Learning objectives “afer studying this chapter, you are able to understand: | g Meaning of Cost of Capital | 5 Cost of Equity Capital considering Dividend Growth Model, Div idend Yield Model, | Pie Earning Model, and Capital Asset Pricing Model | Cost of Retained Earnings under Opportunity Cost Approach and Rights Offer | Approach Cost of Redeemable and Irredeemable Preference Share Capital | Cost of Redeemable and Irredeemable Debentures, Deep Discount Bonds, Convert | | ible Debentures and Term Loans | Calculation of Weighted Average Cost of Capital (WACO) of various sources of | | | finance | 2 Opportunity Cost of Capital and Marginal Cost of Capital and its importance in | pemneacttalanys stment appraisal | eo (16.1) Introduction The main objective of a business firm is to maximise ! the management should only invest in thos projets an ester e cts of the siness c deat of funds invesied in the roles ferent SOB eb The cost Thevatious sources of funds * the company are in the form of equity and eet evost “apital is the rate of return the company has to pay to varie rupee Soe un - 8 s ne ompany, There are variation in the costs of capital due to the fact that differe ssiment carry different levels of risk which is ‘ompensated for bY aterent evel of umon the investment: There are womain sources or MaptaforacompansParEnaS SS meters The providers of debt pala include debenttre that ned 0 e x The ctste of equity.and costs. of debbate H See ea ol Sela olen ination of cost of capital is Pasential for capital PUES get rate of return for IS used as the discount rate in NPV calculations am jhe wealth of its shareholders in the which give a return in excess "The difficulty will arise in 461‘ect’s Internal rate of return. Cost Te see ‘as the mininy, oe its i market value ta firm mustearn on its investments so that n value persharereyit Rh 1 tate of return ARR) method is used in the project apprain ‘the projectis compared with the cost of capital. It provides a yardstick to: Measur it a R of the Pretment proposal and thus performs the role of acceptor eject criterion, also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of rety korea yeturn et Cost of capital isthe minimum rate of return, a firm has to Pye aiaintain its market value and value of its shares. Cost of capital is to be determined to) oan ial decision making like acceptance of capital investment proposals, appraisal of _ profitability and viability of sub-units, restructuring of capital, raising of additional finane, Protect of capital is the minimum rate of return which consists of risk free return 4 premium for risks associated with the particular business. The risks of a business firm ean be categorised into (a) Business risk and (}) Financial risk. Business risk arises when there ie volatility in earnings of a firm due to changes in demand, supply, economic environment, ‘business conditions efc. Financial risk arises when the firm depends more on debt funds, Gave the payment of interest charges and repayment of principal amount is to be made in fie as per the loan obligations. Therefore, the business risk and financial risk associated ‘with a particular firm calls for payment of additional return to the providers of capital and Gebt, called as ‘risk premium The long-term funds requirement of the firms generally met from the following sources: (@ Equity Share Capital (ii) Preference Share Capital (ii) Retained Earnings (iv) Debentures and Bonds (v) Term Loans from Financial Institutions and Banks The firm will incur cost in using the said funds. The costs would be differing for different sources. It depends upon the rights and obligations of the firm, the rightsof providersoflons- ‘term funds, risks associated with the each source of finance, the expectations of the investors, market rates of return of different forms of finance, participation in management stability and growth of the firm, firm's ability in meeting financial obligations, personal taxation of investors, opportunity cost of funds etc. Cost of capital is the hurdle rate, if firm earns above its cost of capital can enable to maximise the firm's value as well a5 shareholders wealth. Therefore, a firm should accept investment proposals whose intern! rate of returnis above its cost of capital-Cost of capital acts as aminimum be