Fund Debt Figure 6.1: Components of Cost of Capital Components of Capital Capital components are funds that come from investors. There are three major long- term components in the capital structures of most firms are debts, preference share capital, and equity shares. Although some firms can finance their operations totally with equity share capital, most rely on other capital components. But, in actual practice,Cost of Capital || 125 firms raise capital from several sources in an effort to reduce the average required rate of return on the firm’s overall capital. Thus, their cost of capital should be the weighted averages of the various types of funds they use. Since, the retained earnings are also a source of funds to a firm therefore, valuation of retained earning is also important. Depreciation is also treated as source of funds, and component of cost of capital. This is to emphasized that determination of cost of leasing. specialised debts, depreciation is beyond the scope of this book. Components of Cost The major components of cost are discussed below. 1. Before Tax or After Tax: Although the corporate tax affects associated with financing can be incorporated in determination of cost of capital, and most of firms do the same. Therefore, analysts should focus on after-tax costs, Taxes only affect the cost of debt because interest, not dividends, is an expense that reduces taxes 2. Historical Cost or Future Cost: The decision-making process of financial management, generally, depends upon accounting information which is historical in nature, but the use of future cost or estimated cost is much relevant than historical cost. At the same point of time, it is emphasized that future cost can’t be generated without the base of historical cost. 3. Average, Marginal, Floating Cost: The role of average cost and marginal cost has wider application in cost of capital. Average cost of capital is the combined cost of all components of capital. The average cost refers to weighted average cost of capital. Marginal cost is an additional cost to raise additional funds. Both, average costs and marginal costs are used in determining cost of capital depending upon case to case. Two distinct opinion are there on floating cost, some authors are in view that floating costs are relevant when a firm raises new financing. Another approach treats flotation costs as an additional outflow that increases the initial cash outlay of an investment. There is disagreement on how to appropriately handle flotation costs. 4. Explicit Cost and Implicit Cost: Explicit cost is the cost which is directly connected with the subject matter, whereas implicit cost refers to opportunity cost. For example, interest to be paid to debenture holders is the explicit cost of debenture. The explicit cost can be measured with the help of following equation (+k)! (14K (4y" Gtk) Where, 1, = Net cash inflow at zero point of time. C, = Cash outflow in different periods. k = Explicit cost of capital126 || Finance for Non-Finance Executives On the other hand, if retained earnings are used in business then the implicit cost of such retained earnings is the opportunity cost, ie. implicit cost of such retained caring is the rate of return available to sharcholders by investing the funds elsewhere 5. Depreciation: For many firms, depreciation is the internally generated source of funds. The cost of funds generated through depreciation depends on how the firm will use the funds. If the firm plans to use these funds as a part of the capital expenditure process, the cost of depreciation will be the weighted average cost of capital before issuing new equity. Thus, using depreciation in total cost increases the weighted average cost of capital unreasonably, therefore including depreciation in cost is unnecessary. 