5S Cost of Capital (510139)

Chapter Five
Cost of capital
Cost of capital
Cost of capital is the cost of funds used for financing a business. 
From an investor's point of view " It is the minimum return that investors expect for
providing capital to the company.”
So Cost of capital is the minimum rate of return that a firm must earn on its
investment for the market value of the firm to remain unchanged.
Cost of capital depends on the mode of financing used – it refers to the cost of equity if the
business is financed solely through equity, or to the cost of debt if it is financed solely through
debt.

Significance of cost of capital in financial decision making

Cost of capital is considered as a standard of comparison for making different financial
decisions. Such importance of cost of capital has been presented below.
1. Making Investment Decision
Cost of capital is used as discount factor in determining the net present value.
Similarly, the actual rate of return of a project is compared with the cost of capital of
the firm. Thus, the cost of capital has a significant role in making investment as well as
financing decisions.

2. Designing Capital structure
The proportion of debt and equity is called capital structure. The proportion which
can minimize the cost of capital and maximize the value of the firm is
called optimal capital structure. Cost of capital helps to design the
capital structure considering the cost of each sources of financing,
investor's expectation, effect of tax and potentiality of growth.

3. Evaluating Firm’s Performance

Cost of capital is the benchmark of evaluating the performance of different
departments. The department is considered the best which can provide the highest
positive net present value to the firm. The activities of different departments are
expanded or dropped out on the basis of their performance.

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4. Formulating Dividend Policy
Out of the total profit of the firm, a certain portion is paid to shareholders as dividend.
However, the firm can retain all the profit in the business if it has the opportunity of
investing in such projects which can provide higher rate of return in comparison of cost
of capital. On the other hand, all the profit can be distributed as dividend if the firm has
no opportunity investing the profit. Therefore, cost of capital plays a key role
formulating the dividend policy.

5. Deciding about the Method of Financing

An efficient financial manager has a thorough knowledge of the capital market
fluctuation. The ultimate aim of the financial management is the wealth maximization.
In order to achieve these objectives, the financial manager finds the financing sources.
Apart from these, comparing the specific cost of different sources of finance, the
finance manager can select the most economical source of finance in a particular
situation.

Why cost of capital is considered as a hurdle rate for new

investment project?
Hurdle rate is the minimum rate that a company expects to earn when investing in
a project. Hence the hurdle rate is also referred to as the company's required rate of
return or target rate.
A company may apply it when deciding whether to undertake a project, or a bank when
extending loans. It must be equal to the incremental cost of capital. It is known as
the hurdle rate because the amount of return determines if the investor is “over
the hurdle” and ready to invest.

Components of cost of capital

The four components of cost of capital are:
1) Cost of borrowing ( Debt/Debenture/Bond/Bank Loan)
2) Cost of preferred stock
3) Cost of common stock/equity
4) Cost of retained earnings

1. Cost of Debt

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 5S Cost of Capital (510139)
The amount of interest which is paid against debt is called the cost of debt. It is the cheapest
source of capital and denoted by “Kd”.
Debt may be issued at par, at premium or discount. It may be perpetual or redeemable.
(a) Debt issued at par: The computation of cost of debt issued at par is
comparatively an easy task. It is the explicit interest rate adjusted further for the
tax liability of the company. It may be computed according to the following
formula:
i. Cost of debt before tax, Kd = Interest /Initial investment
ii. Cost of debt after tax, Kdt = Kd (1-t)
Where, Kdt = Cost of debt after tax
Kd = Cost of debt before tax , ie. Interest rate
T= Tax rate
The tax is deducted out of the interest payable, because interest is treated as an expense while
computing the firm’s income for tax purposes. So after tax cost of debt is the interest on debt
less tax savings.
(b) Debt issued at premium or discount : In case the debentures are issued at
premium or discount, the cost of debt should be calculated on the basis of net proceeds
realized on account of issue of such debentures or bonds. Such cost may further be adjusted
keeping in view the tax applicable to the company.
Cost of debt can be calculated according to the following formula:
Kdt= I(1-T)/NSV
Where,
Kdt    = Cost of debt after tax.
I        = Annual interest payment.
NSV   = Net sale value of bond / debentures.
T       = Tax rate.
Determining net sale value-
NSV= Sale value – Floatation cost
NSV= (FV+ Premium on issue) – Floatation cost
NSV= (FV- discount on issue) – Floatation cost
Floatation cost-
The costs incurred while issuing new share or bond of the company, these costs are called
floatation cost. Like-
o Legal fees