shmarkreto 4 firm should earn enough profits to meet its cost of capital. The cost of capitelconst the following elements: ~ (a) Cost of Equity capital (K,) (B) Cost of Retained Earnings (K,) - (6) Cost of Preferred Capital (K,) " (d) Cost of Debt, includes both Debentures, Bonds and Term Loans (Ky). Th - funds required for the project are raised from the equity nature. These funds neednot be repayable during thelife time of th nce it is a permanent source of funds. The equity shareholders are yee of the company. The main objective of the firm is to maximise eit olders. Equity share capital is the risk capital of the company. Bi, c -well the ultimate beneficiaries are the equity shareholders Y vider the company and the capital appreeChapter 16 Cost of Capital and WACG 463 , less Suan dividends paid out to to the equity shareholders which a1 Roe funds should be itfdluded ti ihe iscussed separately from cost of equity ested i the company and therefore, those nested equity, the cost of retained earnings avery equity may be defined ag Sal, The Cost of equit ) ed as the minimum i hare capital fi a 7 rate of return js cor OF the oe y 28 capital financed portion of an adanten a company veipriceot theshares remain unchanged. The following methods are Re a that alculation: ageost OF equity. pwidend Yield Method di : y 6.2. jend per shareis expected on the current market price per share. As per this meth Z epofeabitalis defined as ‘the discount ratethatequates the rellih valid orale rredividends per share with the net proceeds of the sale (or the current market Hel | ie! This method is based on the assumption that the market value of equity sea ly related to the future dividends on those shares. Another assumption is that the future dividend per equity share is expected to be constant and the company is expected to shedivid eamat least this yield to keep the equity shareholders content, Dy — Po Where, K_ = Cost of equity capital D, = Annual dividend per share on equity capital in period 1 P. = Current market price of equity share Tismethod emphasises on future equity dividend expected to be constant. Itdoesnot allow for any growth rate. But in reality, a shareholder expects the returns from his equity ‘ivestment to grow over time. This approach has no relevance to the company. — Mstration 16.1 s, 30 on each equity sl diant Ld, is expected to disburse a dividend of Rs price of share is Rs, 80. Calculate the cost of equity capital 2° PST Jnare of Rs, 10. The current dividend yield method. Rs. 30 K, = —~ = 0375 or 375% y Rs. 80 ee 162 a es ings’ ted 10,000 equity shares of Rs. 10 each 2 premium of RS ze Ee _ Gaeane ate expenses of Rs, 5,000. The equity shareholders experts ere aia € cost of equity share capital. 3 Be ei ret price of share is Rs: 21? ye calculated as follows: em, of capital of it can be Pe ‘ €quity shares are newly issued, the cost Expected dividend per equ ey share of curment YS Net proceeds of each equity share ee= Expected dividend per equity share of current year ie Rs. 1.80 Current market price per equity share ie Rs. 21 1.80 é esl: ¢ Growth Model an will normally expect dividend to increase year after year and notte constant in perpetuity. In this method, an allowance for future growth in dividend edtothecurrent dividend yield. It is recognised that the current market price of ashare future dividends. This model is also called as ‘Gordon growth model” (For ed study please refer to Chapter 17 on ‘Dividend Policies and Value of Firm’), at = 0.0857 or 8.57% Bee ey bhurds 4 = Expected dividend per Equity share | = Current market price per equity share | és Peet ae _ = Growth rate by which dividends are expected to grow per ae ReienegncY eR at constant compound rate anh The dividend growth model is criticised on the following reasons: future growth pattern is impossible to predict because it will be inconsistentand be Svlansertalnty of future and imperfect information, only historic growers for prediction of future growth. é Only eostof equity capital, ignoring the cost of other forms of capitab my growth growth, depend onthe retained earnings of the company and the466 Part IN Capital Stivcture ani DNdend Decisions Ilustration 16.6 Bright Star Ltd, has its equity shares of RS 10 each quoted in stock exchange has market eek dnd a dividend of Rs. 3.60 