6.5. Factor Affecting Financing Costs The cost of capital is measured under the assumption that both the business and financial risk of the firm are fixed, and that the investor’s disposition towards risk remains unchanged, the only factor that affects the various specific costs of financing is demand and supply of operating in the market for long-term funds. It is the risk -free cost of funds that under these circumstances is of key importance in assessing financing cost. Regardless of the type of financing uses, the following general relationship should prevail K\=1,+bp+ fp Where, he specific cost of the various types of long-term financing = the risk-free cost of the given type of financing business risk premium fp = financial risk premium Above equation shows that cost of each type of capital depends on the risk-free cost of that type of funds, the business risk of the firm, and the financial risk of the firm. ‘The business risk is related to the response of the firm’s earnings before interest and taxes (EBIT) or operating profits, to changes in sales. The financial risk related to the response of the firm’s EPS to changes in EBIT. Though, both affect capital structure of the company, but in determination of cost of capital, these are assumed to be constant. It means only one factor remain open i.e., relationship of demand and supply of a particular fund. 6.6 Determination of Cost of Capital The cost of capital is measured at a given point in time, it must reflect the cost of funds over the long-run, based upon the best information available. This section describes the procedure for measuring the costs of specific sources. The cost of capital of each source of fund will be measured individually, first, then followed by weighted average cost of capitalCost of Capital || 127 6.6.1 Cost of Debt The cost of long-term debt has two basic components. One is the annual interest, and the other arises from the amortization of discounts given or premiums received when the debt is initially issued. In order to simplify the calculations in this section, annual interest payments on debts are, only, taken into account. (i) Cost of debt, issued at par, before tax affect 1 oe y= B Where, Ky», = Cost of debt before tax: I= Interest; P= Principal amount (ii) Cost of debt raised at premium or discount. In case of premium, principal amount will be increased by premium, in case of discount, principal amount will be face value less discount amount. ae NP NP = Net proceeds on issue of debt. In case of debt issued at premium, NP = Face Value + Premium, in case of discount, NP = Face Value — Discount value. Kay, Cost of debt considering tax affect The payment of interest on debt is a statutory obligation. On profit, firstly interest is deducted then tax is paid on remaining earnings. Thus, interest on debt has tax advantage. In this case cost of debt is: I Ky= pl a) Or k= Ka-» NP Where, Ky= cost of debt after tax, and rate of tax net proceeds NI Illustration 1: A Co. Ltd. issued 10% debenture of 2500000 at par. Compute the cost of debt if the applicable tax rate on the company is (i) 50%, (ii) 40%, (iii) 45% Soli (i) Tax Rate = 50% 1 x =—(I-t Cost of debt (ky) we! 1)128 || Finance for Non-Finance Executives 50000, 500000. " (1-0.5) 2x05 50 1 —x0.5 =5% 10 (ii) Tax Rate = 40% I =—(-1) ky we ) = 50000 4 9.4) 500000 1 = +x06 =6% 10* (iii) Tax Rate = 45% 1 = bx (1-045 k= 75 x-045) a. — #055 =5.5% 10 Illustration 2: X Co. Ltd issued 12% debenture of 7200000, face value of the debenture is 7100. Compute cost of debenture if (i) Issued at par, tax rate is 20% (ii) Issued at 10% premium, tax rate is 30% (iii) Issued at 10% discount, tax rate is 40%. Separate the tax adjustment of each case. Solution: In order to separate the tax adjustment, cost of debt are computed (i) before tax adjustment and (ii) after tax adjustment. Before Tax Adjustment ‘After Tax Adjustment () | AtPar Db i =— (1-20) 12% ~ 100 NP 1007 a =— x 0.80 = 9.6% 100 (i) | At Premium 2 I 2 =— (1-0.30) ky === = 10.9% M0 NP 110 L 2 9) NP = Principal + Premium ToeCost of Capital || 129 Before Tax Adjustment After Tax Adjustment (iii) | At Discount D i =—(1-0.40) 4 = == 13.33% 90 NP 90 2 == x0.60=7.9% 90 Thus, cost of debt has tax advantage, it declines as the rate of tax increases. Illustration 3: Z Co. Ltd issues 9% debenture of 7600000, face value of the debenture is 7100 at par value. It spent 220000 as floating expense on issue of debenture. Compute cost of debt, if tax rate is 40%. Solution: 1 =—(I-t ki= Np (I-t) NP = Principal amount — Exp. on issue = 600000 - 20000 = 580000 _ 54000 580000 = 0.0931 «0.6 = 5.58% (1-040) (iv) Cost of Redeemable Debt (Short-Cut Method) When debts are issued for a predetermined period and has to redeem on maturity called redeemable debt. The cost of redeemable