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8. Cost of Capital

Sr Title ICMR Ch. PC Ch. IMP Ch.

2 Overview of Financial Markets 3 Sources of Long-Term Finance 4 Raising Long-term Finance

1*

2* 10* -

1

2 17 18*

1

20, 21 20, 21, 23

6 Time Value of Money 7 Valuation of Securities 8 Cost of Capital 9 Basics of Capital Expenditure Decisions 10 Analysis of Project Cash Flows

4*

3* 5* 11* 18* -

8, 9

6 7 14 11 12*

4, 5

2 3 9 8 10, 11

*Book preference

2 / 46

Cost of Capital

Reference Books 1. Financial Management, ICMR Book, Chapter 11 2. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 14

3. Financial Management, I. M. Pandey, 9th Edition, Chapter 9

3 / 46

1. Concept and Importance 2. Cost of Debenture 3. Term Loans

5. Calculation of Weighted Average Cost of Capital 6. Weighted Marginal Cost of Capital Schedule

4 / 46

Major components of capital are equity, preference and debt. Let us find out the costs of these various types of finances. Capital has a cost. Various sources of capital has varied costs and implications.

various sources of finance that a company uses e. g. equity, preference, debentures, term loans, retained earnings etc. Cost of capital is used for evaluating projects, determining

5 / 46

Suppose a company uses equity, preference and debt in proportions of 50, 10 and 40. If the cost of these components is 16%, 12% and 8% resp. Then weighted average cost of capital (WACC) will be = Proportion of equity x cost of equity + proportion of preference x cost of preference +

= 0.5 x 16 + 0.10 x 12 + 0.40 x 8

= 12.4%

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2. Cost of Debenture

Cost of debenture is defined as the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows in the form of interest and principle repayments, i. e.

I(1 - t) F P t (1 kd) n t 1 (1 kd)

n

(1)

Where, kd = post-tax cost of debenture capital I =annual interest payment per debenture capital t = corporate tax rate F = redemption price per debenture P = net amount realized per debenture n = maturity period 7 / 46

2. Cost of Debenture

Interest payment I is multiplied by factor (1-t) because

tax costs are considered. Same formula can be used for different types of debt instruments such as bank loans and commercial paper. Computation of kd requires a trial-and-error method.

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2. Cost of Debenture

Example: A company issued a debenture of Rs. 100 face value, 14% interest rate p.a. The debenture is redeemable at a premium of 5% after 10 years. Company realizes Rs. 97 per debenture and the corporate tax rate is 50%. Calculate the cost of this debenture to the company. n Solution P I(1 - t) t F n

t 1

(1 kd)

(1 kd)

10

9 / 46

2. Cost of Debenture

To find out the value of kd in the above equation, several values of kd will have to be tried out in order to reach the input value. Therefore to start, consider a discount rate of 8% for kd. The expression becomes Rs. 7 x PVIFA(8%,10yrs)+ Rs.105 x PVIF(8%,10yrs) = Rs. 7 x 6.71 + Rs. 105 x 0.463 = Rs. 95.585 Since the above value is less than Rs. 97 realized price, we have to try with a less discounting rate kd. So let kd = 7%, then 10 / 46

2. Cost of Debenture

Rs. 7 x PVIFA(7%,10yrs)+ Rs.105 x PVIF(7%,10yrs) = Rs. 7 x 7.024 + Rs. 105 x 0.508 = Rs. 102.508 From above, it is clear that kd lies between 7% and 8%. We have to use linear interpolation between 7% and 8%.

kd 7 (8 7) x 102.508 - 97 102.508 - 95.585

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2. Cost of Debenture

By computer Excel 97 7 x PVIFA(kd,10) 105 x PVIF(kd,10) In Excel, put all values of cash flows including initial outflow with minus sign in a row or column e. g.

-95

112

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3. Term Loans

Cost of term loans will be simply equal to the interest rate multiplied by (1 - tax rate). The interest is multiplied by (1 tax rate) as interest on term loans is also tax deductible.

kt I (1 t)

I = interest rate

t = corporate tax rate

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Preference capital carries a fixed rate of dividend and is redeemable on maturity period. Preference stock is much like a bond with fixed commitments, however preference dividend is not a tax-deductible expense and

Cost of redeemable preference share is defined as that discount rate which equates the proceeds from preference capital issue to the payments associated with the same i.e. dividend payment and principle payments,

i. e.

