COST OF CAPITAL

LEARNING OBJECTIVES
2

Explain the general concept of the opportunity cost of capital 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 Illustrate the cost of capital calculation for a real company

3 What is COST OF CAPITAL ? .

the firm¶s 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.Cost of Capital 4 Viewed from all investors¶ point of view. Compensation for TIME and RISK The rate of return required by all investors will be an overall rate of return ² a weighted rate of return. .

which depends on the riskiness of its cash flows.5 The project¶s cost of capital is the minimum required rate of return on funds committed to the project. required rate of return on the aggregate of investment projects . or average. ±Individual project The firm¶s cost of capital will be the overall.

SIGNIFICANCE OF THE COST OF CAPITAL 6 Evaluating investment decisions Designing a firm¶s debt policy Appraising the financial performance of top management .

Risk-return relationships of various securities .CONCEPT OF THE OPPORTUNITY COST OF CAPITAL 7 The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.

OPPORTUNITY COST OF CAPITAL 8 Rate of return required by shareholders on securities of comparable RISK Company must pay same to attract capital .

In an all-equity financed firm. which will depend only on the business risk of the firm. the firm¶s cost of capital is equal to the opportunity cost of equity capital.Shareholders· Opportunities and Values 9 The required rate of return (or the opportunity cost of capital) of shareholders is market-determined. the equity capital of ordinary shareholders is the only source to finance investment projects. .

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. 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.Creditors· Claims and Opportunities 10 Creditors have a priority claim over the firm¶s assets and cash flows.

11 What is average cost of capital ? What is Marginal cost of capital ? .

Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now. The overall cost is also called the weighted average cost of capital (WACC).Weighted Average Cost of Capital vs. or in the near future. or specific. The historical cost that was incurred in the past in raising capital is not relevant in financial decision-making. Specific Costs of Capital 12 The cost of capital of each source of capital is known as component. . cost of capital. Relevant cost in the investment decisions is the future cost or the marginal cost.

DETERMINING COMPONENT COSTS OF CAPITAL 13 Investors¶ required rate of return should be adjusted for taxes in practice for calculating the cost of a specific source of capital to the firm.K(1-T) . Tax adjustment .

In such a case.Cost of the Existing Debt 14 Sometimes a firm may like to compute the ³current´ cost of its existing debt. the cost of debt should be approximated by the current market yield of the debt. .

000 and its share is selling at a market price of Rs 80.EPS 15 A firm is currently earning Rs 100. What is the cost of equity? We can use expected earnings-price ratio to compute the cost of equity. Thus: .000 shares outstanding and has no debt. and it has a payout ratio of 100 per cent. The earnings of the firm are expected to remain stable. The firm has 10.

the required rate of return on equity is given by the following relationship: k e ! R f  (R m  R f )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 (F) .CAPITAL ASSET PRICING MODEL (CAPM) 16 As per the CAPM.

the market risk premium is 9 per cent and beta of L&T¶s share is 1. The cost of equity for L&T is: .54.Example 17 Suppose in the year 2002 the risk-free rate is 6 per cent.

Cost of equity under CAPM 18 .

COST OF EQUITY: 19 CAPM has a wider application although it is based on restrictive assumptions. they are common to all companies.  All variables in the CAPM are market determined and except the company specific share price data. is that it does not probably remain stable over time . . however. One practical problem with the use of beta.  The only condition for its use is that the company¶s share is quoted on the stock exchange.  The value of beta is determined in an objective manner by using sound statistical methods.

that is. the weighted average cost of new capital given the firm¶s target capital structure.WEIGHTED AVERAGE COST OF CAPITAL 20 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 k o o !k !k d d (1  T ) (1  T ) d  k d e e D  k D  E E D  E WACC is in fact the weighted marginal cost of capital (WMCC).

Cost of Capital for Projects Risk Adjustment 21 A simple practical approach to incorporate risk differences in projects is to adjust the firm¶s WACC (upwards or downwards). One approach is to divide projects into broad risk classes. and use different discount rates based on the decision maker¶s experience. . and use the adjusted WACC to evaluate the investment project: Companies in practice may develop policy guidelines for incorporating the project risk differences.

projects may be classified as:  Low risk projects Medium risk projects High risk projects discount rate < the firm¶s WACC  discount rate = the firm¶s WACC  discount rate > the firm¶s WACC .Cost of Capital for Projects 22 For example.

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