debt is measured as follow: Teo (P-NP) Ky= 42 ——(1-) z (P+ NP) Where, N = Number of years in which debt is to be redeemed. P= Principal amount N= Net proceeds N= Tax rate Ilustration 4: Compute the cost of capital of 12% debentures issued by Vikas (P) Ltd., face value of 2100, amount of 3200000, in following situations. The life of debenture is 7 years. (i) issued at par, redeemable at par. (ii) issued at 10% premium. (iii) issued at 10% discount.130 || Finance for Non-Finance Executives Solution: 12% Debenture of 7200000, Face value 7100, Debenture issued at par, Tax rate 20%, 1 = ee ae 3° ) Where, I = 24000; n=7 years; P= 100; NP= 100; t= 20% 24000 + = (200000 — 200000) —_1 x 1-020) ; (200000 + 200000) 24000 +0 ase ~ 400000/2 24000 x 0.80 200000 = 9.6% (ii) Debenture issued at premium (10%) 24000 +4 (200000 - 220000) ky= Sa Sp SvenEpSoSeeeEE (1-03) (200000 + 220000) 24000 + (20000) 420000/2 24000 — 2857 210000 = 7.04% x07 (iii) Debenture issued at discount (10%) 24000 + 4 (200000 - 180000) eee ee (1 040) (200000 + 180000) 24000 + $2000) 380000/2 _ 24000 + 2857 0.60 190000, = 8.48% 0.60Cost of Capital \| 131 Short-cut method has a limitation that this method gives only approximated result, it does not consider the repayment and the annual compounding The above equation can be rewritten as follow: (v) Cost of Redeemable Debt with PV values (before tax) This method overcome the limitation of short-cut method. Bae NP, + Where, Interest rate total life of the debt n= the year in which debt is to be redeemed. Cost of redeemable debt considering tax adjustment. Cost of debt (after tax) = ky (1 — 1) (vi) Cost of Debt Redeemable in Instalments In Some cases, companies redeemed debentures in instalments. In such cases the cost of debt capital is computed with the help of following equation: eee VB 1, +P, kaw = eas eae (+kg) (+k) (+ky) 7 fi Mr, kaw = asks)! Where, kypy = Present value ofa debt Annual interest for ‘t’ period P, = Periodic payment of principal in ‘t” period number of years to maturity cost of debt (vii) Valuation of Zero Coupon Bonds Zero Coupon Bonds are also a form of debt securities, carrying no interest rate, issued at a significant discount. No interest is paid on such bonds/debenture before their redemption and at the time of maturity the value is paid to investors either at face value or at premium, Since, no interest is involved thus, formula discussed above will not serve the purpose to determine the cost of debt. Following steps may be followed in order to compute cost of such bonds. (a) Prepare a cash flow table with an arbitrary discount rate. (b) Find out the NPV by deducting the present value of the outflows from the present value of the inflows.132 || Finance for Non-Finance Executives (c) Ifthe NPV is positive, apply higher rate of return to make NPV equal to zero, or vice-versa. Repeat the same step unless NPV becomes zero o negative (d) If NPV is negative, then cost of debt will lie between these two rates, one where NPV is negative, and second immediately preceding to it. Illustration 5: X Ltd. issued Zero Coupon Bonds, face value = 7100, at 40% discount, for %300000. The bonds are to be redeemed at face value after five year. Year | Cash flow re ae py ve nae py 0 60. 1 60 1 60 5 (100) 0621 621 0593 593 NPV 2.1 (0.7) Amount given in parentheses indicates outflow, where %60 has been received after 40% discount on face value of 100. It shows that the required rate of return is somewhat between these two discount rates ky= 104 —2_ (11-10) 1407) ky= 10.75% 6.6.2 Cost of Preference Share Capital There is fixed percent of payment on preference share capital, whenever the dividend is paid to them. The payment of dividend to preference share holder is dependent upon the discretion of the Board of Directors, but it does not mean that preference share capital has no cost. Since, dividend is paid out of profit after tax, thus, there is no tax advantage on cost of capital of preference share capital. As per the Companies Act, 2013, in India, preference shares have a defined life, therefore, these has to be redeemed as and when maturity period arises. Secondly, no share can be issued at discount, thus, preference shares will be issued either at par or premium. Thus, net proceeds will not be less than the face value in any