COST OF CAPITAL sermon i INNA AAD IDOL [1] Introduction [2] Meaning of Cost of Capital 131 Significance of the Cost of Capital [4] Various Concepts of Cost Capital ())Specitie Cons of Capital for Various Sources of Finance [6] Cost of Debts (7) Cost of Prcterence Capital [5] Cost of Equity Capital (9] Capital Asset Pricing model {10} Cont of Ketsined Earnings (11} Weighted Average Cost of Capital (12) Iustrations Lxercise ‘1. | INTRODUCTION = The cost of capital is a very important factor to be considered in g the firm's capital structure. It is one of the bases of the theories cial management, Of Course, cost of capital is to a certain extent ‘able aspect of financial management. Yet it is a fact that before mining the capital structure a company is required to compute the Of capital of various sources of finance and compare them. On that © company decides which source of finance is the best and in the of the owners and even of creditors, In the past, the cost of capital was ignored and very litle attention was for taking decisions relating to capital budgets or for the investment of a big amount in Capital projects, cost of capital is idcly used for evaluating various sources of finance. In other words, cost ital is a decisive factor in financial decision-making, OF COST OF CAPITAL : | ‘wpoint of investors, cost of capital is the reward of ent of his present needs, so as to get a fair return on his ‘nt in future. But from the viewpoint of the company, the cost ital refers to the financial burden that a company has to bear in ng its business through various sources. If debentures with face of Rs. 100 are issued by a company at a market price of Rs. 90 and if the cost involved in its issue amounts to 2 per cent and if rate on this debentures is 15 per cent, the company concerned can * obtain 4 net amount of Rs. 88 only on which it would have to pay 15 Per Cent interest. Hence, the cost of borrowed capital would be of the of around 17 per cent (15 * 100/88). This means that if the company 18 its borrowed capital in any Project, with rate of return of less than 17 per cent, there will be an adverse effect on the market Price of ‘hares and the net wealth of shareholders will decline.B.S.SHAHPRAKASHAN | | The main responsibility of the financial manager is t te finance for the company. There are several sources of finance. It can be borrowed through the issue of debentures or through long-term loan, Additional equity shares can be issued or preference shares can also be issueg | for this purpose. The profits of the company can be retained and reinveste, in business, instead of distributing it among the shareholders. The burden off cost involved in each of these sources of finance is naturally different. It jg | this burden which is the main concern of the concept of cost of Capital, t Different definitions of the cost of capital will prove interesting gy ~ this point. ae i (1) According to Schall and Haley, ‘Cost of capital is the minimum | acceptable rate of return on new investments made by the firm from the viewpoint of creditors and investors in the firm's securities.’! (2) In the words of I. M. Pandey, ‘The cost of capital is simply the rate of return the funds used should produce to justify their use within | the firm in the light of the wealth maximisation objective.’? (3) Shree Khan and Jain are of the opinion that ‘the cost of capital is the minimum rate of return that a firm must earn on its investments for the market value of the firm to remain unchanged.’ (4) Hampton holds that, ‘Cost of capital is the rate of return which a firm requires from an investment in order to increase the value of the firm in the market place.’ (5) In the opinion of Solomon Ezra, ‘The cost of capital is the! minimum required rate of earnings or the cut-off rate of capital expenditure.” (6) According to Solomon and Pringle, “Cost of capital is the rate of return required by those who supply the capital’, To illustrate the point they say, if a cup of tea is available in a restaurant for Re. 1, then Re. 1 is the amount required by the restaurant owner in exchange fora cup of tea. Similarly, if cost of capital is 15 per cent, it means that those who provide capital to the company require 15 per cent per year in exchange for the use of capital. They ask for a 15 per cent rate of retutt because they know that if they divert their capital to some other investmen’ with an equal degree of risk, they can receive not more than 15 per cen return, Features : The above definitions give a clear idea of what the tert cost of capital means. The following features can be derived from @ analysis of the above definitions : Introduction to Financial Management : Schall and Haley, p. 181. Financial Management : I. M. Pandey, p. 164. Financial Management : Khan and Jain. An Introduction to Financial Management Senn + Solomon and Prinole.COST OF CAPITAL: 5 (1) In its ordinary meaning, cost of capital refers to the burden which a company has to bear