per share hae beg 8 h rate o ie 56. A constant expected annual growth rate oo the for the current year. Calculate the cost of capit t oo Dd +B) - & ~ Py 3.60(1 +0086) , 4.95 = 00681 +006 = 0.1281 or 12.81% 56 Price Earning Method ia i es into consideration the e: earnings of the share and the earnings of ashare need not bein the form of dividend andalso Htmeed not be disbursed to the shareholders. It is based on the argument that even ifthe earnings are not disbursed as dividends itis keptin the retained earnings and it causes future growth in the earnings of the company as well as the increase in market price of the share, Tncalculation of cost of equity share capital, the earnings per shareis divided by the current market price. arnings per share (EPS) and the market price of ae —.* Where, E = Current earnings per share M_ = Market price per share Ilustration 16.7 Prabhat Ltd. has 50,000 equity shares of Rs. 10 each and its current market value is Rs. 45 each. The after tax profit of the company for the year ended 31st March, 2005 is Rs. 9,60,000. Calculate the cost of capital based on price/earning method. = Rs, 9,60,000 7 50000 equity shares ** 1920 ay = oe = 04267 or 42.67% M 45 , Capital Asset Pricing Model heed) The capital asset pricing model (CAPM) divid i ait ; n les the cost of equity into two components near risk-free return available on investing in government bonds and an additional "8 premium for investing in a particular share or investment, This risk premium in '& comprises the averagereturn on the overall market portfolio and the beta factor iss facto?) e particular investment. Putting this all together the CAPM asse cost of equity for an investment as the following Bore the, CAPM assets Sa kK, = R+8(R,-R) = Risk-free rate of return Average market return Beta of the investment fiChapter 16 Cost of Capital and WACG 487 : appropriate Reet, oat to ppply to the forecasted cashflows in an investment ne: PPrg the oppor unity eae of capital for that investment, The opportunity cost of a ihe expected ne sare offered in the capital markets for investments of a ear isk profile, eae Soo s on the risk attached to the investment's cashflows, (For gil ty lease refer to Chapter 10 on Capital Asset Pricing Model) és jon 16.8 Jon Lids sare beta factor is 1.40. The risk free rate of interest on government securities is 9. " rate of return on company e nt ed rate of rel pany equity shares is 16%, Calculate cost of e a a ee Beng model ares ulate cost of equity capital based ” K 9% + 1.40 (16% - 9%) = 9% + 1.40 (7%) 18.8% : A v Cost of Retained Earnings (K,) (16.3) theretained earnings is one of the major sources of finance available for the established companies to finance its expansion and diversification programmes. These are the funds cumulated over years of the company by keeping part of the funds generated without Geribution, The equity shareholders of the company are entitled,to these funds and these funds should also be taken into account while calculating the cost of equity capital. So long «stheretained profits are not distributed to the shareholders, the company can use the funds within the company for further profitable investment opportunities. Some argue that tetzined earnings are cost free funds available with the company, on which no return is payable: Theretained earnings are the distributable profits available for equity shareholders, Keptwith the company without distributing them in the form of dividends. If the retained camningsare distributed among equity sharcholders, the amount would have been reinvested team return onit. Therefore, the cost of retained earnings may be considered equivalent tothe return forgone by the equity shareholders and it is the opportunity cost of funds not auilable for reinvestment by the individual shareholders, In other words, the retained | earnings has the cost equivalent to opportunity rate of earnings forgone by the equity shareholders. Hence cost of equity includes retained earnings, But in practice, retained Fuungsare a slightly cheaper source of capital as compared to the cost of equity capital, relore,the cost of retained earnings is treated separately from the cost of equity capital, Opportunity Cost Approach : (16.3.1) aie of retained earnings to the shareholders is basically an opportunity