case. However, any expenditure incurred on issue of such shares may be deducted from the face value, hence exception. The cost of preference share capital is computed as follows p+1(Rv-np) a Kyet= ORV #NP) Where, Kyer = Cost of preference share capital Dividend (annual) RV = Redemption Value NP = Net Proceeds (face value + premium) or (face value — floatation cost).Cost of Capital || 133 In case, preference shares are to be redeemed in instalments, then equation given under (vi) point of 6.6.1 can be used after deleting tax adjustment factor, and replacing interest with dividend as shown below: c= DERM Dat RV, Da tRVa mo) (14k,) (I+kp) (1+kp)” > D, +RV, Fstpg” 2 (en) y . Where, kneripw = Present value of pref. share cost of capital D = Dividend (Annual) RV = Redemption value (instalments) k, = Cost of pref. share n= Number of years, ie., redeemable life Illustration 6: Harshita Co. Ltd. issued 12% Redeemable Preference Share Capital of %500000, face value each share is 210. Calculate the cost of capital if shares are issued (i) at par, (ii) at a 10% premium. Assuming the shares will be redeemed on 10th year ata premium of 10%. Solution: (i) Issue at par, Redemption at premium p+ Lav - np) = F100 (RV +NP) 6000+ 4 (550000 - 500000) = —_0 5100 $ (550000 +500000) 60000 + 5 (50000) =—2 ___ -x100 1050000/2 60000-+ 5000 = UNO + SON «100 = 12.38% 525000 * ae (ii) Issued at premium, Redemption at premium p+ trv —npy = _ x100 (RV + NP)134 || Finance for Non-Finance Executives 6000+ 4 (550000 - 550000) eee eee 100 3 (650000 +550000) _ 60000+0 = x100 = 10.91% 550000 Illustration 7: Kishore (P) Ltd. issued 10% preference shares, face value €10 each, redeemable after 8 years. Total number of shares issued are 50000. Preference shares are to be redeemed at 20% premium. The cost of issue of such shares is 50 paise per share. Compute cost of capital of preference shares. Solution: p++irv-np) k,= —2_——— «100 Fav +NP) 50000 + 4 (600000 - 475000) = ——_8_______ x 100 3 (600000 +475000) 50000 + 15625 a 537500 RV = (50000 « 10) + 10% premium on redemption Cost of Issue = 50000 = 0.5 = 25000 NP = (50000 x 10) — 25000 = 475000 D = 500000 « 10% = 50000 100 = 12.21% Cost of Preference Share in Respect to Market Value If investors, or company desires to find out the cost of capital of the preference shares on market value, i.e, yield of preference share then above formula can also be used for this purpose with minor changes as given below. p+ ev—my) K, x 100 pret J =(FV +My) Where, : D = Dividend N= Number of years of redemption, FV = Face value of the preference share, MV = Market value of the preference shareCost of Capital || 135 6.6.3 Cost of Equity Share Capital The cost of equity share is not as easy to calculate as the cost of debt or the cost of preference share. The difficulty arises from the definition of the cost of equity share, which is based on the premise that the value of a share of stock ina firm is determined by the present value of all future dividends expected to be paid on the stock. But, payment of dividend to equity shareholders is not a legal binding on a company, moreover, there is not any fix percent at which dividend to be paid to equity shareholders. But this does not make cost of capital of equity share capital free of cost. Of course, there is no explicit method, but with the help of implicit method, i.¢., opportunity cost, cost of equity capital (K,) can be determined The probability of getting dividend and to remain the market price of the equity share unchanged is the first expectation of equity shareholders. With the help of following methods, cost of equity share capital can be ascertained. (i) Dividend Yield Method This method is also known as Dividend/Price Ratio method. According to this method, the cost of equity capital is the discount rate that equates the present value of expected future dividend per share with the current market price of a share. The basic assumptions of this method are: (a) Investors give prime importance to dividend (b) Risk of the firm remain unchanged (c) There is no growth in future dividend. (d) It does not consider the retained earnings. The formula to compute cost of equity is given below: Div > MP ‘Where, K, = Cost of equity capital Div = Dividend per share (expected) MP = Market price per share Illustration 8: A company has issued 10000 equity shares of €100 each. Company has been paying dividend to equity shareholders at 25% p.a. from last three years and expected to maintain the same. The market value of the share is 180. Compute cost of equity. Solution: 2) 180 K, = 13.89% 100136 || Finance for Non-Finance Executives i) Dividend Growth Method Under this method the assumption of earlier method ic, there is no growth in dividend has been revoked, and it is considered that there is an expected growth in divided of equity share in comparison to previous year. The formula to compute “Ke” is given below. Div, =—t+ K.