Corporate Finance Cost Of Capital
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Cost of Capital
Cost of capital meaning and its basic aspects Components of cost of capital Importance of cost of capital Classification of cost of capital Determination of cost of capital Cost of debt -Before tax and after tax -Redeemable debt Cost of preference capital
Cost of equity capital
-The SML approach or CAPM model -Bond Yield Plus Risk Premium Approach -Dividend Growth Model Approach -Earnings-Price Ratio approach
Cost of retained earnings Weighted average cost of capital (WACC) -Book value weights - Market value weights Floatation costs
Cost of capital meaning and its basic aspects
The cost of capital in operational terms refers to the discount rate that would be used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. It is defined as "the minimum rate of return" that a firm must earn on its investment for the market value of the firm to remain unchanged. In economic terms, there are two approaches to define cost of capital. -It is the cost of acquiring the funds required to finance the proposed project. That is the cost of capital is a borrowing rate of the firm. Alternatively, cost of capital in terms of lending rates, may refer to the opportunity cost of the funds to the firm i.e., what the firm could have earned by investing the funds elsewhere. We use the term in the sense of borrowing rate. The approach is based on the borrowing rate is therefore practical and more realistic. -Cost of capital is defined as the weighted average of the cost of each type of capital. Each security capital is given a weight according to either the book value or the market value, most practically the market value, compared to the total security value of the firm. The term "security" includes equity shares, preference shares, retained earnings, debentures and other interest bearing securities. cost of capital is a borrowing rate of the firm.
Components of cost of capital
Return at Zero risk level – This refers to the expected rate of return when a project involves no risk whether business or financial. Premium for business risk – The term business risk refers to the variability in operating profit due to change in sales. The concept is higher the risk, higher is the expected return. Premium for financial risk – The term financial risk refers to the risk on account of pattern of capital structure. In general, it can be said that a firm having higher debt content in its capital structure is more risky as compared to a firm which has comparatively low debt content.
The above three components of the cost of capital may be put in the form of following equation:
K = r0 + b + f
Where K = Cost of capital, r0 = return at zero risk level, b = Premium for business risk; f = Premium for financial risk.
the problem was ignored or by-passed. he may have a better choice of the source of finance which bears the minimum cost of capital. is however. The concept of cost of capital is also important in many others areas of decision making. Although cost of capital is an important factor in such decisions. working capital policy etc. Deciding about the Method of Financing. Designing the Corporate Financial Structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. The concept is quite relevant in the following managerial decisions. In various methods of capital budgeting. Performance of Top Management. but equally important are the considerations of relating control and of avoiding risk.. Evaluation of the financial performance will involve a comparison of actual profitability of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. Whenever company requires additional finance. a recent development and has relevance in almost every financial decision making but prior to that development. It measures the financial performance and determines the acceptability of all investment opportunities. The cost of capital is influenced by the chances in capital structure. cost of capital is the key factor in deciding the project out of various proposals pending before the management. The progressive management always takes notice of the cost of capital while taking a financial decision. Capital Budgeting Decision. such as dividend decisions. The cost of capital is significant in designing the firm's capital structure. The concept. A capable financial executive must have knowledge of the fluctuations in the capital market and should analyze the rate of interest on loans and normal dividend rates in the market from time to time.Importance of cost of capital
The concept of cost of capital is a very important concept in financial management decision making.
. Other Areas.
Importance of cost of capital
If financing cost is reduced NPV increases . more projects end up with NPV > 0 more wealth created to shareholders.
What sources of long-term capital do firms use?
New Common Stock
Composite cost of capital refers to the combined cost of various sources of finance. Thus implicit cost arises only when funds are invested somewhere. Thus.Classification of cost of capital
Historical Cost and future Cost Historical Cost represents the cost which has already been incurred for financing a project.
Average Cost and Marginal Cost
Average cost of capital refers to the weighted average cost of capital calculated on the basis of cost of each source of capital and weights are assigned to the ratio of their share to total capital funds. it is a weighted average cost of capital. otherwise not. Future cost refers to the expected cost of funds to be raised for financing a project. the opportunity cost of the funds is the implicit cost. Preference share. Marginal cost of capital may be defined as the ‘Cost of obtaining another rupee of new capital. debenture. Specific Cost and Composite Cost
Specific costs refer to the cost of a specific source of capital such as equity share. In other words. It is also termed as ‘overall costs of capital’. than marginal cost is the specific or explicit cost. Historical costs help in predicting the future costs and provide an evaluation of the past performance when compared with standard costs. Implicit cost represents the rate of return which can be earned by investing the funds in the alternative investments.’ When a firm rises additional capital from only one sources (not different sources). the explicit cost of capital is the internal rate of return which a firm pays for procuring the finances. retain earnings etc. It is calculated on the basis of the past data.