14 / 46

D F P t (1 kp) (1 kp) n t 1

(1)

Where, kp = cost of preference capital D = preference dividend per share payable annually F = redemption price P = net amount realized per share n = maturity period

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Example: A company has issued preference shares with

p.a. The preference shares are redeemable after 12 years at par. If the net amount realized per share is Rs. 95,

Solution:

D F P t (1 kp) (1 kp) n t 1 14 100 95 t (1 kp) (1 kp)12 t 1

12 n

16 / 46

To find out the value of kd in the above equation, several values of kd will have to be tried out in order to reach the input value. Therefore to start, consider a discount rate of 15% for kd. The expression becomes Rs. 14 x PVIFA(15%,12yrs)+ Rs.100 x PVIF(15%,12yrs) = Rs. 14 x 5.421 + Rs. 100 x 0.187 = Rs. 94.594 Since the above value is less than Rs. 95 realized price, we have to try with a less discounting rate kd. So let kd = 14%, then 17 / 46

Rs. 14 x PVIFA(14%,12yrs)+ Rs.100 x PVIF(14%,12yrs)

= Rs. 100.04 From above, it is clear that kd lies between 14% and 15%.

15%.

= 14 + 0.93 = 14.93

18 / 46

Cost of equity Capital Rate of return required by the equity share holders i.e. cost of equity is difficult to estimate. Because there is no definite commitment from the firm to pay dividends, nor specified by any legal contract, unlike in the case of debenture holders. However we come up with reasonably good estimates of the cost of equity by employing some basic principles. Several approaches are used for estimating cost of equity such as dividend forecast approach, capital asset pricing model, realized yield approach, earnings-price ratio approach and bond yield plus risk premium approach. / 46 19

Dividend forecast approach According to this approach, the present value or intrinsic value of an equity stock is equal to the sum of present values of dividends associated with it, i.e.

Dt Pe (1 ke) t t 1

(2)

Where, Pe = price per equity share Dt = expected dividend per share at the end of year one ke = rate of return required by the equity shareholders or the cost of equity capital 20 / 46

In practice, the model suggested in equation (2) cannot be used in its present form because it is not possible to forecast the dividend stream completely over the life of the company. Therefore the growth in dividends can be categorized as nil growth or constant growth or super normal growth. Equation (2) can be modified accordingly. For instance, assuming a constant growth rate (g) in dividends, equation (2) can be simplified as

D1 Pe ke g

(3)

21 / 46

If the current market price of share is given as Pe, values of D1 and g are known, then the equation (3) can be written as D1 (4) ke g

Pe

Example: Share price of a company is Rs. 125. The dividend expected a year hence is Rs. 12 and the dividends are expected to grow at a constant rate of 8% per annum. Calculate the cost of equity capital of the company Solution: ke D1 g ke 12 0.08 0.176 or 17.6%

Pe 125

22 / 46

Realized Yield Approach According to this approach, past returns on a stock are taken as proxy for returns in the future by the investors. Realized return over n year period is calculated as

D1 ke g Pe

Pt - 1

Dt = dividend per share for year t payable at the end of year Pt = price per share at the end of year t 23 / 46

Example: Calculate the cost of equity by Realized Yield Approach for the data given below. Price per share at the beginning of the year 1 is Rs. 10.