= *” “MP Where, Div, = dividend of last year = growth in dividend (in %) This method can be computed for existing shareholders as well in case of issuing right shares. In case of exiting shares, the denominator is market price, whereas in case of right shares, denominator is net proceeds on new issue Illustration 9: ABC Co. Ltd. wants to issue 20000 new shares of 7100 each at par. The flotation cost is expected to 5%. The company has paid dividend of @15 in last year and it is expected to grow by 7%. Compute the cost of equity (i) in case of new equity shares, (ii) for existing shareholder assuming market price of the share is 7160 per share. Solution: (i) Cost of equity to existing shareholders k= pu 8 NP Net proceeds = Face value ~ Flotation cost = 100 ~ 5 =95 per share BB o07 95 22.78% (ii) In case of existing shareholders 15 = +007 Ke 160 = 16.375% (iii) Earning Yield Method This method is also known as earning/price ratio method. This method adheres the basis relationship between earnings and market price of the security. According to this method, the cost of equity capital is the discount rate that equates the present values of expected future earnings per share with the net proceeds (or current market value), presented below ___Earnings per Share Market Price per ShareCost of Capital \| 137 IMlustration 10: Kapil Co. Ltd. has proposal to expand its business operations for what it needs fresh equity capital of 220,00,000. On the basis of following information determine the cost of equity capital for existing shareholders as well as new equity shareholders. Issue price of new share is 2200. no issuing charges Number of existing equity shares, 200000 Market value of existing share 3300 Net earning 100 lakh Solution: Cost of Capital for existing shareholders Net Eamings _ 10000000 g = —Net Barings _ 10000000 _ EPS™ Number of Shares 200000” EPS 50 = 2 = = 5100 = 16.679 We Cost of Capital for New Share Capital EPS 50 -— 8 as ke Net Proceeds 200 25%: (iv) Cost of Equity and CAPM Capital Asset Pricing Model can also be used to find out the cost of equity capital. A detail discussion on this model is discussed in next chapter. 6.6.4 Cost of Retained Earnings The cost of retained earnings is closely related to the cost of equity share capital If earnings were not retained, they would be paid out to the equity shareholders as dividends. Retained earnings are often looked on as fully subscribed issue of additional equity share capital, since they increase the stockholder’ equity in the same way as a new issue of the equity shares. The cost of retained earnings must therefore be viewed as the opportunity cost of the forgone dividends to the existing equity shareholders. Ifa firm is unable to carn as much on its retained earnings as other firms with a comparable level of risk, it is assumed that shareholders will prefer to receive these earnings in the form of dividends so they can invest in other firms. In contrary case, where company’s internal growth is more, and it is expected that company’s internal source of fund (retained earnings) gives more return than making investment in other opportunities, in such a case shareholders prefer to retain profit than distribution in the form of dividend Ifretained earnings are viewed as a fully subscribed issue of additional equity share, the firm’s cost of retained earnings ‘k,’, can be assumed to be equal to the cost of equity share as given in following equation. K,=K.138 || Finance for Non-Finance Executives Further, in case, the retained earnings are distributed as dividend and shareholders want to reinvest amount so received after tax has to pay additional charges e.g., brokerage, commission, etc. to purchase securities in a new company. Thus, retained earings also have advantages that payment of tax, or additional brokerage is not required. To make adjustment of this advantages existing equation on ‘Kr’ can be updated as follows K,=K,(1-t)*(1~b) k= (Fa+e}c-o> Divy (1+g,)' | Divan, 1 (+k) ke- 8 +k," Where, MP= Market price Divo = Dividend of current year g,= Supernormal growth rate k, = Cost of equity capital n= number of year for growth is to be computed Div,.; = Div, (1 + g,) ‘The equation is solved by trial and error method. 