cost of such fais to them, It is equal to the income that they would otherwise obtain by placing these ee alternative investment. The cost of retained earnings 's determine ab ee i on iheettunity rate of earnings of equity shareholders ‘which is being forgone continuous's 16 elained earnings are distributed to the equity shareholders attract persent ara dual shareholders and therefore, the cost of earnings is caleulated as follows: i indivic ea kK = Da-7) Cost of retained earnings = Dividend rate, 5 OTARRaNGTANS _= Tax rate of individuals i ie SSA naneaterh eam Ses i ion of individual - sa paid on equity share capital of Spectrum Ltd. is 24%, The personal taxation | *18 35%, Calculate the cost of retained earnings. 4 X= 24m (1-035) = 15.6%age Part! Capital Stuctue and Dividend Decisions i roach (16.3.2) Rights cit ove ‘ethin the organisation will add on to the networth of the company ang Retaining of profits wit ve rise in equity shares, According to rights offer approach the it results in increase of Pri Fits retained. Suppose i the company distributed theretaingy \ shareholder is entitle holders and again callback the money thro nes ivi to the equity profitsinthe form of a Gad 10 the individual shareholder attract personal taxation) Hight offer oe ina position to subscribe for rights offer only to the extent of ne ivi the company, If the retained earnings are kept within the company Becca Talibisd to ie extent of retained profits which will attract capital gaing ine Pi ne ndividualshareholder. Therefore, it willnot change the position of the shareholder aes her the retained profits are distributed among shareholders as dividends or keptit with Whe company. The following formula is used for calculation of cost of retained earnings, under rights offer approach, Da-T) PUT) = Cost of retained earnings = Dividend rate = Marginal tax rate on income of individual shareholder = Capital gains tax = Market price per share Mlustration 16.10 Danlaw Ltd. has paid an equity dividend of Rs. 3 per share. The market price of its equity share is Rs 25. The marginal tax rate being at 40% and capital gains tax being at 30%. Calculate the cost of retained earnings under rights offer approach, . DU-T) _ 3(1-040) 18 A =. =o a = 0.1029 10.2 P(I-T) — 25(1-030) 175 OS Where the equity shareholders have no tax liability, then the following formula is used for K: D Ferbane, cost of retained earnings is taken to be the same as market rate of capitalisation, due difficulty in ascertainment of tax rate of individual equity shareholders. v Cost of Preferred Capital (K, Ke = ‘The cost of preference share ea | financed investments, eholders., Iredeemable Preference Shares 1 of irredeemable preference shay ean iidend, ab? Geivon rate divided by net issue rimccers ee ot breterence daar pital is the rate of return that must be earned on preferene” to keep unchanged the earnings available to the equChapter 16 Cost of Capital and WACC 465 jet proceeds received from iss shares after meeting the issue peace ae : F ion 16.11 mus i 0,00,000 irred re elds LAG has issued -edeemable preference shar oe elprpe issue expenses are Rs. 15 per share Calculate See ae accom ” alae = 2h > = 0.1555 or 1555% of Redeemable Preference Shares (16.4.2) cost ofredeemable preference shares is calculated as follows: a ‘The Cost of preference shares Constant annual preference dividend payment Number of years to redemption “Ry = Redeemable value of preference 7 Sy = Sale value of preference shares less shares at the time of redemption discount and flotation expenses llustration 16.12 DellLtd. has Rs, 100 preference share redeemable at a premium of 10% with 15 years maturity, The coupon rate is 12%, Flotation cost is 5%. Sale price is Rs. 95, Calculate the cost of preference shares. " v 3 12 Neldtross 1333 _ 9.4333 or 13338 | 100 100 wm (16.5) (ee 2 Cost of Debt «,) Ss also. Debt may bein be capital structure of a firm normally include the debt component also. th 4 eae ae foo loans from financlalinstieule?s and banks ete The debt of inter s from jem, irrespective of the profitability of the creases its earnings through debt eases Mjusis available for equity vemembered that to be h i yropriation. ee ay a fixed rate of interest payabl 7 ae Since the coupon rate is fixed, the firm in ing. Then, after payment of fixed