Year DPS (dividend per share) Rs. Price per share at the end of the year 1 1.5 12 2 2 11 3 1.5 12

Year

Wealth ratio

1

1.35

2

1.08

3

1.23

24 / 46

Capital Asset Pricing Model (CAPM) Approach This is a popular approach for estimating the cost of equity. According to this approach, the cost of equity is calculated as

ki Rf i (Rm Rf)

Where ki = rate of return required on equity or the cost of equity Rf = risk free rate of return i = beta of security i Rm = rate of return on market portfolio 25 / 46

Example: Consider a risk free rate of return as 6%, rate of return on market portfolio as 12% and value of beta for a stock as 1.2. Calculate the cost of equity.

ki Rf i (Rm Rf)

26 / 46

Bond Yield Plus Risk Premium Approach According to this approach, return required by the investors is based on risk profile of a company. Risk profile is adequately reflected in the return earned by the bondholders or debt. Since the risk borne by the equity investors is higher than the bondholders or debt, the return expected by equity holders is also higher. Hence this return is calculated as Cost of equity = Yield on long term bonds of the company + Risk premium Risk premium based on operating and financial risks of the company and it is a subjective figure normally ranges 27 / 46 between 2% and 6%.

Earnings Price Ratio Approach According to this approach, cost of equity is equal to

E1 P0

Where E1 = expected EPS for the next year P0 = current market price per share E1 can be estimated by multiplying current EPS by (1+ growth rate)

28 / 46

Cost of Retained Earnings Earnings of a firm can be reinvested or paid as dividends to shareholders. If the firm retains part of its earnings for future growth of the firm, the shareholder will demand compensation from the firm for using that money. As a result, the cost of retained earnings represents a shareholders expected returns from the firms common stock. Thus the firms cost of retained earnings is equal to the cost of equity capital i.e.

kr ke

Cost of retained earnings is always less than the cost of new issue of common stock due to absence of floating costs. 29 / 46

Cost of External Equity Cost of external equity includes certain floatation costs involved in the process of raising equity from the market. It is the rate of return required by the equity holders or the cost of equity on the net funds raised. With the dividend capitalization model, following formula is used for calculating the cost of external equity.

Where ke = cost of external equity f = floatation costs as a % of current market price g = constant growth rate applicable to dividends D1 = dividend expected at the end of year1 P = current market price per share 30 / 46

D1 ke g P0 (1 f)

'

Method 1

Cost of External Equity

for accounting for the floatation costs. Following formula can be used as an approximation in such cases

ke ' ke (1 f)

Where ke = cost of external equity ke = rate of return required by the equity holders f = floatation costs as a % of current market price

31 / 46

Weighted Average Cost of Capital (WACC) is calculated by multiplying the specific cost of each source of financing by its proportion in the capital structure and adding these weighted values. WACC is calculated for various components of capital such as equity, preference, debentures, term loans, retained earnings etc. depending on their proportions and their cost of capital values.

WACC We ke Wp kp Wd kd Wt kt Wr kr

Where We, Wp, Wd, Wt and Wr are the weights or the proportions of equity, preference, debentures, term loan and retained earnings resp. ke, kp, kd, kt and kr are the corresponding costs 32 / 46

Example: A company has a following capital structure

Capital Rs. In lakhs Equity capital (10 lakh shares at par value) 100 12% Preference capital (10,000 shares at par value) 10 Retained earnings 120 14% Non-convertible Debentures (70,000 debentures at par) 70 14% term loan from SFC 100 Total 400

Market price per equity share is Rs. 25. Next expected dividend per share is Rs. 2 and DPS is expected to grow at a constant rate of 8%. Preference shares are redeemable after 7 years at par and are currently quoted at Rs. 75 per share. Debentures are redeemable after 6 years at par and their current market price is Rs. 90 per share. Tax rate is 50%. Calculate WACC.46 33 /

Solution We will adopt a three step procedure to solve this problem Step 1: Determine the costs of various sources of finance. We shall define symbols ke, kr, kp, kd and kt to denote the costs of equity, retained earnings, preference capital, debentures and term loans resp. Cost of equity ke D1 g

P0 2 0.08 0.16 or 16% 25 Cost of retained earnings kr ke 0.16 or 16%

34 / 46

To find out the value of kp

D F P t (1 kp) (1 kp) n t 1 12 100 75 t (1 kp) (1 kp) 7 t 1

7 n

By trial-and-error method, start kp = 19%, the expression becomes Rs. 12 x PVIFA(19%,7yrs)+ Rs.100 x PVIF(19%,7yrs) = Rs. 12 x 3.706 + Rs. 100 x 0.296 = Rs. 74.072 Next, try kp = 18%, then

35 / 46

Rs. 12 x PVIFA(18%,7yrs)+ Rs.100 x PVIF(18%,7yrs) = Rs. 12 x 3.812 + Rs. 100 x 0.314 = Rs. 77.144 kp lies between 19% and 18%. By linear interpolation between 19% and 18%.