in obtaining a definite type of capital. It includes the rate of interest on borrowed capital and the cost of issuing the debts etc. (2) In other words, meaning of the term cost of capital is the rate of return which the suppliers of capital demand from the company. That is it is the rate of return which they expect to receive. In case of debentures, the rate of interest payable on them is called the cost of capital. (3) In the context of new investments cost of capital indicated the } minimum rate of return that a company must earn, otherwise it cannot Maximise its wealth, (4) The minimum rate of return which must be received on new investment is that rate of return which maintains the markent value of the company. If the actual rate of return is higher than the minimum necessary rate of return, the value of the firm increases and value of its shares also goes up. If the actual rate of return is lower than the minimum necessary rate, the value of the firm and value of its shares also decline. (3. SIGNIFICANCE OF THE COST OF CAPITAL : The concept of cost of capital is important in financial management in many ways. Especially, it is useful in deciding the capital structure of a company. It has great significance in the field of financial management. Recently, increasing attention is being paid to it by the academicians, as also by the newly appointed finanical managers of the companies. In the past, the concept of cost of capital was neglected. Most of the economists took it for granted that cost of capital is not affected by the capital structure of a company. But at present this concept plays an important role in the determination of capital structure and in capital budgeting both. The significance of the concept of cost of capital will be clear from the following : (1) For Capital Budgeting Decisions : The concept of cost of capital helps in making financial decisions. Specially, in case of capital budgeting, it is used as a decision criterion in capital decision. If the present value of cash flows of the project is greater than the present value of investment in it, the project would be accepted. The rate of discount that is used to calculate the present value of future cash flows of the project is nothing but the cost of capital. Thus, cost of capital is the minimum rate of return required on investment projects. It is the rate of discount which is used to evaluate the profitability of an investment project. Thus, minimum rate f return of an investment project cut-off rate, target rate and hurdle rate are ll synonyms used for the cost of capital. Fi ae If the investment project is to be evaluated on the basis of an internal ate of return, the project will be acceptable when the internal rate of return xceeds the cost of capital.(2) Maintaining Market Value of Shares : An important decision inthe field of financial planning is concerning maximisation of the equity harcholders' wealth. For the maximisation of equity shareholders’ wealth, it is necessary that market value of shares are maintained at a high level, The cost of capital is in fact that minimum rate of return which ‘maintains the market value of shares as its curtetit level. If a company succeeds in raising its earnings the market value of its shares would naturally move above this level: Thus, cost of capital serves as a criterion which helps in optimum utilisation of company's financial resources. (3) Helps in Designing Capital Structure : A proper capital structure can be built with the help of the concept of cost of capital. The lowér the cost of capital, the stronger can be the market value of the firm. That is, they can move towards the goal of wealth maximisation. Hence, the capital structure should be planned in such a manner that cost of capital is minimised. This will raise the market value of the firm. (4) Issue of New Securities : If an investment scheme is found profitable, it may be necessary to issue new securities to raise money for this investment scheme, The concept of cost of capital provides guidance in deciding which type of securities should be used for this purpose. For taking such decisions the following must be taken into consideration : the nature of existing capital structure, the cost of capital of different sources of finance, the effect on aggregate cost of capital when money is raised through debts instead of equity shares etc. How to raise the required finance can be decided on the basis of the information about cost of existing capital and that of raising additional capital. (5) To Evaluate the Performance of Top Management : The concept of cost of capital is helpful also in evaluating the financial performance of the top management. For this purpose, actual profitability of the new scheme of investment is to be compared with the projected overall cost of capital, and actual cost incurred in raising required funds is also to be assessed. : (6) Financial Decisions : The concept of cost of capital is important