interest charges ™ An snppuanE ‘ iscalled “ax shield’, The tax shield is vieweg TH chia geared ‘To gain the full tax shield, the Tolowing cong [he company must be able to show a taxable profit every year to take full addvant © ofthe tax shield. Af the company makes loss, the tax s - Illustration 16.13 Ltd, has earned a profit before interest and tax of Rs, 2005. Calculate its profit after tax in the following situations: {@ The company has entirely financed its projet through issue of 3,00,000 equity shares of 1 each. {The company has financed its project through issue of 1,00,000 equity shares oF Rs, 10 each ang 20,000, 14% debentures of Rs. 100 each, ‘The company’s applicable corporate tax rate is 40%. hield goes down and cost of borrowing thera 6,00,000 for the year ended 319, March - ieee ze ; Situation T Equity share capital 30,00,000 14% Debentures a 30,00,000 Partigulars ee "Situation I Profit before interest and tax mS ai 6,00,000 Less: Interest charges : Profit after interest before tax “6,00,000 Less: Tax @ 40% 2,40,000 Profit after tax (PAT) 3,60,000 EPS _(PAT/No. of equity shares) Rs, 120 Rs. 192 ‘using the tax shield and ad: a 7 of i and advantage of fixed interest bearing funds in the capital structure, the EPS ‘he owners ie, equity shareholders is increased by Re. 0.72 (ie, Rs, 1.92 - Re 120) 3 Ina situation of loss making th : é ; ‘ increase the cost of debt. The Gene of tax shield and gearing cannot be gained. It will further on of ‘Cost of debt the following information eet SU ae (@) Net eash inflow from each source of debt and cost of raising debt. Payment and principal repayment on maturity. and Real Cost of Debt The are not compensated for eee eb wil be less shan the nial calculated in theet perpetual Debt recat of hee Ka — Costok debt 1 Annual inter ae Company's ef NP. stration 16.15 Steels: ventures is 5% of the total issu ofdeb. Toial issued amount Less; Flotation cost (Rs. 45,00,000 X 5/ 100) Net proceeds from issue ‘Annual interest charge 45,00,000 x 14/100 Rs. 6,30,000 1a-t) 6,30,000 ( 1 - 0.40) 3,78,000 = — — =— — = 0.0884 or 8.84% NP 42,75,000 42,75,000 Cost of Redeemable Debt (16.5.2) The cost of redeemable debt is calculated by applying the following formula: Rv - Sv i+ a-t) kK = ce Rv + Sv | 2 nt K, = Cost of debt aR T Annual interest payment * Ry = Redeemable value of debt at the timé of maturity | Sv = Sale value less discount and flotation expenses f N Number of years to maturity : . t = Company's effective tax rate | titration 16.16 nasa 2 es of Rs. 150 each ata discount | of ne inusties Lid. has raised funds through issue of 10,000 se sof Motation costs Rs. 5 et esl PEF debenture with 10 years maturity, "HS coupon rates 16 rporate taxation rates 0% Calculate g The debentures are redeemable with @ 10% premium: ta {the cost of debentures. perpetual debt (irredeemable debt) is calculated with the following formul ormula: Net proceeds of issue of debentures, bonds, term loans etc Ltd. has issued 30,000 irredeemable 14% debentures of Rs. 150 each. The cost of flotation Chapter 16 Cost of Capital and WACO 474 (16.5.1) ‘est payment fective corporate tax rate 1ed amount. The company's taxation rate is 40%. Calculate the cost (30,000 debentures X Rs. 150)1-040) ee) = = 0.108 or 10.8% ‘i 150 sised is certain of its redemption at the end of specified period, the cost of debt z ted on the internal rate of return (IRR) basis. ; capital can on 16.17 Machines Ltd, has issued redeemable debentures of Rs. 100 each repayable at the end of g ‘on a coupon rate of 14%. The flotation expenses is 10% of issue amount. Calculate the cost. Cash flow = DF. Rs) (@ 14%) 0 (20) 1.000 (90.00) Interest payments 14 4.639 64.95 Repayment on maturity! 100 0.351 35.10 10.05 ae 10.05 — a 1005 + 6.31 Bins tee ee olmaa tc = 16.46% 16.36 | Discount Bonds and Zero Coupon Bonds sbondsare issued at large discount and no interest is payable on them during their -At the time of redemption, the nominal value of the bond will be repaid to the +s, Calculation of cost of debt on these deep discount bonds is illustrated delow: paeetee! 