Module 3

Cost Of Capital
 INTRODUCTION
2

 The project’s cost of capital is the minimum

required rate of return on funds committed to the
project, which depends on the riskiness of its cash
flows.

 The firm’s cost of capital will be the overall, or

average, required rate of return on the aggregate of
investment projects
 THE CONCEPT OF THE OPPORTUNITY COST OF
CAPITAL
3

 The opportunity cost is the rate of return foregone on the next

best alternative investment opportunity of comparable risk.

 Opportunity cost of capital is given by the following formula:

 where Io is the capital supplied by investors in period 0 (it

represents a net cash inflow to the firm), Ct are returns
expected by investors (they represent cash outflows to the
firm) and k is the required rate of return or the cost of capital.
 Weighted Average Cost of Capital vs. Specific
Costs of Capital
4

 The cost of capital of each source of capital is known as

component, or specific, cost of capital.
 The overall cost is also called the weighted average cost of
capital (WACC).
 Relevant cost in the investment decisions is the future cost or
the marginal cost.
 Marginal cost is the new or the incremental cost that the firm
incurs if it were to raise capital now, or in the near future.
 The historical cost that was incurred in the past in raising
capital is not relevant in financial decision-making.
 COST OF DEBT
5

 Debt Issued at Par

INT
kd  i 
P
 Debt Issued at Discount or Premium
INT
kd  i 
NP / SV
 Tax adjustment

After  tax cost of debt  kd (1  T )

 COST OF REDEEMABLE DEBT
6

 Before Tax

INT 1 / n( RV  SV )
kd 
1 / 2( RV  SV )

 After Tax

INT(1  t )  1 / n( RV  NP)
kd 
1 / 2( RV  NP)
 EXAMPLE
7

a) X Ltd issues Rs 50,000 8% debentures at par. The tax rate

applicable to the company is 50%. Compute the cost of debt capital.

b) Y Ltd issues Rs 50,000 8% debentures at a premium of 10%. The tax

rate applicable to the company is 60%. Compute the cost of debt
capital.

c) A Ltd issues Rs 50,000 8% debentures at a discount of 5%. The tax

rate applicable to the company is 50%. Compute the cost of debt
capital.

d) B Ltd issues Rs 100,000 9% debentures at a premium of 10%. The

cost of floatation are 2%. The tax rate applicable to the company is
60%. Compute the cost of debt capital.
-> NP = 110,000 - (.02x110,000)
 EXAMPLE
8

A company issues Rs 10,00,000 10% redeemable debentures at

a discount of 5%. The cost of floatation amount to Rs 30,000.
The debentures are redeemable after 5 years. Calculate
before tax and after tax cost of debt assuming a tax rate of
50%.
-> RV = 10,00,000
-> NP = (10,00,000-50,000-30000)

A 5 year Rs 100 debenture of a firm can be sold for a net price

of Rs 96.50. Coupon rate of interest is 14% and it will be
redeemed at 5% premium on maturity. The tax rate is 40%.
Compute after tax cost of debenture.

-> RV = 105
-> NP = 96.5
 EXAMPLE
9

Assuming that a firm pays tax at 50% rate, compute the after tax
cost of debt capital in the following cases:

a) A perpetual Rs 100 bond sold at par, coupon rate being 7%

b) A 10year, 8% Rs 1000 bond sold at Rs 950 less 4%

underwriting commission.
-> Redeemable Or Irredeemable
-> RV = 1000
-> NP = 912
 COST OF PREFERENCE CAPITAL
10

 IrredeemablePreference Share
PDIV
kp 
NP
 Redeemable Preference Share

MV  NP
D
Kp  n
1
( MV  NP)
2
 Example
11
 Example
12

A company issues 10,000 10% Preference Shares

of Rs 100 each. Cost of issue is Rs 2 per share.