77.144 - 75 kp 18 (19 18) x 77.144 - 74.072

= 18 + 0.70 = 18.70 %

36 / 46

To find out the value of kd

I(1 - t) F P t (1 kd) (1 kd) n t 1 14(1 - 0.5) 100 90 t (1 kd) 6 t 1 (1 kd)

6 n

By trial-and-error method, start kp = 10%, the expression becomes Rs. 7 x PVIFA(10%,6yrs)+ Rs.100 x PVIF(10%,6yrs) = Rs. 7 x 4.355 + Rs. 100 x 0.564 = Rs. 86.885 Next, try kp = 9%, then

37 / 46

Rs. 7 x PVIFA(9%,6yrs)+ Rs.100 x PVIF(9%,6yrs)

kd lies between 10% and 9%.

= Rs. 91.002

38 / 46

Step 2: Determine weights associated with various sources of finance. Let We, Wr, Wp, Wd and Wt represent the weights of various sources of finance.

100 0.25 400 120 Wr 0.30 400 10 Wp 0.025 400 70 Wd 0.175 400 100 Wt 0.25 We

39 / 46

Step 3: Multiply the costs of various sources of finance

to determine WACC.

WACC We ke Wr kr Wp kp Wd kd Wt kt

0.25 x 0.16 0.30 x 0.16 0.025 x 0.187 0.175 x 0.0924 0.25 x 0.07 0.1263 or 12.63%

40 / 46

WACC tends to rise as the firm seek more and more capital. As the suppliers provide more capital, the rate of return required by them tends to increase. A schedule (Table) or a graph showing the relationship between additional financing and the WACC is called the weighted marginal cost of capital schedule. Determining Weighted Marginal Cost of Capital Schedule The procedure involves following steps 1. Estimate the cost of each source of finance for various levels of its use 41 / 46

2. Identify the levels of new financing at which the cost of new components would change, as per capital structure policy of the firm (ratios of different sources of finance). These levels called the breaking points and they can be calculated as Breaking point on account of financing source i =

Total new financing from source i at the beraking point Proportion of financing source i in the capital structure

3. 4.

Calculate the WACC for various ranges of total financing between the breaking points Prepare the weighted marginal cost of capital schedule which reflects the WACC for each level of total new financing 42 / 46

Example: A company is planning to raise equity, preference and debt capital in the following proportions: Equity : 0.50 Preference : 0.20 Debt : 0.30 The costs of the three sources of finance for different levels of usage has been estimated as below

Source of Finance Equity Range of new financing from the source (Rs. In lakh) 0 15 15 25 25 and above 03 3 and above 0 20 20 and above Cost % 16 17 18 14 15 8 10

Preference Debt

43 / 46

Calculation of Breaking Point

Source of Finance Equity Cost % 16 17 18 Preference 14 15 Debt 8 10

0 15 15 25 25 and above 03 3 and above 0 20 20 and above

0 30 30 50 50 and above 0 15 15 and above 0 66.67 66.67 and above

44 / 46

Calculation of WACC for various ranges of total new financing

Range of total new financing (Rs. in lakh) 0 15 Source of finance Proportion Cost % Weighted Cost % WACC

15 30

30 50

50 66.67

Equity Preference Debt Equity Preference Debt Equity Preference Debt Equity Preference Debt Equity Preference Debt

0.5 0.2 0.3 0.5 0.2 0.3 0.5 0.2 0.3 0.5 0.2 0.3 0.5 0.2 0.3

16 14 8 16 15 8 17 15 8 18 15 8 18 15 10

13.2

13.4

13.9

14.4

15

45 / 46

Weighted Marginal Cost of Capital Schedule

Range of Total New Financing (Rs. In Lakh) 0 15 15 30 30 50 Weighted Marginal Cost of Capital (%) 13.2 13.4 13.9

50 66.67

66.67 and above

14.4

15

*****

46 / 46

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