Explicit Cost and Implicit Cost
Explicit cost refers to the discount rate which equates the present value of cash outflows or value of investment. In other words. In financial decisions future costs are more relevant than historical costs.
This economic variable is reflected in the risk less rate of return. Market Conditions When an investor purchases a security with significant risk. When investors increase the irrequired rate of return. operating and financing conditions within the company. also results from decisions made within the company. the marketability of the firm’s securities (market conditions). Essentially. as risk increases. the cost of capital rises simultaneously. For instance. the investor’s required rate of return (and the cost of capital) will move in the same direction.free investments. or the cost incurred by the firm from issuing securities. Business risk is the variability in returns on assets and is affected by the company’s investment decisions. As business risk and financial risk increase or decrease. an opportunity for additional returns is necessary to make the investment attractive. the investors’ required rate of return may rise. such as the interest rate on short-term government securities. the investor requires a higher rate of return. additional flotation costs. as more securities are issued.Determination of cost of capital
We identify four primary factors : general economic conditions. This rate represents the rate of return on risk.
. General Economic Conditions Determiness the demand for and supply of capital within the economy. and the amount of financing needed for new investments. as management approaches the market for large amounts of capital relative to the firm’s size. the weighted cost of capital increases for several reasons. Also. Amount of Financing As the financing requirements of the firm become larger. as well as the level of expected inflation. Financial risk is the increased variability in returns to common stockholders as a result of financing with debt or preferred stock. This increase is called a risk premium. Risk resulting from these decisions is generally divided into two types: business risk and financial risk. will affect the percentage cost of the funds to the firm. or the variability of returns. Operating and Financing Decisions Risk.
Tax plays an important role as the debenture interest expense is allowed as an expense for tax purposes. It can be measured as Irredeemable and Redeemable debt. Cost of Irredeemable debt: Before tax cost of Irredeemable debt After tax cost of Irredeemable debt Cost of Redeemable debt: Before tax cost of Irredeemable debt After tax cost of Irredeemable debt
.Cost of debt
Cost of debt is the interest rate that the company pays on its debt content of the capital structure.
Cost of debt
Cost of Irredeemable debt:
Irredeemable debentures are those debentures issuing by which the company has no obligations to pay back the value of the debenture on some fixed date or time and has the full authority to choose any time to pay back the debt until the company is a going entity and does not default in it’s interest payments. Before tax cost of Irredeemable debt After tax cost of Irredeemable debt
. So we take into account only the sale value (SV) while evaluating the cost of irredeemable debentures.
Cost of debt
Cost of Irredeemable debt: Before tax cost of Irredeemable debt Interest/Sale Proceeds or Sale value of debentures Or I / SV Where: I = Annual fixed interest and SV = Sale value of debentures After tax cost of Irredeemable debt Kd = (1-T) * Before tax cost of debt Kd = (1-T) * I/SV Where: T = Tax rate Kd = After tax cost of debt I = Annual interest payment SV = Sale value of debentures The SV of debentures would be adjusted for issuance at discount or premium. This would be net of commission and floatation costs if any.
we take the average of Sale Value and Redeemable value while calculating the cost of redeemable debentures. So. the maturity date is fixed initially.
Before tax cost of Irredeemable debt After tax cost of Irredeemable debt
. The meaning redeemable denotes that the debentures would be redeemed by the company at a fixed date or after a specified period of notice.Cost of debt
Cost of Redeemable debt:
For redeemable debentures.
. if any.T ) Where: T = tax rate Thus. This SV would also be adjusted if issued at a discount or at a premium.SV ] / n) divided by ( RV + SV ) / 2 Where: I = Annual fixed interest RV = Redeemable Value of debenture net of commission and floatation costs.Cost of debt
Cost of Rredeemable debt: Before tax cost of Redeemable debt :Kd (before tax) = (I + [ RV . N = Term of debt till maturity
After tax cost of Redeemable debt :Kd (after tax) = Kd (before tax) * ( 1 . Kd (after tax) = ((I + [ RV .SV ] / n) / (( RV + SV ) / 2)) * ( 1 .
in other terns. the value of a firm. and in an efficient market. It does not matter if the firm's capital is raised by issuing stock or selling debt. if the firm is paying dividends or interest. this is to say the market value. It does not matter what the firm's dividend policy or the financial structure is.Modigliani-Miller Theorem
The basic theorem states that. and asymmetric information.