5 years zero coupon bonds of Rs. 1,000 each at a price of Rs. 4 ne J Brae : on 319 e208 MBAR TE Sainsr oy i Enver AT gia sie. Me | Lwetitnsdot to $203 wets 25 = 131255Chapter 16 Cost of Capital and WACC 479 Convertible Debentures | ion of cost of fixed interest deber tte sain the following illustration. (16.5.4) ‘tures which are convertible into equity shares ost is 5% of the issue amount. Calculate inst of convertible debentures, te " Bie Soe aa Cash flow Discount BY Biseolint PY sulars ea Rs. @ 14% Rs. Rs. ' ilierpeceds (95.00) 1.000 (95.00) (95.00) [4 Interest less tax [I (1 - )] 8.40 2914 24.48 23.98 4 Conversion value (8 X Rs. 15) 120.00 0.592 71.04 68.64 "052 = 14+ = 14+018 = 14.18% 29 ae (16.5.5) Cost of Floating Debt me to time. In Now the companies are raising debt on a rate of interest thet ne iar =| Scie floating debt rate, a certain percentage of interest will be io ee dependingga Gama fixed rate of interest, the lender will charge extra rate of ne ks eepon ena Ravketand economic policies of the country. The commercial banks are now ens! Pais ling rate plus variable portion of interest thal vary from custome fet sound fenbi porton will act ike a risk premium. In case of ost thelending the ariable fompanies the variable rate will be lesser an a any raises from rae il te ere ean for floating debt rate is if a company i f interest onitsloanequal any will be payingarateo lesa sources 39%, The company will es ; Owtstever ras peas x ons an extra 3%. (This 3% is che toed ee Oe TABOR is 6%, the company pay’s 0% interest on its loan; s ers rate will fall to 89%. a a . a prime lending rate plus 4%. blasted Rs, 2 crores from a commercial bank on AMS og Callate ihe emcendng ate Ja bei is Late. The company’s COTPO pee x g rate of the ). - ae of debt raised from the bank. Te company Pays a rate of interest to the bank is eae = 12%+ 4% Srl St K, = 16% (1-040) = 9.6% Me og 1 ted Average Cost of Capital a : \ defines the weighted average cost of capit ty deberes, ba oan) eee a 2olof capital, weightingsQ site cost of capital and may be defined as th : atl oy ore Ria Walpted average cost of capital (WACC) is d ined z weighted average of the cost of various sources of finance, a being the market valueye each source of finance outstanding. Cost of various Heiter bi inance refers to the Teturn expected by the respective investors. A firm may procure long-term funds from ations sources like equity share capital, preference share capital, debentures, term loans ee, a different-costs depending on the risk perceived by the investors. When all these costs i different forms of long-term funds weighted by their relative proportions to get vera Composite cost of capital termed as ‘weighted average cost of capital (WACC): The fini, WACC should be adjusted for the risk characteristics ofa project for which the long-t funds are raised. Therefore, project's cost of capital is WACC plus risk adjustment factor. The argument in favour of using WACC stems from the concept that investment capital from various sources should be seen as a poo! of available capital for all the capital projects of an organisation. Hence cost of capital should be weighted average cost of capital. Financing decision, which determines the optimal capital mix, is traditionally made without makin referencetoWACC. Optimal capital structureis assumed at a point where WACCis minimum, For project evaluation, WACC is considered as the minimum rate of return required from project topay off the expected return of the investors and as such WACC is generally referred to as the required rate of return’. The relative worth of a project is determined using this required rate of return as the discounting rate. Thus, WACC gets much importance in both the decisions. Simple WACC The simple WACC is calculated without consideration to the impact of taxon, costof capital. The combined cost of equity capital and debt capitalis the WACC fora company as whole. If the company is all equity financed, the cost of equity will be the cost of capital. in ‘case of geared companies, the WACC can be stated as follows: WAGE = (Cost of Equity x WEquity) + (Cost of Debt X % Debs) IMlustration 16.21 ABC Ltd. has a gearing ratio of 40%. Its cost of equity is 21% and the cost of debt is 15%. Calculate the company’s WACC. - Ae oil WACC = (21% X 0.60) + (15% X 040) = 126 +6 = 186% - Illustration 16.22 ‘The required rate of return on equity is 16% and cost of debt is 12%, The firm has a capital structure mix of 608 of equity and 40% debt. What is the overall rate of