LONG TERM FINANCE & COST OF CAPITAL

1. LONG TERM FINANCE

The primary goal of financial management is ‘maximization of shareholders’ wealth’. Hence, all decisions of
management are directed towards such wealth maximization. There are three basic functions of financial
management, viz. investment decisions, financing decisions and dividend decisions.

A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture etc. These
assets may be regarded as the foundation of a business. The capital required for these assets is called fixed
capital. Funds required for long term fixed capital is called long term finance.

2. FEATURES OF LONG TERM FINANCE

 It involves financing for fixed capital required for investment in fixed assets

 It is obtained from Capital Market

 Long term sources of finance have a long term impact on the business

 Generally used for financing big projects, expansion plans, increasing production, funding operations.

3. PURPOSES OF LONG TERM FINANCE

1. To finance Fixed Assets – Business requires fixed assets like machines, building, furniture etc. Finance
required to buy these assets is for a long period, because such assets are used for long period.

2. To finance the Permanent Working Capital – Business is a continuing activity. It must have a certain
amount of working capital which would be needed again and again. This part of working capital is of a fixed
or permanent nature. This requirement is also met from long term funds.

3. To finance Growth and Expansion of business – Expansion of business requires investment of a huge
amount of capital permanently or for a long period.

4. FACTORS DETERMINING LONG TERM FINANCE

a) Nature of Business – The nature of a business determines the amount of fixed capital. A manufacturing
company requires land, building, machines etc. So it has to invest a large amount of capital for a long
period. But a trading firm will require a smaller amount of long term fund as it does not have to buy building
or machines. Also, a service oriented firm will not require much long term funds.

b) Nature of goods produced – If a business is engaged in manufacturing small and simple articles it will
require a smaller amount of fixed capital as compared to one manufacturing heavy machines or heavy
consumer items like cars, refrigerators etc. which will require more fixed capital.

c) Technology used – In heavy industries like steel the fixed capital investment is larger than in the case of a
business producing plastic jars using simple technology or using labour intensive technique.
 Cost of Capital

5. SOURCES OF LONG TERM FINANCE

 Shareholders’ Funds (Equity Capital)

o Equity Share Capital
o Preference Share Capital
o Retained Earnings

 Borrowed Funds (Loan Funds)

o Debentures Issues
o Loans from Financial Institutions
o Deposits / Bonds etc.

6. COST OF CAPITAL

 Cost of Capital can be defined as the minimum rate of return that a firm must earn on its investments, so
that the market value of the firm is constant.

 It is the cut-off rate for determining future benefits (cash flows) against current investments.

 The decision regarding feasibility of a project is taken on the basis of cost of capital.

 Hence, cost of capital is the cost of obtaining funds from various sources.

 Thus, cost incurred by a company for obtaining funds is the minimum rate of return that it must earn.

 It can be stated as the opportunity cost of an investment, i.e. the rate of return that a company would
otherwise be able to earn at the same risk level as the investment that has been selected.

 John J. Hampton defined “Cost of capital is the rate of return the firm required from investment in order to
increase the value of the firm in the market place”

 According to Ezra Solomon “Cost of capital is the minimum required rate of earnings or the cut-off rate of
capital expenditure”.

 James C. Van Horne defined it as “a cut-off rate for the allocation of capital to investment of projects. It is
the rate of return on a project that will leave unchanged the market price of the stock”.

 According to William and Donaldson, “Cost of capital may be defined as the rate that must be earned on
the net proceeds to provide the cost elements of the burden at the time they are due”.

7. IMPORTANCE OF COST OF CAPITAL

 Securities analysts use Cost of Capital in valuation and selection of investments.

 In discounted cash flow analysis, Cost of Capital is used as the discount rate applied to future cash flows
for deriving a business’s net present value. It is an important constituent in Capital Budgeting decisions.

 It also plays a key role in Economic Value Added (EVA) calculations. Used for deciding debt-equity mix.

