Cost of Capital

Equity
Preference
Share
Debentures
Government
Risk- Bonds like RBI
free relief bonds
security
 Cost of Capital
• The firm’s cost of capital is the rate of return
required to all the suppliers 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.

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 WACC Vs. Specific Cost of Capital
• 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.
• Suppose:
Cost of Equity = 11%
Cost of Debt = 6%
Project A: Expected rate of return = 10% & Financed by
Debt.
Project B: Same Risk return class – Financed by Equity

(The debt equity ratio of the firm is 3:2)

• It can also be thought of a rate of return required
by the all the capital providers.
• The cost of capital is the rate of return that a firm
must earn to maintain the market value of the
stock.
• It is considered as a hurdle rate.
• The cost of capital is estimated at a given point of
time.
 COST OF DEBT

• Current Yield = Coupon / Current Market Price

• Yield to Maturity

• Debt Issued at Par INT

kd  i 
P0

6
Dutch Corporation, a major hardware manufacturer,
is contemplating selling Rs.10 million worth of 20-
year, 9% coupon bonds with a par value of Rs.1,000.
The similar types of bonds offered by other
companies offering 10% coupon rate. Because
current market interest rates are greater than 9%,
the firm must sell the bonds at Rs.980. The floatation
costs are 2% of the face value of the bond. The net
proceeds to the firm from the sale of each bond
would be Rs.960.
Calculate the cost of the bond.
 Before-Tax Cost of Debt
Approximating the Cost

 
Kd = = = 9.4%
 Tax adjustment  
• The interest paid on debt is tax deductible. The higher the interest
charges the lower will be the amount of tax payable by the firm.
• As a result of these interest tax shield, the after tax cost of debt to
the firm will be substantially less than the investors required rate
of return.

• After-tax cost of Debt = Kd(1-t)

• Find the after-tax cost of debt for Duchess assuming it has a 40%
tax rate:
• kd = 9.4% (1-.40) = 5.6%
• This suggests that the after-tax cost of raising debt capital for
Dutch is 5.6%.
 COST OF PREFERENCE CAPITAL
• Irredeemable Preference Share  
PDIV
kp 
P0

• Dutch Corporation is contemplating the issuance

of a 10% preferred stock that is expected to sell
for its Rs.87per share value. The cost of issuing
and selling the stock is expected to be Rs.5 per
share. The dividend is Rs.8.70 (10% x Rs.87). The
net proceeds price (Np) is Rs.82 (Rs.87 – Rs.5).
• KP = DP/Np = Rs.8.70/Rs.82 = 10.6%
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Example

11
 COST OF EQUITY CAPITAL Using CAPM

• As per the CAPM, the required rate of return

on 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 ()

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 Example

Dutch Corporation’s investment advisor

indicates that the firm’s beta is 1.5 and the
market return Rm is equal to 11%. The 364-days
T-bill rate is hovering around 7%.
As per CAPM, the cost of equity share is

ke  R f   ( Rm  R f )
Ke = 7 + 1.5 (11 – 7 ) = 13%

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 COST OF EQUITY CAPITAL
• Cost of External Equity: The Dividend Growth
Model
DIV1
ke  g
P0

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• Dutch
  Corporation's shares are currently
trading in the market at Rs.50 per share. The
firm expects to pay a dividend of Rs. 4 per
share in the next year. The annual growth rate
of dividend is coming at 5 percent p.a.
• The cost of equity capital would be
Ke = + 0.05 = 0.08 + 0.05 = 13%
Example

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 THE WEIGHTED AVERAGE COST OF CAPITAL

• 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 ) wd  k e we
D E
k o k d (1  T )  ke
DE DE

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 WACC of Dutch
Sources of Capital Weights Cost Weighted Cost

Long Term Debt 0.40 5.6% 2.2%

Preferred Stock 0.10 10.6% 1.1%

Equity Shares 0.50 13% 6.5%

Total 1.00 9.8%

 WACC – Book Value Approach
Source Amount Proportion (%) After tax Cost Weighted Cost
(%)
Equity Capital 45,00,000 45 18 8.1