return gf the firm should earn ? . “ te of return on equity funds - tate of return on debt funds ll rate of return required to earn by the firm (16 x 0.60) (12% x 0.40) 0,000 fue detteChapter 16 Cost of Capital anc 418 | yertible Debentures , ‘ ixed inter (16.5.4) jon of cost of fixed interest debentures which nap {n the following illustration. ich are convertible into equity shares pst 16.19 Ld. | has issued 14% convertible debentures of Res 100 each at par, Bach | sandals to Sequity shares of Rs. 10 each at a premium of Rs. 5 per shakers ebenie wl be spemibeendo 4 veer The corporate tax rate is assumed to be 40%, Assumi cea Boesame j : | ve that te | that the interest payments arise, The flotation cost is 54 of the issue omc ee Geeatof convertible debentures. : “ : a ods ee Cash flow Discount PV Discount Rs. @ 14% Rs. @ 15% Net proceeds (95.00) 1,000 (95.00) 1,000 (95.00), {4 Interest less tax [1 (1 - t)] 3.40 2.914 24.48 2.855 23.98 G Conversion value (8 X Rs. 15) 120.00 0.592 71.04 0.572 68.64 oe 052 NPV = 238 K, (16.5.5) CrstofFloating Debt Now the comp: i ies from time to time. In anies are raising debt on a rate of interest that varies a fing debt rate, a certain eentaee sf interest will be of fixed nature over and ae = inter & es ree extra rate of interest depending on the money, " Béirate of interest, the lender will charge extra ineres na _ Giistand economic policies of the country. The commercial Ta Site lus variable portion of interest that vary from cuslomes fey F te will act like a risk premium. In case of estal financially ts ski the lending the variable Tie wih ie Variablerate wil belesser and in caseriskis attached too ‘tceson term ing debt rate is if a comp: er Dr willbe paying araie uh nr 4 Tate LIBOR is, plus an extra 3%. (This 39% is the fixe eee sy c len ini othe company pays 9% interest on IS Joan; if LIBO u ate will fall to 8%. 0, 20 seaman tS “daa term loan of Rs. 2 crores from a commercial ae arnt | «itor tea ‘oF interest to the Bane) 0s ito 2 fe uuinaanaiieChapter 16 Cost of Capital ang Acc ATS ft cost of capital of a company is calculated in two way Lys. 2 weight of costs by the book value of the different forms of capital, ‘on weight of market value of each form of capital, Vi ¢ Funds and WACC ' yeue.” Vite.) l a vyalue approach is more realistic for the reasons given below: |, Thecost of funds invested at market prices is familiar with the investors, tments are generally rated by the reference to their i i tipany has a responsibility to maintain that yield, Cee Ee {Historic book values have no relevance in calculation of real cost of capital , The market value represents near to the opportunity cost of capital. js the discount rate that can be used to evaluate the company’s new investments, adedthatthey have the same risk profile as the company asa whole and provided that they ised the same combination. of debt and equity to finance the proposed investments, or funced by company reserves. (station 16.23, Juarath Cements Ltd. has the following capital structure: (Rs.lakhs) "Market values Book values Cost qty share capital 80 120 16 reference share capital 30 20 15 Til secured debentures 40 40 14 Gikie the company's weighted average cost of capital based on both market values and book Cost of individual sources of capital is net of tax. u NAGC based on Market Values Bee Market values Weight a (Rs. lakhs) 38 80 0.5333 eaiaial 30 0.2000 Mente 40 0.2667 1/0000476 Part Ill Capital Structure and Dividend Decisions Cost of equity capital = Cost of debt = Market value of equity capital = Market value of debt = Corporate tax rate i GOK, STE +B The simplified version of the above formula is given below WACC = (Cost of Equity x % of Equity) + [Cost of Debt (1 - Tax rate) x % of Deby} The percentage of equity and debt represents the gearing of the company. The tax rate ig corporate rate of tax payable by the company from profits. Mlustration 16.24 Good Health Ltd. has a gearing ratio of 30%, The cost of equity is computed at 21% and the cost of debt 14%. The corporate tax rate is 40%. Calculate WACC of the company WACC = (21% X 0.70) + [14% (1 - 0.40) x 0.30] = 14.70% + 2.52% = 17.22% Opportunity Cost of Capital (16.7) When an organisation faces shortage of capital and it has to invest capital in more than one project, then the company