 Investors use Cost of Capital as a tool to decide whether or not to invest. It is known as ‘Hurdle Rate’

 Cost of Capital represents the minimum rate of return at which a company produces value for its investors.

 Cost of Capital is used for evaluating investments plans, discounting cash flows, compare with ROI.

 Weighted Average Cost of Capital is the outcome of the relative proportions of different sources of finance.
 Cost of Capital

8. TYPES OF COST OF CAPITAL

a) Explicit and Implicit Cost

Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of return associated with
the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently
under consideration by the firm were accepted. In other words, implicit costs refer to the opportunity cost.

b) Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital employed by the company. It
considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc. Marginal
cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when
the company goes for further raising of finance.

c) Historical and Future Cost

Historical cost is the cost which has already been incurred for financing a particular project. It is based on the
actual cost incurred in the previous project. Future cost is the expected cost of financing in the proposed project.
Expected cost is calculated on the basis of previous experience.

d) Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of
capital. It is very useful to determine the each and every specific source of capital. The composite or combined
cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. It is used to
understand the total cost associated with the total finance of the firm.

9. FACTORS DETERMINING COST OF CAPITAL

1. General Economic Conditions – Economic conditions determine the demand and supply of funds within the
economy, as well as expected inflation. Any change in demand and supply of money in the economy changes
the interest rates. Thus, if demand for money increases without much increase in supply, there will be rise in
interest rate and vice versa.

2. Market Conditions – Where risk increases, an investor requires a higher rate of return. Such increase is
called a risk premium. When investors increase their required rate of return, the cost of capital rises
simultaneously. The rate of return also depends on the ease of marketability of securities.

3. Operating and Financing Decisions – Various decisions of a company creates different levels of risk. Such
risk is divided into two types: business risk and financial risk. As business risk and financial risk increase or
decrease, the investor’s required rate of return (and the cost of capital) will move in the same direction.

4. Amount of Financing – Cost of funds depends on the level of financing that the firm requires. As the fund
requirements is higher, the cost of capital increases due to additional flotation costs, legal compliances,
underwriting commission, brokerage etc.
 Cost of Capital
5. Controllable Factors

a. Capital Structure Policy (Debt-Equity ratio) – A firm can control its debt-equity ratio, and it targets an
optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued,
the cost of equity increases.

b. Dividend Policy – A company can control its dividend payout ratio. For example, as the payout ratio of the
company increases, more the cash outflow and additional need for funds is created.

c. Investment Policy – Generally, while taking investment decisions, a company is making investments with
similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt
and cost of equity change.

6. Uncontrollable Factors

a. Interest Rates – The level of interest rates will affect the cost of debt and, potentially, the cost of equity.
For example, when interest rates increase the cost of debt increases, which increases the cost of capital.

b. Tax Rates – Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.

c. Inflation Rates – The rate of inflation affects purchasing power, and thus affects cost of capital.

10. MEASUREMENT OF COST OF CAPITAL

a) Cost of Debt Capital (‘Kd’)

 Basically, debt capital represents long term borrowing of a company.
 Borrowings include Debentures and funds obtained from financial institutions, banks, Government etc.
 The period of borrowing is fixed and the rate of interest is also fixed. Interest payment is mandatory i.e.
payable even in case of losses.
 However, interest is tax deductible, i.e. tax shield is available on interest payments.

Cost of Term Loans (Kd) = Interest (1 – tax rate) * 100

Net Proceeds
Debentures:
 Debentures are issued by companies to the public and financial institutions.
 Debentures can be classified as irredeemable & redeemable. Irredeemable debentures are not redeemable
during life of company, whereas redeemable debentures are redeemed at maturity.
 The rate of interest is fixed, and it is paid on its face value.
 Interest attracts tax benefits and it is payable even in case of losses.
 Debentures can be issued at par, premium or discount as well as redeemed at par, premium or discount.
 Based on issue and redemption value, the net proceeds received at maturity value paid will changes
accordingly.

