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LEARNING OBJECTIVES

2

Distinguish between the project cost of capital and the firm’s

cost of capital

Learn about the methods of calculating component cost of

capital and the weighted average cost of capital

Recognize the need for calculating cost of capital for divisions

Understand the methodology of determining the divisional beta

and divisional cost of capital

Illustrate the cost of capital calculation for a real company

INTRODUCTION

3

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

SIGNIFICANCE OF THE COST OF CAPITAL

4

management

THE CONCEPT OF THE OPPORTUNITY COST OF

CAPITAL

5

on the next best alternative investment opportunity

of comparable risk.

Shareholders’ Opportunities and Values

6

is shareholders is market-determined.

shareholders is the only source to finance investment projects,

the firm’s cost of capital is equal to the opportunity cost of

equity capital, which will depend only on the business risk of

the firm.

Creditors’ Claims and Opportunities

7

cash flows.

The firm is under a legal obligation to pay interest and

repay principal.

There is a probability that it may default on its obligation

to pay interest and principal.

Corporate bonds are riskier than government bonds since

it is very unlikely that the government will default in its

obligation to pay interest and principal.

General Formula for the Opportunity Cost of

8

Capital

Opportunity cost of capital is given by the following formula:

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.

The opportunity cost of retained earnings is the rate of return,

which the ordinary shareholders would have earned on these

funds if they had been distributed as dividends to them

Cost of Capital

9

cost of capital is the rate of return required by them

for supplying capital for financing the firm’s

investment projects by purchasing various

securities.

The rate of return required by all investors will be

an overall rate of return — a weighted rate of

return.

Weighted Average Cost of Capital vs. Specific

Costs of Capital

10

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.

DETERMINING COMPONENT COSTS OF CAPITAL

11

of capital is equal to the investors’ required rate of

return, and it can be determined by using

adjusted for taxes in practice for calculating the

cost of a specific source of capital to the firm.

COST OF DEBT

12

INT

kd i

B0

n INTt Bn

B0

t 1 (1 k d ) t (1 k d ) n

Tax adjustment

EXAMPLE

13

Now,

Cost of the Existing Debt

14

“current” cost of its existing debt.

approximated by the current market yield of the

debt.

COST OF PREFERENCE CAPITAL

15

PDIV

kp

P0

Redeemable Preference Share

n PDIVt Pn

P0

t 1 (1 k p ) t (1 k p ) n

Example

16

COST OF EQUITY CAPITAL

17

opportunity cost.

Cost of Internal Equity: The Dividend-Growth

Model DIV1

P0

Normal growth (k e g)

n

DIV0 (1g s ) t DIVn 1

1

Supernormal growth P0

(1k e ) t k e g n (1k e ) n

t 1

ke (since g 0)

P0 P0

COST OF EQUITY CAPITAL

18

Cost

of External Equity: The Dividend Growth

Model

DIV1

ke g

P0

EPS 1 ( 1 b )

ke br (g br)

P0

EPS 1

(b 0)

P0

Example

19

Example: EPS

20

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)

21

equity is given by the following relationship:

k e R f (R m R f ) j

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

22

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:

COST OF EQUITY: CAPM VS. DIVIDEND–

23

GROWTH MODEL

The dividend-growth approach has limited

application in practice

It assumes that the dividend per share will grow at a

constant rate, g, forever.

The expected dividend growth rate, g, should be less than

the cost of equity, ke, to arrive at the simple growth

formula.

The dividend–growth approach also fails to deal with risk

directly.

Cost of equity under CAPM

24

COST OF EQUITY: CAPM VS. DIVIDEND–

25

GROWTH MODEL

CAPM has a wider application although it is based on

restrictive assumptions.

The only condition for its use is that the company’s share is

quoted on the stock exchange.

All variables in the CAPM are market determined and

except the company specific share price data, they are

common to all companies.

The value of beta is determined in an objective manner by

using sound statistical methods. One practical problem with

the use of beta, however, is that it does not probably remain

stable over time .

THE WEIGHTED AVERAGE COST OF CAPITAL

26

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.

k o k d (1 T ) w d k d w e

D E

k o k d (1 T ) ke

DE DE

that is, the weighted average cost of new capital given the firm’s

target capital structure.

Book Value Versus Market Value Weights

27

calculating WACC

Firms in practice set their target capital structure in terms of

book values.

The book value information can be easily derived from the

published sources.

The book value debt-equity ratios are analysed by investors

to evaluate the risk of the firms in practice.

Book Value Versus Market Value Weights

28

questioned on theoretical grounds;

First, the component costs are opportunity rates and are

determined in the capital markets. The weights should also

be market-determined.

Second, the book-value weights are based on arbitrary

accounting policies that are used to calculate retained

earnings and value of assets. Thus, they do not reflect

economic values

Book Value Versus Market Value Weights

29

to book-value weights:

They reflect economic values and are not influenced by

accounting policies.

They are also consistent with the market-determined

component costs.

The difficulty in using market-value weights:

The market prices of securities fluctuate widely and

frequently.

A market value based target capital structure means that the

amounts of debt and equity are continuously adjusted as the

value of the firm changes.

FLOTATION COSTS, COST OF CAPITAL AND INVESTMENT

ANALYSIS

30

A new issue of debt or shares will invariably involve flotation costs in the

form of legal fees, administrative expenses, brokerage or underwriting

commission.

One approach is to adjust the flotation costs in the calculation of the cost of

capital. This is not a correct procedure. Flotation costs are not annual costs;

they are one-time costs incurred when the investment project is undertaken

and financed. If the cost of capital is adjusted for the flotation costs and

used as the discount rate, the effect of the flotation costs will be

compounded over the life of the project.

The correct procedure is to adjust the investment project’s cash flows for

the flotation costs and use the weighted average cost of capital, unadjusted

for the flotation costs, as the discount rate.

DIVISIONAL AND PROJECT COST OF CAPITAL

31

calculating the required rate of return for a division

(or project) is the pure-play technique.

The basic idea is to use the beta of the comparable

firms, called pure-play firms, in the same industry

or line of business as a proxy for the beta of the

division or the project

DIVISIONAL AND PROJECT COST OF CAPITAL

32

capital involves the following steps:

Identify comparable firms

Firm’s cost of capital

33

Example

34

The Cost of Capital for Projects

35

projects is to adjust the firm’s WACC (upwards or

downwards), and use the adjusted WACC to evaluate the

investment project:

incorporating the project risk differences. One approach is to

divide projects into broad risk classes, and use different

discount rates based on the decision maker’s experience.

The Cost of Capital for Projects

36

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

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