Calculate the cost of preference shares if it is issued

A) at par
B) at a premium of 10%
C) at a discount of 5%
 Example
13

A company issues 10,000 10% Preference Shares

of Rs 100 each redeemable after 10 years at a
premium of 5%. Cost of issue is Rs 2 per share.
Calculate the cost of preference share capital.
MV  NP
D
Kp  n
1
( MV  NP)
2
-> MV = 10,50,000

-> NP = 980,000
 Example
14

A company issues 1000 7% Preference Shares of

Rs 100 each at a premium of 10% redeemable after
5 years at par. Calculate the cost of preference
share capital.
MV  NP
D
Kp  n
1
( MV  NP)
2
-> MV = 100,000

-> NP = 110,000
 COST OF EQUITY CAPITAL
15

 a) Dividend Yield Method:

DIV1
Ke 
NP

DIV1
Ke 
MP

 b) Dividend Yield Plus Growth:

DIV1
Ke  G
NP
 Example
16

 A company issues 1000 Equity Shares of Rs 100 each at a premium

of 10%. They have been paying 20% dividend and will continue to
do so. Calculate the cost of equity share capital. Will it make any
difference if the market price is Rs 160?

DIV1 DIV1
Ke  Ke 
NP MP

a) Ke = 20/110 = 18.18%
b) Ke = 20/160 = 12.5%
 Example
17

 A) A company issues 1000 Equity Shares of Rs 100 each at par.

Floatation cost are expected to be 5% of the share price. They have
been paying Rs10 dividend per share and the growth in dividend is
expected to be 5%. Calculate the cost of equity share capital.
->NP = (100-5) DIV1
Ke  G
NP
 B) If the current market price is Rs 150, calculate the cost of equity.

->MP = 150
DIV1
Ke  G
MP
 COST OF EQUITY CAPITAL
18

 Earnings–Price Ratio and the Cost of Equity

EPS1
ke 
P0
 Example: EPS
19

A firm is currently earning Rs 100,000 and its share is selling

at a market price of Rs 80. The firm has 10,000 shares
outstanding and has no debt. The earnings of the firm are
expected to remain stable, and it has a payout ratio of 100 per
cent. What is the cost of equity?
 We can use expected earnings-price ratio to compute the cost
of equity. Thus:
 THE CAPITAL ASSET PRICING MODEL (CAPM)
20

 Asper the CAPM, the required rate of return on

equity is given by the following relationship:

ke  R f  ( Rm  R f ) 
 Equation requires the following three parameters
to estimate a firm’s cost of equity:
 The risk-free rate (Rf)
 The market risk premium (Rm – Rf)
 The beta of the firm’s share ()
 Example
21

 Suppose in the year 2012 the risk-free rate is 6 per

cent, the market risk premium is 9 per cent and beta
of L&T’s share is 1.54. The cost of equity for L&T
is:
 Example
22

 1) T-Billreturn is 8%, Systematic risk of ABC Ltd

is around 1.125 and Market/Index return of 12%.
Calculate the cost of ABC equity.

 2) T-Billreturn is 10%, XYZ ltd Beta is 1.10 and

Index return is of 18%. Compute the cost of equity.
 THE WEIGHTED AVERAGE COST OF CAPITAL
23

 The following steps are involved for calculating the firm’s WACC:
 Calculate the cost of specific sources of funds
 Multiply the cost of each source by its proportion in the capital
structure.
 Add the weighted component costs to get the WACC.
ko k d (1  T ) wd  ke we
D E
ko k d (1  T )  ke
DE DE
 WACC is in fact the weighted marginal cost of capital (WMCC);
that is, the weighted average cost of new capital given the firm’s
target capital structure.
 The Cost of Capital for Projects
24

 For example, projects may be classified as:

 Low risk projects
discount rate < the firm’s WACC
 Medium risk projects
discount rate = the firm’s WACC
 High risk projects
discount rate > the firm’s WACC
 Example
25

 Source Of Funds:
Debt - 15,00,000 - 5% cost
Preference Share - 12,00,000 - 10% cost
Equity Shares - 18,00,000 - 12% cost
Retained Earnings - 15,00,000 - 11% cost
Total - 60,00,000

Solve Weighted Average Cost Of Capital.