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 5S Cost of Capital (510139)
o Administrative expenses
o Brokerage and underwriting commission
o Documentation cost
o Printing prospectus cost

2. Cost of Preference Capital

In case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while
in case of preference shares, there is no such legal obligation. Hence, some people argue that
dividends payable on preference share capital do not constitute cost. However, this is not true.
This is because, though it is not legally binding on the company to pay dividends on
preference shares, it is generally paid whenever the company makes sufficient profits.
Moreover, the accumulation of arrears of preference dividends may adversely affect the right
of equity shareholders to receive dividends. This is because no dividend can be paid to them
unless the arrears of preference dividend are cleared. On account of these reasons the
cost of preference capital is also computed on the same basis as that of
debentures.
The method of its computation can be put in the form of the following :
In case of Perpetual Preferred stock (Irredeemable)
Kp=Dp/NSV
Where,
 Kp  = Cost of preference share capital
 Dp  = Fixed preference dividend
 NSV = Net sales value of preference shares.
If there is floatation cost then,
Kp= Dp/ P0-Floatation cost
In case of redeemable preference shares,
the cost of capital is the discount rate that equals the net proceeds of sale of preference shares
with the present value of future dividends and principal repayments.

3. Cost of Equity Capital

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The equity shareholders invest money in shares with the expectation of getting dividend from
the company. The company also does not issue equity shares without having any intention to
pay them dividends. The market price of the equity shares, therefore, depends upon
the return expected by the shareholders.
Conceptually cost of equity share capital may be defined as the minimum rate of return
that a firm must earn on the equity financed portion of an investment in a project in order to
leave unchanged the market price of such shares.
In order to determine the cost of equity capital, it may be divided into new equity and
existing equity.
The following are some of the variations of DDM according to which the cost of equity capital
can be worked out:
 Zero growth model
 Constant growth model
 Capital asset pricing model( CAPM)
(a) Zero growth model
The company with zero growth provides a constant amount of dividend perpetually,
that means no growth in dividend for an infinite period of time.. In this case the cost of
common stock will be calculated by using the following formula-
Ks = D0/P0
(b) Constant growth valuation model (Gordon Model)
This model assumes that the value of a share of stock equals the present value of all
future divedends ( which are assumed to grow at a constant rate) and it is expected to
provide for an infinite time horizon.
This approach rightly emphasizes the importance of dividends, but it ignores the fact
that the retained earnings have also an impact on the market price of the equity shares.
The approach therefore does not seem to be very logical.
In case of Existing common stock
The Maket price of equity can be determined according to the following formula:
P0 =D1/Ks-g
Where,
Ks= Cost of equity/ common stock;
D1= Dividend per share expected at the end of year 1;
g = Constant rate of growth in dividends.

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 5S Cost of Capital (510139)
So cost of equity can be found out from the following formula-
Ks = D1/(P0) + g
In case of new issue of common stock
The cost of new issue is determined by calculating the cost of common stock net of
underpricing and floatation costs.
In this case formula will be-
Ks = D1/(P0 – FC) + g
Here FC= Floatation cost
(c) Capital Asset pricing model
CAPM provides the framework for determining the equilibrium expected return for
risky assets. It describes the relationship between the required return, K s and non-
diversifiable risk of the firm as measured by the beta coefficient, b.
The basic CAPM is-
Ks = Rf + (Rm – Rf) b
Here, Ks = Cost of capital
Rf = Risk free return
Rm = Market rate of return, i.e; return on the market portfolio of assets.
Rf = Risk free rate of return
b = Systematic risk measured by Beta.
It normally describes the risk-return trade off for securities.
CAPM states that the required rate of return by investors is equal to the risk
free rate of return plus a risk premium determined by multiplying the beta
coefficient by the difference between the return on the market portfolio
and risk free rate.

CAPM can be shown in the following graph-

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CAPM vs Constant growth model
 CAPM directly considers firm’s risk, as reflected by Betam in determining the cost of
common stock.
But constant growth model does not consider risk, but the market price P 0 as a
reflection of risk return preference of investors in the market.
 Constant growth model can be easily adjusted for floatation cost to find the cost of new
common stock, but
CAPM doesnot provide such kind of adjustment mechanism.

3. Cost of Retained Earning

Retained earning is the earning of the firm which is not distributed to the shareholders as
dividend. It has opportunity cost.
The cost of retained earning is the same as cost of common stock.
So if there is no personal tax, then-
Cost of retained earning, Kr = Ks = D1/ P0 + g
Management should retain earning only if they can earn as much as shareholder’s next best
investment opportunity at the same level of risk.