in many other areas of financial decision making such as dividend decisions, working capital policy, capital budgeting decisions etc, The decision about dividends to be taken on the basis of the amount of profit that is to be reserved in the company, and the amount of reserves depends on the relation between its capital cost on the one hand and possible rate of return if it is invested in busin on the other, [4 [VARIOUS CONCEPTS OF COST OF CAPITAL The meaning of cost of capital given above is a general meaning. It facty there are various concepts of cost of capital which are relevant for different Purposes. Some of these concepts are discussed below :(1) Future Cost and Historical Cost : Historical cost is the cost of capital Taised in the past, while future cost is the cost of capital to be raised in furture, Tt is the future cost of capital which is significant in making financial decisions, For example, while making capital investment decisions, a comparison is made between the rate of return of the investment, and the cost of funds to be Taised to finance it. In other words, it is the future cost of capital which js relevant in decision making. Historical costs’are important in that they help in predicting the future costs, (2) Specific Cost and Combined Cost : There are various sources of finance such as equity shares, preference shares, debentures and long term loans. These are called components of capital. The cost of each of these components of capital is called specific cost. For example, if the cost of raising funds through debentures is 15 per cent, then 15 per cent is the specific cost of debentures, If the concept of specific cost of capital is used, the cost of capital of a Project would be assessed on the basis of specific cost of various sources of finance used to raised funds for it. But when the cost of raising funds from all sources is considered jointly, it is known as composite or combined cost of capital. It is called weighted average cost of capital also. It is the combined cost’ of capital which is significant in measuring the profitability of an investment scheme. (3) Average Cost and Marginal Cost : Average cost is the weighted average of all specific costs of various components of capital used. The weights assigned to different components of capital are according to their Proportions in capital structure. The marginal cost is the average cost of additional funds raised for a new investment scheme, For most of the financial decisions and for capital budgeting purposes, it is the concept of marginal cost which is more important. Here too, a distinction can be made between the specific average cost of additional capital and total marginal cost for the company as a whole. If additional funds are to be raised through debentures, the cost of debentures is called marginal cost, while the average capital cost incurred when these additional funds are raised through different sources is known as total marginal cost. In capital budgeting decisions, the concept of total marginal cost is more useful. bi ; (4) Explicit Cost and Implicit Cost : The explicit cost of any source of finance is the rate of discount which equates the present value of its cash inflows with the present value of its cash outflows. For example, if a company decides to issue debentures to ra ise Rs, 5,00,000, The cash inflow to the company will be Rs. 5,00,000. If rate of interest is {0 per cent and if debentures are of seven years’ duration, the annual cash outflow will be Rs. 50,000 and payment of the principal sum of Rs. 5,00,000 at= i ete meee Seventh year will also be a cash outflow, een tres with ih 'scount which equates the present value of all nese i ows '¢ present value of cash inflow of Rs. 5 lakhs. 7 According to this interpretation the explicit cost of an interest free loan will be nil, while the explicit cost of a loan carrying interest, will © equated to that rate of discount which equates the cash receipt with the present value of the future interest payments plus the payment of the Principal amount of the loan. The explicit cost of a free gift will be 100% because neither interest nor principal amount is to be paid in this case, Implicit cost refers to the rate of return associated with the best alternative investment opportunity that will be foregone if the project under consideration by the firm were accepted. Thus, when investible funds have alternative uses, the firm has to choose between them. The implicit cost of the choosen investment scheme is the rate of return on the best alternative that the firm has to sacrifice. Implicit cost arises when funds are invested in a particular project. (5) Spot Cost and Normalised Cost : Spot cost is that rate which is Prevailing in the market at a certain point of time when a financing decision is to be taken involving appraisal of alternatives, Normalised cost is that cost which is found out by some averaging process so that cyclical element 1s removed from it. | 