6.7 Weighted Average Cost of Capital (WACC) ‘As we have learnt that in the capital structure of a company there are different combination of securities viz., equity, preference, and debt. Their different combination leads to make variation in total cost of the company. In the preceding section, we also learnt about the cost of capital of each component of capital. Once the individual component costs have been calculated, they are multiplied by the proportions of the respective sources of capital to obtain the weighted average cost of capital (WACC), WACC is also known as composite cost of capital, overall cost of capital. WACC is found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure. The proportions of capital must be based on target capita structure.Cost of Capital || 139 Itis to emphasized that WACC follows weighted average not simple average method. A simple average method may distort the whole objective of WACC. However, there are two common schemes on the basis of which weight can be assigned to particular cost. These are Book Value vs. Market Value, and Historic vs. Target schemes. Book Value vs. Market Value: book value weights are based on the use of accounting values to assess the proportion of each type of capital in the firm’s structure. Market value weights measures the proportion of each type of financing at its market value. The weights under book value are mostly criticised as the book values do not reveals the opportunity costs, and involves only historical value than economic value Market value approach is theoretically more appealing. since the market values of, securities are closely related with actual value. It seems only reasonable to use market value weights. However, it is more difficult to calculate the market values of a firm’s sources of finances than book value, The market value may fluctuate due to any reason beyond to the scope of firm level. Thus, book value is preferred over market value. Historic vs. Target: Under second approach, the weight may be assigned on the basis of historic weights or target weights. The historic weights are based on actual data, And target weights are based on book plus desired capital structure proportions Firms using target weights establish these proportions on the basis of the optimal capital structure they wish to achieve. From a strict theoretical point of view, the preferred scheme is target market value proportions. WACC is performed by multiplying the specific cost of each form of financing by its proportion in the firm’s capital structure and summing the weighted values. Thus WACC, “Ka” can be presented as given below. K,= Wa ka + Wy kp + We ke Where, K,= WACC W, = Weight for cost of debt securities ky W, = Weight for cost of preference share capital k, W, = Weight for cost of equity capital k, _ Sxw oO kK i Ew cost of specific source of finance. W = weight of specific source of finance Two important points should be noted: 1. The sum of the weights must be equal to 1 (or 100%). Simply, stated, all capital structure components must be accounted for. 2. The firm’s equity share capital weight ‘Ws’ is multiplied by either the cost of retained earnings, Kr, or the cost of new equity share capital.140 || Finance for Non-Finance Executives Illustration 11 The cost of various types of capital of Shiv Co. Ltd. is given below along with target market proportions. Compute WACC from the following Proportion (w) ; Source of funds (Amount) |) in'totalleapitaly | Co! ae structure Debts 240000 30% 5.68 Preference share capital 80000 10% 9.33 Equity Share Capital (®100 each) | 400000 50% 13.30 Cost of retained earnings 80000 10% 13.00 Total 800000 100% Sol awa Cost of Source of funds | Amount : Capital | Wace capital structure ) @) ®) © 0) | ®=©=0) Debts 240000 30% 5.68 1.704 Preference share capital | 80000 10% 933 0.933 Equity Share Capital 400000 50% 13.30 6.65 Cost of retained earnings 80000 10% 13.00 13 Total 800000 100% 10.587% wants to change WACC aj approach, the price of equi Compute WACC under market approach IMustration 12: Taking data of illustration 11, what would be your opinion if company pproach from book value to market approach? In market ity share is €250 per share instead of 7100 in book value. Solution: Re Cost of Source of funds Amount | "0 Capital WACC capital as structure (A) (B) (©) (D) (E)=(©) x (D) Debts. 