 Example
26

 Source Of Funds:
Debt - 18,00,000 - 10% cost
Preference Share - 22,00,000 - 14% cost
Equity Shares - 18,00,000 - 12% cost
Retained Earnings - 10,00,000 - 10% cost
Total - 68,00,000

Solve Weighted Average Cost Of Capital.

 27

CAPITAL STRUCTURE
Capital Structure Theories:
28

 Net operating income (NOI) approach.

 Traditional approach and Net income (NI)

approach.

 MM hypothesis with and without corporate tax.

 Miller’s hypothesis with corporate and personal

taxes.
 Net Operating Income (NOI) Approach
29

 According to NOI approach

the value of the firm and the
weighted average cost of
capital are independent of
the firm’s capital structure.
In the absence of taxes, an
individual holding all the
debt and equity securities
will receive the same cash
flows regardless of the
capital structure and
therefore, value of the
company is the same.
 Net Income (NI) Approach
30

 According to NI approach
both the cost of debt and the
cost of equity are independent
of the capital structure; they
remain constant regardless of
how much debt the firm uses.
As a result, the overall cost of
capital declines and the firm
value increases with debt.
This approach has no basis in
reality; the optimum capital
structure would be 100 per
cent debt financing under NI
approach.
 Traditional Approach
31

 The traditional approach

argues that moderate degree Cost
of debt can lower the firm’s
ke
overall cost of capital and
thereby, increase the firm
ko
value. The initial increase in
the cost of equity is more than
offset by the lower cost of kd
debt. But as debt increases,
shareholders perceive higher
risk and the cost of equity Debt

rises until a point is reached

at which the advantage of
lower cost of debt is more
than offset by more expensive
equity.
 Relationship between capital structure and
the firm value :
32

 Firststage: Increasing value

 Second stage: Optimum value
 Third stage: Declining value
 Criticism of the Traditional View
33

 The contention of the traditional theory, that moderate

amount of debt in ‘sound’ firms does not really add very
much to the ‘riskiness’ of the shares, is not defensible.

 There does not exist sufficient justification for the

assumption that investors’ perception about risk of
leverage is different at different levels of leverage.
34
MM Approach Without Tax: Proposition I
 MM’s Proposition I is
that, for firms in the
same risk class, the total
market value is
independent of the
debt-equity mix and is
given by capitalizing the
expected net operating
income by the
capitalization rate (i.e.,
the opportunity cost of
capital) appropriate to
that risk class.
 MM’s Proposition I: Key Assumptions
35

 Perfect capital markets

 Homogeneous risk classes
 Risk
 No taxes
 Full payout
 The cost of capital under MM proposition I
36
 Criticism of the MM Hypothesis
37

 Lending and borrowing rates discrepancy

 Non-substitutability of personal and corporate
leverages
 Transaction costs
 Institutional restrictions
 Existence of corporate tax
 MM Approach With Tax: Proposition II
38

 MM show that the value of the firm will increase

with debt due to the deductibility of interest
charges for tax computation, and the value of the
levered firm will be higher than of the unlevered
firm.
39

LEVERAGE
Operating Leverage

Operating Leverage -- The use of

fixed operating costs by the firm.
 One potential “effect” caused by the
presence of operating leverage is that a
change in the volume of sales results in a
“more than proportional” change in
operating profit (or loss).
 Degree of Operating Leverage (DOL)

Degree of Operating Leverage -- The

percentage change in a firm’s operating
profit (EBIT) resulting from a 1 percent
change in output (sales).

Percentage change in
DOL operating profit (EBIT)
=
Percentage change in
output (or sales)
 Financial Leverage

Financial Leverage -- The use of

fixed financing costs by the firm. The
British expression is gearing.
 Financial leverage is acquired by choice.
 Used as a means of increasing the return to
common shareholders.
 Degree of Financial Leverage (DFL)

Degree of Financial Leverage -- The

percentage change in a firm’s earnings per
share (EPS) resulting from a 1 percent
change in operating profit.

Percentage change in
DFL earnings per share (EPS)
=
Percentage change in
operating profit (EBIT)