5, | SPECIFIC COSTS OF CAPITAL FOR VARIOUS SOURCES |“ OF FINANCE : Costs of various sources of finance are computed, measured and compared while making investment decisions. Capital is raised through that source which is most economical and the cheapest. Of course, the main question is how to measure cost of various sources of capital. In fact, there is no fixed or definite method of measuring cost of capital. It mostly depends upon the forecasts or assumptions and it is likely that errors may be there. Of course, while computing costs of capital, various factors such.as requirements of the company, the circumstances under which the company raises capital, the constraints of company policy etc. In fact, the company raises capital through various sources and a composite cost of capital is determined after ascertaining specific costs of various sources. It suggests that specific costs of various sources is a base for determining average cost of capital. A copany can raise funds from various sources Such as debentures, Public deposits, long-term loans, preference shares, equity shares and retained earnings. It is very difficult to assess the cost of capital in respect of each of these sources of funds, because it requires us to make certaill assumptions, Yet it is essential to determine the specific cost of each source of funds to arrive at the aggregate cost of capital. Let us consider the specific cost of capital with respect to the following :(1) Cost of Debts (2) Cost of Preference Capital (3) Cost of Equity Capital ‘ (4) Cost of Retained Earnings. S| COST OF DEBTS : | ) Cost of Perpetual Debt : i tah | It is relatively easy to calculate the cost of perpetual debt (which is lot repayable at a certain date in future) because the rate of interest on is given and is fixed. The cost of debt is the interest rate specified at € time of incurring debt or issuing the debentures. Of course, the mpany must have received the full amount of debentures issued. In fact, fe cost of the debt.is defined as the required rate of return that debt vestment must yield to protect the shareholders’ interest. A company issues 10% debentures to raise Rs. 5,00,000 at par, Iculate the cost of debt. f Solution : Interest 1 Cost of Debt (K,)= ‘Amount of Principal x 100 [K,= px 100) 50.000 K, = 5,00,000 * 100 I = Interest, annual = 10% P = Net amount received K, = Cost of debt OR Some authors use the following formula, where total interest and total oceeds are not included, but the calculation is based on rate of interest id net proceeds of one debenture only. 1 K. = p * 100 Where I = Interest per debentue 10 P = Net proceeds of debenture Ky = Joo * 100 = 10% Impact of Tax : Of course, this is cost of debt before tax. If tax taken into consideration, the cost of debt would be less than this: Because terest paid on debt is tax deductible; which reduces the tax liability of company. If, for instance, the tax rate is 50% and company's profit ounts to Rs. 1,50,000 the gain to the company in the form of lower liability would be as follows : (i) If no interest is to be paid, the profit after tax would be Rs. 75,000 50% of its total profit of Rs, 1,50,000, i.e. Rs. 75,000 would have to paid to the Government by way of tax.UI) But if the comps have to pay 50% of its remainin; . 8 Profit of R, 00 b neue ae after tae would be Rs. 50, 000 _ even, after Ay declines by Rs. 25.000 one out 408s not decline by Rs. 50,000. Brn’ the actual burden on the oe interest on debentures is tax decluctbie after tax is lower than Meare Of Rs, 25,000. Hence, cost of dey follows’: Of capital before tax. It can be calculated a Cost of debt after tax K-10 -jokK(-t Where, 1 = Interest payable t tax rate Using the above example, Cost of debt after tax K, = 100 - 0.5) 10 x 0.5 fx = 3% It 1S Important to remember here that this gain accrues only to those companies which make profit and pay tax on it. This benefit is not available to the company, which does not make Profit and therefore pays no tax. Cost of Floatation : Certain costs are to be incurred to issue the shares or debentures. The examples are the cost of printing prospectus, legal expenses, advertisement cost, underwriting commission, brokerage etc. To the extent these costs are to be borne, the company receives a smaller amount of money. Yet, it has to pay a fixed rate of interest on a smaller sum, which’ raises the cost of debt. If in the example given above, the floatation cost of debt is 5%; the company would receive a net proceeds of Rs. 95 only on each debenture of Rs. 100 and the interest on it being 10%, the actual cost of 0 100 5 debt would amount to 10.53%. (10 * G5 7 (1053 Debt Issued at a Premium or Discount : The debentures may be issued at a premium or at a discount. If they are issued at a discount, the company receives a smaller amount than the face value of the debentures and hence, the cost of debt goes up. If they are issued ata premium, the company receives a larger amount than the face value of