will meet the problem by rationing the capital to projects whose returns are estimated to be more, The firm might decide to estimate the opportunity cost of capital in other projects. Mlustration 16.25 Western Ltd. has got two project proposals A and B on hand with limited resources to take up one out Of it. The estimated return on capital employed of two projects are 15% and 18% respectively. The opportunity cost of capital for taking up Project A is 18%, since if the funds are invested in Project B, the company will get 18% return on invested funds, Hence expected opportunity cost of capital for Project A. Another approach to opportunity cost of cay that equates to the market interest rate { Hence, expected return on Project Bis the pital concept is that the expected rate of retum vile di i or investments of a similar risk profile. Whil iscounting therisky cash flows at different rates, the companies will take into considera? different risk premium for different types of investine spendi e nature © investment. This is usually in the form of premium on whan Pea ats company ost of capital. The opportunity cost of funds can be analysed from the following wwoaneles Opportunity Cost of Equity Funds Ifa company cannot earn sufficient profi , shareholders will be dissatisfied. The company will not be able to raise funds from new issue of SBaSr because investors will not be attracted, Existing shareholders who wish tosell their shares™ find that buyers, who can invest in whatever securities they choose, will offera comparatively Jow price, and the market price of the shares will be depressed Sree investors have 9 range of shares available to them there is a market opportunity cost of equity funds- Opportunity Cost of Debt Funds Financial mana, forinvestment, and investing those funds profitability ae 1 is not enough to invest at a profit, it is necessary to invest so that the profits are S4 icl is concerned with obtaining to maximise the value of the: an nds ful iChapter 16 Cost of Capital ana Wace, a A ers satisfactory amount of interest, Ifa company cat _ palo ded by lenders, the lenders will prefer to invest cleat, terest at the market ip eheyooneettbsrate Thereisa market opportunity cost of debt fund te, cai market, meq expect 10 PAY for new finance, Is wi oan yarginal Cost of Capital ‘ ci ‘eat _ans calculate cost of capital in order to determine a discount oe epee capital expenditure projects, The cost of capital is measured and oy an, theexpec i ital is measured and | ed benefits from the proposed projects, The marginal cost of “und tthe ee ihenext increments of capital raised by the firm. The costs of additional individual mnents of finance like shares, debentures, term loans etc. should be ascertained to {germineits weighted marginal cost of capital. The new capital projects should be accepted ifthey have a positive net present value calculated after discounting the revenue and cost reams at marginal cost of capital to the firm. Emphasis is being placed on marginal cost of capital, for itis used as a cutoff point for new investments, The concept of marginal cost of capitalisbased on economic theory that a firm should undertake a project whose marginal revenuesare in excess of its marginal costs. When the capital investment decisions are taken inconsonance of this principle, shareholder's wealth is maximised. The weighted average cost of capital (WACC) of the firm is not relevant for making new (marginal) resource location decisions. All the projects that have an internal rate of return greater than its marginal cost of capital would be accepted. Only when the returns of a particular project is inexcess of its marginal cost of capital, can add to the total value of the firm. The marginal cost of capital of additional finances of a new project will reflect the changes in the total weighted average cost of capital structure, after the introduction of new capital into the sxisting capital structure. ‘Investment Appraisal and WACC (1.2 Thecost of capital is a market determined rate of interest, and isthe discount rateorrequired fateof return which is used for discounting cashflows in investment appraisal calculating overall investment of a firm, in different projects can be invested, so long as its inte! Tate of return is above its WACC. nh a ee eh 088,