THE COST OF CAPITAL

Dr Suresha B
 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
⮵ 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

⮵ 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
 SIGNIFICANCE OF THE COST
4
OF CAPITAL
⮵ Evaluating investment decisions

⮵ Designing a firm’s debt policy

⮵ Appraising the financial performance of top management

 THE CONCEPT OF THE
OPPORTUNITY COST OF CAPITAL
5

⮵ The opportunity cost is the rate of return foregone on the next best
alternative investment opportunity of comparable risk.

Risk-return relationships of various securities

 Shareholders’ Opportunities and Values
6

⮵ The required rate of return (or the opportunity cost of capital) is shareholders is
market-determined.

⮵ In an all-equity financed firm, the equity capital of ordinary 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
7
Opportunities
⮵ Creditors have a priority claim over the firm’s assets and 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
8
Cost of Capital
⮵ 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.
⮵ 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 major standard of comparison used in modern financial

decisions.
⮵ Acceptance or rejection of an investment project depends on cost the
company is required to pay for financing it.
⮵ Viewed from all investors’ point of view, 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.
⮵ The rate of return required by all investors will be an overall rate of
return — a weighted rate of return.
definition
◻It may be defined as cost to the company of
procuring funds.

◻This is equivalent to the average rate of return

that an investor in a firm would expect for
supplying capital.

◻This is the minimum rate of return that a project

must yield to keep the value of the firm intact.
CALCULATION OF COMPOSITE COST
OF CAPITAL

In order to compute the composite cost (overall cost) of

capital, a finance manager has to take the following three
steps:
To determine the types of funds to be raised and their share in the
total capitalization of the company.

■To determine the cost of each type of funds.

To calculate combined cost of capital of the company by

assigning weights to each type of funds in terms of the
proportion of funds so raised to total funds.
⮵ It is, therefore, becomes inevitable for a finance manager to calculate
cost of capital which the company would be required to pay and
compare it with the rate of return which a project in hand is expected
to yield.
 Weighted Average Cost of Capital vs. Specific
Costs of Capital
14

⮵ 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.
 DETERMINING COMPONENT
15
COSTS OF CAPITAL
⮵ Generally, the component cost of a specific source of capital is equal to
the investors’ required rate of return, and it can be determined by using

⮵ But the 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.
 COST OF DEBT
16

⮵ Debt Issued at Par

⮵ Debt Issued at Discount or Premium

⮵ Tax adjustment  
Cost of Short-Term Debt
⮵ Short-term debt is obtained particularly from banks for few
months to meet temporary working capital requirements of the
business.
⮵A part of the permanent working capital requirements of the
business is generally financed by means of such loans.
⮵In view of this, cost of some type of short-term loans must
be computed and included in the company's overall cost.
◻ Cost of short-term loan may be
expressed as interest rate on such
loan, as stated in the loan
agreement. Thus, in the case 01 a
bank loan the formula for
estimating the cost of capital is
◻ The interest rate on short-term
debt must be adjusted after tax
since interest is a tax deductible
expense.
Kd = R (1 - T)

Where,
Kd = Cost of debt
R = Rate of interest
T = Tax rate
 In case of debt issued at discount or premium

Kd = R/SP (1 - T)
Where,
In case of debt issued at Kd = Cost of debt
discount or premium R = interest in value
T = Tax rate
SP = Realized value of debt
Illustration - 1
◻ A company borrows short- ◻ Solution:
term loan on renewal basis at
7 percent interest rate. Kd =R(1-T)
= .07 (1 - 0.5)
◻ The company's tax rate is 50 Cost of debt = .035 or
per cent. Determine the cost of 3.5%
debt
Illustration : 2
Kd = R/SP (1- T) ...
◻ X ltd issues debentures of Rs.1000
@5%discount. Coupon rate is 6@ 60/950 (1 - 0.40)
◻ Determine the cost of debt.
◻ Tax rate is 40%. Cost of debt = .03789 or
3.78% appr..
Illustration - 3
◻ Oriental Engineering Company Ltd.
decides to float a 12% irredeemable Solution :
debentures of Rs. 10,00,000. Kd=120,000/10,00,000 (1-.5)
◻ The tax rate is 50 per cent. .006 or 6%
◻ Determine the Cost of Debt.
Cost of Redeemable Debt
⮵ Redeemable debt has definite date of maturity and the company is under
legal obligation to pay back the money when due.

⮵ This repayment can be made in one lumsum at the time of maturity or in

a number of installments at regular time intervals.
Cost of Redeemable Debt
The before tax cost of redeemable debt
payable in one Lum sum can be
computed with the help of the
following formula
I+1/N(RV-NP)
Krb= -----------------
1/2 (RV+NP)
Where,
I = Annual interest payment
RV = Redeemable value
NP = Sale proceeds from the issue
N = Tenure of debt
The after tax cost of redeemable debt payable
in one lumsum can be computed with the
help of the following formula
I(1-T)+1/N(RV-NP)
Kra= -----------------------
1/2 (RV+NP)
Where,
I= Annual interest payment
T= Tax
RV = Redeemable value
NP = Sale proceeds from the issue
N = Tenure of debt
Example