its debentures and hence cost of debt goes down. ion 2 a aes has issued 5,000 10% debentures of Rs. 100 each. Tg rate is 50%. Calculate the cost of debentures under following circumstan (i) If they are issued at a discount oe (ii) If they are issued at a premium 0! h. = — c; discount of 10%’ (1) If they are issued af 2 Corey x Rs. 100 = 5,00,000 - 10% Net amount of debentures Rs. 4,50,000COST OF CAPITAL Cost of debt before tax « te £ _Rs.50,000 : p * 100 = 377.50,000 * 100 = 11.11% ax cost of d a After tax’ cost of debt (Ki): =: Coat of “adie before tax x (1 ~ +) = Ka - = 111% (1 = 9,5) - = S:55% (ii) If they are issued at a Premium of 10% 3 Rs. 50,000 Cost of Capital Before tax (K) = Rs. 5,50,000 * 100 = 9.09% After tax Cost of Capital (K) = 9.09 x (1 - 0.5) = 4.54% Illustration 3 = | A company has issued 10% perpetual debentures of Rs. 100 each to raise Rs. 5 lakhs. The tax rate is 55%. Calculate the cost of debentures under following circumstances : If they are issued (i) at par (ii) at a premium of 8% (iii) at a discount of 8%. {Solution =] We shall use the above formula for these three situations k= 5-9, Where, I = Rs. 10 P = Net amount received t = Rate of tax 0.55 (i) If debentures are issued at par : P = Rs. 5,00,000 Total Proceeds; | = Total Interest = Rs. 50,000 Rs. 50,000 Cost of Debt = Ro 300, 5,00,000 (1-.55) 10 x 0.45 = .045 = 4.5% ii) If debentu are issued at a premium of 8% : Pe 5,00,000 + plain 8% = Rs. 40,000 premium + 5,00,000 = Rs. 5,40,000. 100 ——— - 55, 40,000 ( , 5 = | 45) 093 x .45 | | Cost of Debt = | 0418 = 4.18%. | |ey TAHT PRAKASHAN (iii) 1f debentures are issued % + ies at a discount of 8% ? P = 5,00,000 ~ 8% discount Rs. 40,000 = Rs. 4,60,000 Cost of debt = 22200. be 4,60.000 (1-55) 5 i o AS qe (45) = 109% * = 049 = 4.9% Mlustration 4 : | A company issued 10,000 15% Irredeemable debentures of Rs. The company paid following floatation charges : Underwriting commission 1.5%, brokerage 0.5% and other charges Rs. 10,000. If the tax rate is 50%, Calculate the cost of debentures under the following circumstances : (i) If they are issued at par 100. | (ii) If they are issued at a discount of 10% (iii) If they are issued at a premium of 10% Solution = (1) If they are issued at par : K,- 30-9 Where, I = Rs. 1,50,000 P = 10,000 (Rs. 100 — Expenses) 150,000 K, = F900 (1 - 05) = 10,000 (100 - 3) = 9,70,000 = .1546 (0.5) | Rate of tax 50% 0.1546 x 0.5 t = 0.0773 = 7.73% (ii) If they are issued at a discount of 10% : 10 — Expenses Rs. 3 Here, P= Rs. 100 — Discount Rs. = Rs. 87 x 10,000 = Rs. 8,70,000 Ky, =p 0-9 1,50,000 = $70,000 (1 - 9) = 17.24 x 0.5 = 8.62% f 10% = (iii) If they are issued at a premium 0 : Here, P = Rs. 100 + Rs. 10 premium Expenses Rs. 3 = Rs. 107 x 10,000 = Rs. 10,70,000 kK, =p 0-9COST OF CAPITAL, 13 150,000 10.70,000, C= 0.5) 14.02 x 0.5 7.01% | (B) Cost of Redeemable Debentures If the debentures are redeemabl be returned within a particular the following formula : » that is, its pring; . Principal amount is to Period, the cost of debt is calculated by Cost of Capital Before tax = {8+ %) 5 +P) 2 Where, R = Rate of interest F = Face Value of Debenture P= Net Proceeds of Debenture Here, X = Average annual Premium or discount, If premium is Rs. 5 and is repayable after 5 years, aint then annual average premium is Re. 1. X= 4 (F-P) = + (Rs. 100 — 105) = — Re. 1 Where, n = Number of years R+ + py Combined formula = a ee are 2 Where F = original price (Face Value) Net proceeds of debenture Number of years of maturity Rate of interest on debenture Remember : This formula is to be used only when the principal amount of the debentures is to be repaid at a fixed point of time. ration 5 A company issued seven year 10% debentures at a price of Rs, 93 to raise Rs. 5,00,000. The face value of the debentures is Rs, 1Q9, The tax rate is 50 per cent. Calculate the post tax €ost of this issue. hae (100 ~ 93) =o «7 1 = (R+X) Before tax cost of debt (K,) = Ton Tipe) 2 i} ax &— {0+ 1 = tt) 5 (100 + 93) ell a 19372 ~ 965 = 114 OR 11.4% After tax cost of debt-(K,) = K (1 ~ 1) 11.4 (1 = 0,5) = 5.7% In we do not want to calculate Before tax and After tax cost of capital separately, we can use the following formula : ~ =) (R+ X) FEHR) Wow After tax cost of capital (K. A} _ (= 05) (10 +) $ (loo + 93) _ 050*11 "965 = 5.1% 96.5 Illustration 6 : A company issued 10% debentures of Rs. 100 each at par. The debentures are to be repaid after 10 years. These debentures are floated at their face value, but the cost of floatation comes to 4 per cent. The tax rate is 55%. Calculate the cost of debt. Solution : First, let us calculate the values to be used in the formula. R = Interest per debenture = Rs. 10, F = Face value = Rs. 100 P = Net proceeds = Rs. 96 (Rs. 100 — Rs. 4, floatation cost) 1 1 aoe X= 7. (F- P) = jg (100 - 96) = jg = 0-4 _ (R#X) _ (10 + 04) Now before tax cost of debt = lp ”) Loo +96) 2 2 x - 224 = 0.1061 OR 10.61% 1-98 P pe =K0~-9 After tax cost of debt K) = KET 55) = 10.61 * 0.45 = 4.77%