. is unaffected by how that firm is financed.
ke :cost of equity k0 :the cost of capital for an all equity firm. D/E :the debt-to-equity ratio. in the absence of taxes. Therefore the capital structure irrelevance principle refers to Modigliani & Miller’s theorem. Kd :cost of debt.
The preference share holders have to be paid their fixed dividends before any distribution of dividends to the equity shareholders. the preference dividend is a distribution of profits of the business. Because dividends are paid out of profits after taxes. the question of after tax or before tax cost of preference shares does not arise as in case of cost of debentures. Their dividends are not allowed as an expense for the purpose of taxation. They are entitled to a fixed dividend. but subject to availability of profit for distribution.Cost of preference capital
Preference shares represent a special type of ownership interest in the firm.
Preference shares can be divided into: Irredeemable preference shares Redeemable preference shares
. In fact.
the formula will take the following shape: Kp = Annual dividend/Net proceeds(1-floatation costs)
. share) = Annual dividend of preference shares Market price of the preference stock Cumulative preference shares: In case of cumulative preference shares. If the company issues new preference shares. Cumulative preference shares are those shares whose dividends will get accumulated if they are not paid periodically. If the floatation costs are expressed as percentage. The cost of irredeemable preference shares is: Kp (cost of pref. The only liability of the company is to pay the annual dividends. the cost of preference capital would be: Kp = Annual dividend / Net proceeds after floatation costs. Non-cumulative preference shares: These are preference shares whose dividends do not get carried forward to the next year if they are not paid during a year. the market price of the preference stock will be increased by such amount of dividend in arrears. All the arrears of cumulative preference shares must be paid before paying anything to the equity share holders.Cost of preference capital
Irredeemable preference shares Irredeemable preference shares are those shares issuing by which the company has no obligation to pay back the principal amount of the shares during its lifetime. if any.
Cost of Redeemable preference shares =
Annual Dividend + (Redeemable Value .Sale value) / Number of years for redemption (Redeemable Value + Sale value) / 2
Kp = D +(RV .Cost of preference capital
Redeemable preference shares are those shares which have a fixed maturity date at which they would be redeemed.SV) / N (RV + SV) / 2
They are: The SML approach or CAPM model Bond Yield Plus Risk Premium Approach Dividend Growth Model Approach Earnings-Price Ratio approach
. However. The cost of equity capital is rather difficult to estimate because there is no definite commitment on the part of the company to pay dividends. there are various approaches for computing the cost of equity capital.Cost of equity capital
The cost of equity capital is the minimum rate of return that a company must earn on the equity financed portion of its investments in order to maintain the market price of the equity share at the current level.
the cost of equity capital is: Ke = Krf + ß (Km .Krf) Where: Ke = Cost of equity Krf = Risk-free rate Km = Equity market required return (expected return on the market portfolio) ß = beta
. According to the SML.Cost of equity capital
The SML (security market line ) approach or CAPM (Capital asset pricing model) This is a popular approach to estimate the cost of equity.
Cost of equity capital
The SML (security market line ) approach or CAPM (Capital asset pricing model)
In this approach. a judgmental risk premium to the observed yield on the long-term bonds of the firm is added to get the cost of equity.
Cost of equity = Yield on long-term bonds + Risk Premium
.Cost of equity capital
Bond Yield Plus Risk Premium Approach
This approach is a subjective procedure to estimate the cost of equity.
Cost of equity capital
Dividend Growth Model Approach
the cost of equity capital is:
Ke = E1 P0
E1 P0 = Expected earnings per share for the next year = Current market price per share
E1 can be calculated as (Current EPS) * (1 + growth rate of EPS)
.Cost of equity capital
Earnings-Price Ratio approach According to this approach.