Cost of Irredeemable Debentures (Kd) = Interest (1 – tax rate) * 100

Net Proceeds
 Cost of Capital
Cost of Redeemable Debentures (Kd) = Interest (1 – tax rate) + (RV – NP) / N * 100
(RV + NP) / 2
Where,
RV = Redeemable value on maturity
NP = Net Proceeds on issue N = Life of redeemable debt.

b) Value of Bonds
In case of bonds, cash flows and the discount rate can be determined easily. They are issued by Govt. and
hence there is no risk of default and there is no difficulty in calculating the cash flows associated with a bond.
The expected cash flows consist of annual interest payments plus repayment of principal. The appropriate
capitalisation or discount rate would depend upon the risk of the bond. The risk in holding a government bond is
less than the risk associated with a debenture issued by a company. Therefore, a lower discount rate would be
applied to the cash flows of the government bond and a higher rate to the cash flows of the company debenture.

Value of Bonds = Annual Coupon * PVIFA (R %, N years) + Maturity Value * PVIF (R %, Nth year)

c) Cost of Preference Share Capital (‘Kp’)

 Preference shares are issued to promoters, venture capitalist who invest in the company in its initial stages.
 Earlier preference shares could be issued with an irredeemable feature. However, after the amendment of
Companies Act, preference shares can be issued for a maximum period of 20 years.
 The rate of dividend on preference shares is fixed and dividend payment is mandatory in cases of sufficient
profits. The dividend is paid as a percent of face value of the shares.
 However, dividends paid on preference shares is a non-tax deductible expense and the company doesn’t
get any tax benefits on payment of preference dividends.
 Preference shares can be issued at par or premium, thus net proceeds changes accordingly.
 Also, redemption of preference capital may be done at par or premium, according to agreement with
preference shareholders.

Cost of Irredeemable Preference Shares (Kp) = Dividends * 100 OR Dividend * 100

Net Proceeds Mkt. Price

Cost of Redeemable Preference Shares (Kp) = Dividend + (RV – NP) / N * 100

(RV + NP) / 2
Where,
RV = Redeemable value on maturity
NP = Net Proceeds on issue
N = Life of redeemable preference shares
 Cost of Capital
d) Cost of Equity Share Capital (‘Ke’)
 Cost of equity shares can be defined as the rate of return expected by equity shareholders.
 Equity shares are issued to promoters, financial institutions and general public.
 Such shares can be issued at par or premium.
 Equity shares of public company are freely transferable.
 The dividend payout is not fixed, as well as rate of dividend not fixed.
 Also, dividend is a non-tax deductible expense and no tax shield is available to the company.
 The cost of equity depends purely upon the expectations of the shareholders. Shareholders’ expectations
and returns are reflected in market price per share.
 Any decline in returns results in adverse share price and vice versa. Since the dividend payment is not
mandatory cost of equity shares cannot be wholly based on dividends.
 The earnings of the company also influence the share price and hence the shareholders’ expectations.
 Thus there are manly two approaches used for computation of cost of equity, based on shareholders’
expectations, i.e. dividends and earnings, coupled with expected growth rate.

i. Dividend Price Approach: Here, cost of equity capital is computed by dividing the current dividend by the
market price per share. This dividend price ratio expresses the cost of equity capital in relation to what
dividend the company should pay to attract investors. However, this method cannot for units suffering
losses.
Cost of Equity (Ke) = DPS1 * 100
MP0
Ke = Cost of equity
DPS1 = Annual dividend
MP0 = Current Market Price per equity share

ii. Dividend Price Growth Approach: Earnings and dividends do not remain constant and the price of equity
shares is also directly influenced by the growth rate in dividends. Where earnings, dividends and equity
share price all grow at the same rate, the cost of equity capital may be computed as follows:

Cost of Equity (Ke) = (DPS1 * 100) + g

MP0
Where, g = annual growth rate of earnings of dividend

iii. Earning / Price Approach: According to this approach, the earnings of the company have a direct impact
on the market price of its share. Accordingly, the cost of equity share capital would be based upon the
expected rate of earnings of a company. The argument is that each investor expects a certain amount of
earnings, whether distributed or not from the company in whose shares he invests.