240000 18.19% 5.68 1.04 Preference share capital | 80000 6.06% 9.33 0.56 Equity Share Capital 10.07 (4000 * 250) 1000000 75.75% 13.30 Cost of retained earnings 7 7 7 7 Total 1320000, 100% 11.67%Cost of Capital || 141 In market value approach, the retained earnings are automatically covered under equities as these are valued at market price which takes reserves of the companies in to account while valuing firm’s security. Review Questions 1. Define the term ‘cost of capital’, and give its features. 2. Cost of capital provides basis to capital budgeting decision-making process? Illustrate. 3. Explain the significance of cost of capital in the financial management. 4. Compute cost of capital of 8% Debenture, face value 100 each in following cases: (a) Issued at par, tax rate is 40% (b) Issued at discount of 10%, tax rate is 50% (c) Issued at premium of 10% tax rate is 45%, 5. A company issues 800000 12% Debenture at discount of 5%. The costs of floatation amount to 240000. Calculate cost of debenture if tax rate is: (i) zero, (ii) 20%, (iii) 50% 6. “Cost of retained earnings is equal to cost of equity capital”. Do you agree with the statement, if yes, elaborate? Also state the circumstances when cost of retained earning will be lower than cost of equity itself. 7. What is WACC? Examine the rationale behind the use of WACC. 8. Illustrate various methods to determine cost of debt. Justify your answer. 9. X Co, Ltd, issued 5000 Debenture, face value of £100, carrying rate of interest @ 10% p.a. Assuming the applicable tax rate is 50%, compute the cost of debt in following cases (a) Debenture issued at par, but redeemed at 10% premium, (b) Debenture issued at 5% premium, and redeemed at 10% premium (c) Debenture issued at 10% discount, and redeemed at par. (d) Debenture issued at 10% discount, but redeemed at 5% premium. 10. A company issued zero-coupon bonds, face value of 2100 at a discount rate of 30%. Compute the cost of bond if these are to be redeemed after 6 years at face value. 11. Compute the cost of zero-coupon bond on the following information. The face value of the coupon z100 Discount rate at which coupon were issued 80% Repayment of coupon: at the end of 3rd year 330 at the end of Sth year 70142 || Finance for Non-Finance Executives 12. Determine the cost of preference share capital of company Robin (P) Ltd 10% Redeemable preference share, face value 7100 each Issued at par, redeemable at 5% premium. Total number of shares issued 20000 Shares are to be redeemed afier 7 years Flotation expenses on issue of such shares 750000. 13. Following information is submitted to you to compute cost of equity capital of the company which wants to issue new equity share capital of face value of 2100. Market value of the share 2260 Floatation charges ®2 each share Dividend in las year 230 per share, expected to increase by 5% 14, Taking the data of question number 12, what would be the cost of capital if net earnings of 210 lakh are available to 40000 existing equity shares 15, From the data of question number 13 compute cost of retained earnings for existing shareholders assuming that rate of tax is 30% and brokerage charges are 10%. 16. A firm has the following capital structure and cost of capital associated with it as, shown in the following table. You are required to compute WACC Source of funds Amount Sete an anny Debts 400000 40% 9.60 Preference share capital | 200000 20% 1065 Equity Share Capital 300000 30% 13.15 Cost of retained earnings 100000 10% 12.00 Total 1000000 100% You are required to compute WACC in following cases (i) according to book value (ii) according to market value, if the market price of the share is 180 per share. Q00