X ltd issues Rs.10,00,000 10%redeemable debentures at a discount of

5%. The flotation cost Rs.30000. The debentures are redeemable
after 5 years.
Calculate before tax and after tax cost of debt assuming a tax rate of
50%.
Before tax cost of debt
100,000+1/5(10,00,000-920,000)
I+1/N(RV-NP)
Krb= ----------------- = ----------------------------------------
1/2 (RV+NP)
½ ((10,00,000+920,000)
Where,
I = Annual interest payment
T= Tax Krb = .1208
RV = Redeemable value 12.08%
NP = Sale proceeds from the issue
N = Tenure of debt
 100,000(1-0.5)+1/5(10,00,000-920,000)
The after tax cost of redeemable debt
= ---------------------------------------
I(1-T)+1/N(RV-NP) ½ (10,00,000+920,000)
Kra= -----------------------
1/2 (RV+NP)
Where, Krb = .6875 0r
I= Annual interest payment
T= Tax
6.875%
RV = Redeemable value
NP = Sale proceeds from the issue
N = Tenure of debt
◻ A 5years Rs.100 Debenture of a firm can be
sold for a net price of RS.96.50. The coupon ◻ Hint.
rate of interest is 14%pa, and the debenture will 🞑 RV=100+5
be redeemed at a 5% premium on maturity. The 🞑 NP=96.5
firms tax rate is 40%. Compute the after and 🞑 TAX = 40%
before tax cost of debenture 🞑 I=14%

◻ Cost before tax = 15.58%

◻ Cost after tax = 10.025%
Assuming that a firm pays tax at 50% rate, ◻ Hint-1
compute after tax cost of debt capital in Kda=I/NP(1-T)
the following.
3.5%
◻ A perpetual bond sold at par, coupon rate
◻ Hint - 2
of interest being 7%
◻ A 12 year 8%Rs.1000 per bond sold at I(1-T)+1/N(RV-NP)
Kra= -----------------------
Rs.950 less 4% underwriting commission. 1/2 (RV+NP)
5.10%
 EXAMPLE
30

Now,
 Cost of the Existing Debt
31

⮵ Sometimes a firm may like to compute the “current” cost of its existing
debt.

⮵ In such a case, the cost of debt should be approximated by the current

market yield of the debt.
 COST OF PREFERENCE CAPITAL
32

⮵ Irredeemable Preference Share  

⮵ Redeemable Preference Share  

 Example 1
33
 COST OF EQUITY CAPITAL
34

⮵ Is Equity Capital Free of Cost? No, it has an opportunity cost.

⮵ Cost of Internal Equity: The Dividend-Growth Model
⭬Normal growth  

⭬Supernormal growth  

⭬Zero-growth
 COST OF EQUITY CAPITAL
35

⮵ Cost of External Equity: The Dividend Growth Model

⮵ Earnings–Price Ratio and the Cost of Equity

 Example
36
 Example: EPS
37

⮵ 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
38
MODEL (CAPM)
⮵ As per the CAPM, the required rate of return on equity is given by the
following relationship:

⮵ 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 (β)
 Example
39

⮵ Suppose in the year 2002 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:
 COST OF EQUITY: CAPM VS.
40
DIVIDEND–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
41
 Bond-Yield-plus-Risk-Premium Approach
42

⮵ In situations where reliable inputs for the CAPM approach are not available, as
would be true for a closely held company, analysts often use a somewhat subjective
procedure to estimate the cost of equity.
⮵ Empirical studies suggest that the risk premium on a firm’s stock over its own bonds
generally ranges from 3 to 5 percentage points.
⮵ Based on this evidence, one might simply add a judgmental risk premium of 3% to
5% to the interest rate on the firm’s own long-term debt to estimate its cost of
equity.
⮵ Firms with risky, low-rated, and consequently high-interest-rate debt also have risky,
high-cost equity; and the procedure of basing the cost of equity on the firm’s own
readily observable debt cost utilizes this logic.
 For example, given
43

⮵Allied’s bonds yield 10%, its cost of equity might be estimated

as follows:
⭬E =Bond yield +Risk premium
⭬E= 10:0% + 4:0% =14:0%
 COST OF EQUITY: CAPM VS.
44
DIVIDEND–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
45

⮵ 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.

⮵ 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.
 Book Value Versus Market Value
46
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.
 Book Value Versus Market Value Weights
47

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

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
48

⮵ 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.
 FLOTATION COSTS, COST OF CAPITAL AND
INVESTMENT ANALYSIS
49

⮵ 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.
Steps in WACC
50
 DIVISIONAL AND PROJECT
51
COST OF CAPITAL
⮵ A most commonly suggested method for
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
52
COST OF CAPITAL
⮵ The pure-play approach for calculating the divisional cost of
capital involves the following steps:
⭬Identify comparable firms
⭬Estimate equity betas for comparable firms:
⭬Estimate asset betas for comparable firms:
⭬Calculate the division’s beta:
⭬Calculate the division’s all-equity cost of capital
⭬Calculate the division’s equity cost of capital:
⭬Calculate the division’s cost of capital
 Firm’s cost of capital
53
 Example
54
 The Cost of Capital for Projects
55

⮵ A simple practical approach to incorporate risk differences in projects is to adjust the

firm’s WACC (upwards or downwards), and use the adjusted WACC to evaluate the
investment project:

⮵ Companies in practice may develop policy guidelines for 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
56

⮵ 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
 Case Study
57

The cost of Various sources of funds of Shiva Co.Ltd. Is given below with
target market proportions. Compute the WACC

What would be your opinion if the firm wants to change Book Value to
Market Value approach?
The current market price of the equity share is Rs.250