Cost of equity capital
Where there are no taxes and brokerage fees Where there are taxes and brokerage fees
. as a source of finance for investment proposals differ from other sources like debt. In other words. Retained earnings. The cost of retained earnings is the earnings foregone by the shareholders. The cost of retained earnings can be measured as follows: . Accordingly. the amount retained would have been distributed to the shareholders who in turn. Some profits are retained by them for future expansion of the business. It is equal to the income that the shareholders could have otherwise earned by placing these funds in alternative investments.Cost of retained earnings
The companies do not generally distribute the entire profits earned by them by way of dividend among their shareholders. would invest it and earn a return on it and second. The first of these criteria is based on what shareholders are able to obtain on other investments. preference shares and equities. the opportunity cost of retained earnings may be taken as the cost of retained earnings. the firm itself could utilize them in external investment opportunities. there could be two possible approaches to evaluate the cost of retained earnings. while second approach is expressed as "external yield criterion". There are two alternatives or opportunities to the retention of earnings – First.
Cost of retained earnings
Where there are no taxes and brokerage fees:
Kr = Ke = D1 + g P0 Where:
Kr Ke D1 P0 g = Cost of retained earnings = Cost of equity capital = Expected Dividend at the end of Year 1 = Current price of the stock = Growth rate
T) (1 .B)
Where: T = Marginal tax rate of shareholder and B = Brokerage or commission to acquire new shares.Cost of retained earnings
Where there are taxes and brokerage fees:
Kr = Ke (1 .
since UFCFs are computed after-tax. Long-term WACCs should incorporate assumptions regarding long-term debt rates. because market values reflect the true economic claim of each type of financing outstanding whereas book values may not. WACC must use nominal rates of return built up from real rates and expected inflation. since each expects a return that compensates for the risk assumed. While calculating the weighted-average of the returns expected by various providers of capital. The discount rate is a weighted-average of the returns expected by the different classes of capital providers (holders of different types of equity and debt). not just current debt rates.Weighted average cost of capital (WACC)
The rate used to discount future unlevered free cash flows (UFCFs) and the terminal value (TV) to their present values should reflect the blended after-tax returns expected by the various providers of capital. market value weights for each financing element (equity.) must be used. etc. because the expected UFCFs are expressed in nominal terms. Considerations in Calculating WACC The following are important considerations when calculating WACC: WACC must comprise a weighted-average of the marginal costs of all sources of capital (debt.
. equity. While a separate discount rate can be developed for each projection interval to reflect the changing capital structure.) since UFCF represents cash available to all providers of capital. debt. etc. and must reflect the long-term targeted capital structure as opposed to the current capital structure. the discount rate is usually assumed to remain constant throughout the projection period. WACC must be computed after corporate taxes. WACC must be adjusted for the systematic risk borne by each provider of capital.
Multiplying the cost of each of the sources by its weight which is obtained by calculating its' proportion to the total capital. the WACC can be calculated as follows: WACC = We Ke + Wp Kp + Wd kd (1 .
. (1 .t) can be eliminated from the formula.
Given the cost of specific source of finance and the scheme of weighing.t) Where: We = Proportion of Equity Wp = Proportion of Preference Wd = Proportion Debt Ke = Cost of equity capital Kp = Cost of preference capital Kd = Cost of debt t = Tax rate But where Kd after tax is taken. Add these weighted costs from all the sources of funds to arrive at weighted average cost of capital.Weighted average cost of capital (WACC)
The computation of the over-all cost of capital involves the following steps: Calculate the cost of specific source of funds such as the cost of debt. cost of preference capital. cost of equity and cost of retained earnings.
the book value of different sources of capitals already in use is considered for the purpose of obtaining the proportions in which they are used. Book value weights: Here.Weighted average cost of capital (WACC)
WACC can be calculated using Book Value weights or Market value weights.
. Market value weights are more practical because it reflects the expectations of the investors and market value closely reflects how a company has to raise new capital. This is more practical for raising new capital. Market value weights: Instead of using book value. the market values of various sources of capital are used in assigning weights. These proportions are used as weights for calculating the weighted average cost of capital.
Determination of Weighted Marginal Cost of capital schedule The determination of WMCC involves the following steps: Estimation of cost of each source of financing for various levels of its use through an analysis of current market conditions and an assessment of the investors' expectations.Weighted average cost of capital (WACC)
Weighted Marginal Cost of Capital: The weighted average cost of capital generally tends to rise as the firm seeks more and more capital. Identification of the levels of total new financing at which the cost of the new components would change. the rate of return required by them tends to increase.as suppliers provide more capital. Preparation of WMCC schedule which reflects the WACC for each level of total new financing. This may happen because the supply schedule of capital is typically upward sloping . Calculation of WACC for various ranges of total financing between the breaking points. given the capital structure policy of the firm.
. These levels are called as breaking points.
