Cost of Capital

Prof. Prabhakar Patil

 The concept of the Cost of Capital plays a central role in
various aspects of corporate decision-making and
investment analysis.

Why it is highly relevant:

Relevance of
Cost of ➢Investment Decision-Making
➢Financing Decisions Making
Capital:
➢Used in Valuation
➢Risk Management
➢Strategic Planning
➢Performance Measurement
 Investment Decision-Making

➢ ProjectEvaluation: The cost of capital is often used as the discount rate in capital
budgeting techniques like Net Present Value (NPV) and Internal Rate of Return
(IRR). It helps determine whether an investment or project is worth pursuing by
comparing the expected return against the cost of financing it.

➢ Hurdle Rate: The cost of capital acts as a benchmark or hurdle rate that potential
projects must exceed to be considered viable. If a project's return is less than the
cost of capital, it may be rejected.
 Financing Decisions

➢ Capital Structure: The cost of capital influences

decisions on the mix of debt and equity financing.
Companies aim to optimize their capital structure
by balancing the costs of debt and equity to
minimize the overall cost of capital.
➢ Cost of Debt vs. Equity: Understanding the cost
of capital helps in choosing between different
financing options. For example, debt might be
cheaper than equity due to tax shields, but too
much debt increases financial risk.
 Cost of Capital in Valuation

➢ Company Valuation: In discounted cash flow (DCF)

models, the cost of capital is used as the discount rate
to value a company. A lower cost of capital increases
the present value of future cash flows, raising the
company’s valuation.
➢ Investor Expectations: The cost of capital reflects
the return required by investors for taking on the risk
of investing in the company. A higher cost of capital
indicates higher perceived risk, potentially lowering a
company's valuation.
 Risk Management

➢ Understanding Risk: The cost of capital incorporates

the risk associated with different financing sources. By
understanding this, companies can make informed
decisions about which projects to fund and how to
manage financial risk.
➢ Impact of Market Conditions: Changes in market
interest rates or investor sentiment can alter the cost of
capital, affecting a company’s ability to finance
projects or manage its capital structure effectively.
 Strategic Planning

➢ Long-term Planning: Companies use the cost

of capital to plan for future investments and
growth. It helps in setting realistic expectations
for returns and in making strategic decisions
about expanding operations, entering new
markets, or acquiring other companies.

➢ Mergers and Acquisitions: In M&A

activities, the cost of capital is essential in
assessing the value of potential acquisition
targets and in determining the financial
feasibility of the deal.
Performance Measurement

➢ Return on Investment: The cost of capital serves as a

benchmark to evaluate the performance of
investments. Comparing the actual return on
investment (ROI) against the cost of capital helps
determine whether a project is generating value.
➢ Economic Value Added (EVA): EVA is a
performance measure that calculates the value created
beyond the cost of capital. It’s a way for companies to
assess whether they are generating returns that exceed
the capital cost.
 Components of Cost of Capital

✓The cost of capital is the rate of return that a company needs to earn on its investment to
maintain its market value and attract funds.
✓It represents the opportunity cost of using capital for a specific project instead of
investing it elsewhere.

Component of Cost of Capital

1. Cost of Debt (Kd)
2. Cost of Equity (Ke )
 Debt (Cost of Debt):
✓The cost of debt is the effective rate that a company
pays on its borrowed funds.
✓It can be calculated before or after taxes.
✓Since interest expenses are tax-deductible, the after-tax
cost of debt is typically used for valuation.

Cost of Debt (after tax) = Interest Rate × (1−Tax Rate)

➢ InterestRate: The cost of debt is primarily determined

by the interest rate that the company pays on its
borrowed funds.
➢ Tax Shield: Interest payments are tax-deductible, so the
after-tax cost of debt is lower than the nominal interest
rate.
 Steps to Calculate Cost of Debt

1. Determine the Total Interest Payments: Sum up all the

interest payments the company makes in a year.
2. Calculate the Total Debt: Sum up all the debt (Short term +
long term debts) the company has.
3. Compute the Before-Tax Cost of Debt: Divide the total
interest payments by the total debt.
4. Apply the Tax Shield: Multiply the before-tax cost of debt
by (1−tax rate) to get the after-tax cost of debt.
Example of Cost of Debt

Suppose a company has debts from

two major sources:
Rs.8,00,000 cr. of bond at 9.5%
interest rate and Rs. 5,00,000 cr. of
debt at 8.5% interest rate.
If corporate tax rate is 30%, then
calculate before tax and after-tax cost
of debt.
Example Cont….