Cost of Equity (Ke) = EPS1 * 100

MP0
Where,
Ke = Cost of equity EPS1 = Earnings per share MP0 = Current Market price / equity share
 Cost of Capital
iv. Earnings Price Growth Approach: When earnings increase every year, it influences the market price per
share, and the same is considered in this approach. Since, dividends are recommended by the Board of
Directors and shareholders cannot change it. Thus, this approach concentrates on the actual strength of the
company, i.e. its earnings. So, cost of equity will be given by:

Cost of Equity (Ke) = (EPS1 * 100) + g

MP0

v. Realized Yield Approach: According to this approach, the average rate of return realized in the past few
years is historically regarded as ‘expected return’ in the future. The yield of equity for the year is:

Cost of Equity (Ke) = DPS1 + (MP1 – MP0) * 100

MP0
Ke = Actual yield for the year
DPS1 = Dividend per share expected at end of the year
MP1 = Market Price per share expected at the end of the year
MPo = Market Price per share at the beginning of year

vi. Capital Asset Pricing Model Approach (CAPM): This model describes the linear relationship between risk
and return for securities. The risk a security is exposed to, are diversifiable and non-diversifiable. The
diversifiable risk can be eliminated through a portfolio consisting of large number of well diversified
securities. The non-diversifiable risk is assessed in terms of beta coefficient through fitting regression
equation between return of a security and the return on a market portfolio. Thus, the cost of equity capital
can be calculated under this approach as:

Ke = E(r) = Rf + b x (Rm – Rf)

Where,
Ke = Cost of equity capital
Rf = Rate of return on security
b = Beta coefficient of systematic risk
Rm = Rate of return on market portfolio

Therefore, required rate of return = risk free rate + risk premium. The idea behind CAPM is that investors
need to be compensated in two ways - time value of money and risk. The CAPM says that the expected
return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected
return does not meet or beat the required return, then the investment should not be undertaken. The capital
asset pricing approach is useful in calculating cost of equity, even when the firm is suffering losses.

vii. Bond Yield plus Risk Premium Approach: This approach is a subjective procedure to estimate the cost of
equity. In this approach, a judgmental risk premium to the observed yield on the long-term bonds of the firm
is added to get the cost of equity. Generally, the risk premium is 5% over the before tax cost of debt.

Ke = Yield on long-term bonds + Risk Premium.

 Cost of Capital
e) Cost of Retained Earnings (‘Kr’)
Cost of Retained Earnings or Reserves & Surplus are generally taken as the same as Cost of Equity. This is
because reserves and surplus is the opportunity cost of dividends foregone by the shareholders. It is the rate of
return, which the existing shareholders can obtain by investing the dividends in alternative options.
Cost of Retained Earnings (Kr) = (DPS1 * 100) + g
MP0

Cost of Retained Earnings (Kr) = Opportunity Loss * (1 – brokerage rate) * (1 – tax rate)

f) Weighted Average Cost of Capital (WACC)

 WACC denotes the Weighted Average Cost of Capital. It is defined as the Overall Cost of Capital computed
by reference to the proportion of each component of capital as weights. It is denoted by Ko.
 WACC is the average cost of various sources of financing, i.e. cost of its capital structure.
 The proportion of the sources of finance forms the weights. The weights can be allotted using the book
value or market value. After-tax cost of the sources of finance is considered.
 Hence WACC = Sum of [Cost of Individual Components X Proportion i.e. Capital]

The following format may be adopted for computation of WACC:

Component Amount Proportion (%) Individual Cost Multiplication (Ki * Wi)

Debt Wl Kd Kd * W1
Preference Capital W2 Kp Kp * W2
Retained Earnings W3 Ke Kr * W3
Equity Capital W4 Ke Ke * W4
Total Ko = WACC = Total of above

Advantages of market values as weights:

a. Market values represent the opportunity cost.
b. It represents the present economic value of various sources of finance.
c. It is consistent with the definition of cost of capital i.e. the cost of capital is the minimum rate of return
needed to maintain the market value of the firm
d. Market value is the true reflection of the firm’s capital structure.