Reserve & 15,00,000 15 18 2.7

Surplus
Pref. Capital 10,00,000 10 11 1.1

Debenture 30,00,000 30 8 2.4

100,00,000 WACC 14.3%

The Company issued 4,50,000 shares @ Rs.10 per share

 WACC – Market Value Approach

Source Amount Proportion (%) After tax Cost Weighted Cost

(%)
Equity Capital 90,00,000 69.2 18 12.5

Pref. Capital 10,00,000 7.7 11 0.8

Debenture 30,00,000 23.1 8 1.8

130,00,000 WACC 15.1%

The current market price per share is Rs.20.

 Book Value Versus Market Value Weights

• Managers prefer the book value weights for

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.

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 Book Value Versus Market Value Weights

• The use of the book-value weights can be seriously

questioned on theoretical grounds;
– 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

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 Book Value Versus Market Value Weights

• Market-value weights are theoretically

superior 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.

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 Weighted Marginal Costs of Capital
• The historical cost that was incurred in the past in raising
capital is not relevant in financial decision-making.

• As the volume of financing increases, the cost of various

types of financing will increase and raising the 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.
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 The Marginal Cost
& Investment Decisions
• The Weighted Marginal Cost of Capital (WMCC)
– The WACC typically increases as the volume of new capital
raised within a given period increases.
– This is true because companies need to raise the return to
investors in order to entice them to invest to compensate
them for the increased risk introduced by larger volumes
of capital raised.
– In addition, the cost will eventually increase when the firm
runs out of cheaper retained equity and is forced to raise
new, more expensive equity capital.
• The Weighted Marginal Cost of Capital (WMCC)
– Finding Break Points
• Finding the Break points in the WMCC will allow us to
determine at what level of new financing, the WACC
will increase due to the factor listed above.
• BPj = AFi / Wj
Where:
BPj = break point for financing sources j
Afi = amount of funds available from financing sources j
at a given cost.
Wj = capital structure weights.
• Cost of Debt = 5.6%
• Cost of Preference Share = 10.6%
• Cost of Retained earnings = 13%
• Cost of New issue of equity shares = 14%
• Cost of new issue of debenture = 8.4%

Sources of Capital Weights

Lone term Debt 40%
Preferred Stock 10%
Equity Shares 50%
• When the company exhausts its Rs.3,00,000 of
available retained earnings (at 13%), it must use
the more expensive new equity shares (at 14%).
• In addition, the firm expects that it can borrow
only Rs.4,00,000 of debt at 5.6%. Additional debt
will have after tax cost of 8.4%.
• Calculate two break-even points when:
(i) Rs.3,00,000 retained earnings will be exhausted.
(ii) Rs.4,00,000 of long term debt will be exhausted.
• BPequity = Rs.3,00,000/0.50 = Rs.6,00,000
• BPdebt = Rs.4,00,000/0.40 = Rs.10,00,000

• This implies that the firm can fund up to Rs.6 lakh

of new investment before it is forced to issue new
equity and Rs.10 lakh of new investment before it
is forced to raise more expensive debt.
• Given this information, we may calculate the
WMCC as follows:
 WACC for Ranges of Total New Financing

Range of total Source of Weighted

New Financing Capital Weight Cost Cost
Rs.0 to Rs.6 lakh Debt 40% 5.6% 2.2%
Preferred 10% 10.6% 1.1%
Common 50% 13.0% 6.5%
WACC 9.8%

Rs.6 lakh to Rs.10 lakh Debt 40% 5.6% 2.2%

Preferred 10% 10.6% 1.1%
Common 50% 14.0% 7.0%
WACC 10.3%

Rs. 10 lakh and above Debt 40% 8.4% 3.4%

Preferred 10% 10.6% 1.1%
Common 50% 14.0% 7.0%
WACC 11.5%