The Marginal Cost and Everage cost of capital
Weighted average cost of capital (WACC)
Factors affecting Weighted Average Cost of Capital: Factors outside a firm’s control:
Interest rate levels Market risk premium Tax rates
Factors within a firm’s control:
Investment policy Capital structure policy Dividend policy
Debt and Equity
.Average cost of capital (WACC) .
We will frequently ignore flotation costs when calculating the WACC. since most firms issue equity infrequently. However.
. the per-project cost is fairly small.Floating costs
Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity.
stern.Cost of Capital By Sectors
Data Used: Value Line database.nyu. of 5891 firms Date of Analysis: Data used is as of January 2012
48% 8.31% 7.03% 8.87% 9.46% 9.27% 6.41% 9.77% 10. Drug E-Commerce Educational Services Number of Firms 31 64 36 57 51 12 426 45 34 158 45 21 16 31 70 20 184 87 107 279 57 34 Cost of Capital 11.35% 7.74% 6.22% 7.21% 5.42% 7.57% 4.26% 7.93% 8.47%
.81% 7.Cost of Capital By Sectors
Industry Name Advertising Aerospace/Defense Air Transport Apparel Auto Parts Automotive Bank Bank (Midwest) Beverage Biotechnology Building Materials Cable TV Chemical (Basic) Chemical (Diversified) Chemical (Specialty) Coal Computer Software Computers/Peripherals Diversified Co.27% 5.98% 8.30% 7.83% 6.
(Div.51% 8.29% 10.95% 7.21% 9.60% 9.) Number of Firms 21 21 14 68 139 25 77 40 82 225 112 9 6 35 25 21 23 51 26 23 137 27 30 49 Cost of Capital 4.Cost of Capital By Sectors
Industry Name Electric Util.40%
.) Food Processing Foreign Electronics Funeral Services Furn/Home Furnishings Healthcare Information Heavy Truck & Equip Homebuilding Hotel/Gaming Household Products Human Resources Industrial Services Information Services Insurance (Life) Insurance (Prop/Cas.57% 9.43% 6.76% 8.29% 4.79% 5.26% 7.14% 7.99% 5.73% 6. (Central) Electric Utility (East) Electric Utility (West) Electrical Equipment Electronics Engineering & Const Entertainment Entertainment Tech Environmental Financial Svcs.91% 6.30% 6.82% 7.32% 6.40% 8.51% 6.98% 8.14% 9.19% 4.
Packaging & Container Paper/Forest Products Petroleum (Integrated) Petroleum (Producing) Pharmacy Services Pipeline MLPs Power Precious Metals Precision Instrument Number of Firms 186 60 100 52 83 146 122 24 73 29 22 13 24 13 93 26 32 20 176 19 27 93 84 77 Cost of Capital 8.31% 7.92% 9.32% 9.16% 9.76% 7.) Natural Gas Utility Newspaper Office Equip/Supplies Oil/Gas Distribution Oilfield Svcs/Equip.69% 8.27% 5.66% 6.) Natural Gas (Div.60% 6.60% 5.58% 7.Cost of Capital By Sectors
Industry Name Internet IT Services Machinery Maritime Med Supp Invasive Med Supp Non-Invasive Medical Services Metal Fabricating Metals & Mining (Div.50% 7.71%
.72% 7.47% 8.89% 8.07% 6.97% 10.32% 6.11% 6.96% 8.94% 7.81% 4.37% 7.
06% 7.46% 9.65% 4.23% 7.70% 10.55% 8.E.I.89% 4.36% 11.95% 7.23% 8.53% 7.79% 10.88% 8.84% 10.44% 6.52% 6.Cost of Capital By Sectors
Industry Name Property Management Public/Private Equity Publishing R.05%
. Utility Thrift Tobacco Toiletries/Cosmetics Trucking Utility (Foreign) Water Utility Wireless Networking Total Market Number of Firms 31 11 24 5 12 56 13 63 75 47 20 8 37 30 28 141 12 19 32 99 74 25 148 11 15 36 4 11 57 5891 Cost of Capital 5.43% 10.10% 3.82% 8.27% 5.41% 8.13% 7.T.91% 8. Services Telecom.28% 9. Railroad Recreation Reinsurance Restaurant Retail (Hardlines) Retail (Softlines) Retail Automotive Retail Building Supply Retail Store Retail/Wholesale Food Securities Brokerage Semiconductor Semiconductor Equip Shoe Steel Telecom.82% 5.30% 3.70% 8.78% 6.19% 6. Equipment Telecom.