Disadvantages of market values as weight

a. Market values are not available in case of unlisted companies.
b. It is not reliable when shares are not actively traded (no purchase or sale of share)
c. Market price fluctuates frequently and is affected by speculations. (Manipulation of share prices)

Advantages of using book values as weight

a. The data is easily available i.e. the Balance Sheet data.
b. Calculations are simple
c. Fewer fluctuations in Book Value.
d. Useful when Mkt. price is not available, (unlisted company) or when the shares are not actively traded,
 Cost of Capital
Disadvantages of Book values as weights
a. Affected by accounting policies.
b. Does not truly represent the opportunity cost of capital.
c. Does not represent the present economic values of various sources of finance.

11. MARGINAL COST OF CAPITAL

 Marginal Cost of Capital (MCC) is the cost of additional capital introduced in the capital structure.
 MCC is the differential cost of capital between original capital structure and revised capital structure.
 It is derived when the average cost of capital is computed with marginal weights. The weights represent the
proportion of funds the firm intends to employ.
 When funds are raised in the same proportion as at present and if the component costs remain unchanged,
there will be no difference between average cost of capital and marginal cost of capital
 As the level of capital employed increases, the component costs may start increasing. In such a case both
the WACC and marginal cost of capital will increase. But marginal cost of capital will rise at a faster rate.
 
 
12. LIMITATIONS OF COST OF CAPITAL (WACC)

The determination of cost of capital suffers with a number of problems. Conditions are continuous changing in the
modern world, i.e. present conditions today may not remain static in future. Therefore, cost of capital which is
determined today, is dependent on certain conditions or situations which are subject to change. A form shall
continuous (annually) re-examine its cost of capital before determining annual capital budget.

Following are reasons for monitoring cost of capital –

 The firms’ internal structure and character change. For instance, as the firm grows and matures, its
business risk may decline resulting in new structure and cost of capital.
 Capital market conditions may change, making either debt or equity more favourable than the other.
 Demand-Supply funds may vary from time to time leading to change in cost of different capital components.
 The company may experience subtle change in capital structure because of retained earnings unless its
growth rate is sufficient to call for employment of debt on a continuous basis.

13.COST OF CAPITAL & ITS IMPLICATIONS IN BUDGETING DECISIONS

Investment decisions are directly related to financial decisions influenced by cost of capital. A company is always
eager to maximise return on investments. A company wants to reduce its cost of capital and yield highest returns.
Management needs to expands or diversify due to reasons such as –
 technological change requiring replacements,
 necessitating expansion or taking up new activities;
 competition strategies to avail of economic opportunities;
 short-term and long-term market forecasts with reference to sales, revenue proceeds, net profits etc.;
 incentives offered by the Govt. to promote investment in particular areas
 Cost of Capital
The management computes capital investments and correlates with the expected receipts (cash inflows) generated
from the activity through such investment. The optimum decision covers cost of financing such fund requirement.
Capital budgeting decisions are directly linked with the cost of capital. Before dealing with investment decision, it is
necessary to finalize the sources of capital and the cost of capital.

Cost of capital is used as the basis to evaluate investments whose cash flows are perfectly correlated with the cash
flows from the company’s present assets. Weighted average cost of capital represents an averaging of all risks of
the company and can be used to evaluate investments. Present value of an investment can be computed using a
weighted average cost of capital and this can be compared with present values calculated using the other discount
rates. Evaluation of capital investment projects requires some basis which could serve as the minimum rate of
return which a project should generate. In such cases, weighted cost of capital could serve as an accepted
discounting rate for evaluating investment decisions as no project will be acceptable which does not generate funds
equal or greater to the cut-off rate represented by weighted cost.