Why returns of common stock is greater than the return on

preferred stock
Shareholders of preferred stock receive fixed, regular dividend payments for a specified period
of time, unlike the variable dividend payments sometimes offered to common stockholders. Of
course, it’s important to remember that fixed dividends depend on the company’s ability to
pay as promised. In the event that a company declares bankruptcy, preferred stockholders are
paid before common stockholders. Unlike preferred stock, though, common stock has the
potential to return higher yields over time through capital growth. Remember that
investments seeking to achieve higher rates of return also involve a higher degree of risk.
A disadvantage of preferred stocks is the lower yield compared with common stocks. This is
due to the reduced risk of the investment, which is linked to the company's
performance instead of the trading price.

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WACC
The weighted average cost of capital (WACC) is the rate that a company is expected to
pay on average to all its security holders to finance its assets.
The WACC is commonly referred to as the firm’s cost of capital. Importantly, it is dictated by
the external market and not by management. The WACC represents the minimum
return that a company must earn on an existing asset base to satisfy its creditors,
owners, and other providers of capital, or they will invest elsewhere.
Companies raise money from a number of sources: 
 common stock, 
 preferred stock,
 straight debt, 
 convertible debt, 
 exchangeable debt, 
 warrants, 
 options, 
 pension liabilities,
 executive stock options,
 governmental subsidies, and so on.
Different securities, which represent different sources of finance, are expected to generate
different returns. The WACC is calculated taking into account the relative weights
of each component of the capital structure. The more complex the company's capital
structure, the more laborious it is to calculate the WACC.

How WACC is calculated

The following steps are followed to calculate WACC-
1. Calculate the costs of all the sources of funds separately.
2. Find the portion of each financing source in the capital structure of the firm. This is
called weight, and the sum of total weight should be 1.
3. Multiply each cost with its weight and sum up to find WACC.
Firm’s cost of capital should be calculated on after tax basis.
So, WACC = (ws* Ks)+( wp * Kp)+ ( wd*Kdt) + (wr*Kr)
Where Ws+ wp + wd + wr= 1

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Ks= Cost of Common stock

Kp= Cost of Preferred stock
Kdt= Cost of Debt that is tax adjusted interest rate.
Kr= Cost of Retained earning
Ws= proportion of common stock on firm’s capital structure
wp = proportion of Preferred stock on firm’s capital structure
wd= proportion of Debt on firm’s capital structure
wr= proportion of Retained earnings on firm’s capital structure
Opportunity cost
The opportunity cost is the value of the best alternative foregone, where a choice needs to
be made between several mutually exclusive alternatives given limited resources. Assuming
the best choice is made.
It is the "cost" incurred by not enjoying the benefit that would be had by taking the second
best choice available.
opportunity costs are not restricted to monetary or financial costs: the real cost of output
forgone, lost time, pleasure or any other benefit that provides utility should also be considered
opportunity costs.
Example: If you have two choices - either an apple or an orange - and you choose the apple,
then your opportunity cost is the orange you could have chosen but didn't. You gave up the
opportunity to take the orange in order to choose the apple. In this way, opportunity cost is
the value o f the opportunity lost.

Marginal cost of capital

The marginal cost of capital (MCC) is the cost of the last dollar of capital raised,
essentially the cost of another unit of capital raised. As more capital is raised, the marginal
cost of capital rises. 
The marginal cost will vary according to the type of capital used. For example,
raising funds through the use of unsecured or subordinated debt, or
through debt that requires higher interest rates to offset risk, will be more expensive than debt
that is backed by collateral, such as a secured bond.

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Marginal Cost Of Capital And Investment Schedule
A company's marginal cost of capital (MCC) may increase as additional capital is raised,
whereas returns to a company's investment opportunities are generally believed to decrease as
the company makes additional investments, as represented by the investment opportunity
schedule (IOS). The following graph demonstrate the relationship between cost of capital and
investment returns. In the context of a company's investment decision, the optimal capital
budget is that amount of capital raised and invested at which the marginal cost of capital is
equal to the marginal return from investing. In other words, the optimal capital budget occurs
when the marginal cost of capital intersects with the investment opportunity schedule.

The relation between the MCC and the Investment opportunity schedule (IOS) provides a
broad picture of the basic decision-making problem of a company. However, we are often
interested in valuing an individual project or even a portion of a company, such as a division
or product line. In these applications, we are interested in the cost of capital for the project,
product, or division as opposed to the cost of capital for the company overall

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