𝐷𝑒𝑏𝑡 1 × 𝐼𝑛𝑡 𝑟𝑎𝑡𝑒 1 + (𝐷𝑒𝑏𝑡 2 × 𝐼𝑛𝑡 𝑅𝑎𝑡𝑒 2)

• 𝐵𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 =
(𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡)

8,𝑜𝑜,𝑜𝑜𝑜 ×0.095 +(5,00,000 ×0.085)

• 𝐵𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = = 0.0912 𝑜𝑟 9.12%
(8,00,000+5,00,000)

• 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = 𝐼𝑛𝑡𝑒𝑠𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 × 1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒

• 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = 0.0912 × 1 − 0.3 = 0.0638 𝑜𝑟 6.38%

 Equity (Cost of Equity):
• The Cost of Equity represents the rate of return that
shareholders require on their investment in a company .
• It is the minimum return that an investor accepts for holding a
company's stock, as a compensation for the given level of risk
associated with holding the stock.

Ways to Calculate Cost of Equity:

➢ Dividend Discount Model (DDM) using Gordon Growth

Model
➢ Capital Asset Pricing Model (CAPM)
 Cost of Equity Through (DDM)
𝐷1
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = × 100 + 𝑔
𝑃0

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑡
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = × 100 + 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑜𝑓 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
Example:
Suppose a firm is expected pay an annual dividend of Rs. 11 next year and its stock is currently
trading at Rs. 325 per share. From the last couple of years, the company has been steadily raising its
dividend each year by 5% (i.e., dividend is expected to growth at 5% rate).

𝑅𝑠.11.00
• 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = × 100 + 5% ⇒ 3.38% + 5% = 8.38%
𝑅𝑠.325
 Cost of Equity Through CAPM

𝑪𝑨𝑷𝑴(𝑲𝒆) = 𝑹𝒇 + 𝜷𝒊 (𝑹𝒎 − 𝑹𝒊 )
Example:
(1) Risk-free rate is 5% (short-term Treasury / interest rate in Banks)
(2) The average rate of return from the market (SENSEX) is 18%.
(3) Beta of Security i and j is ∶ ( 𝛽𝑖 ) = 1.45 and 𝛽𝑗 = 0. 45

𝐶𝐴𝑃𝑀 𝐾𝑒 = 5% + 1.45 18% − 5% 𝐶𝐴𝑃𝑀(𝐾𝑒) = 23.85%

𝐶𝐴𝑃𝑀 𝐾𝑒 = 5% + 0. 45 18% − 5% 𝐶𝐴𝑃𝑀 𝐾𝑒 = 10 .85%

 Meaning and Implication of Beta (β)

• Beta is a key financial metric used in the context of the Capital Asset Pricing Model (CAPM).
• It measures the volatility of a stock or portfolio relative to the overall market, typically
represented by a benchmark index like SENSEX, NIFTY.

𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑚 )
𝛽𝑖 =
𝑉𝑎𝑟(𝑅𝑚 )

𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑚 ) = Co-movement of Return of Security i (Ri ) with Market Return (Rm)

𝑉𝑎𝑟(𝑅𝑚 ) = Market Movement, i.e., how much the market return deviates from its mean.
 Implications of Beta (β)

Market Risk Assessment:

➢ Beta > 1: The security is more volatile than the market. If the market rises by 1%, the
stock is expected to rise by more than 1%. Similarly, if the market falls, the stock is
expected to fall by a greater percentage.
➢ Beta < 1: The security is less volatile than the market. It will experience smaller
fluctuations in response to market changes.
➢ Beta = 1: The security's price moves in line with the market.
➢ Beta < 0: Indicates an inverse relationship with the market. If the market goes up, the
security tends to go down, and vice versa.
 Βeta (β) as Risk-Adjusted Return
➢ Investors use Beta to assess the risk associated with a
particular investment relative to the market. A higher Beta
implies higher risk but also the potential for higher returns.
Higher Beta increases the expected return by reflecting
additional risk.
➢ Beta helps in constructing diversified portfolios. By mixing
assets with different Betas, investors can manage portfolio
volatility and align with their risk tolerance.
➢ Active Investors may seek High-Beta stocks for greater
returns during bullish markets.
➢ Conservative Investors may prefer Low-Beta stocks to
minimize risk during market downturns.
 Analysis of Beta (β)

Historical Beta Analysis:

➢ Analysing the historical beta of a stock helps to understand how its price has responded to market
movements over time. However, historical beta may not always predict future volatility.
Industry and Sector Influence:
➢ Different industries have varying average Betas. For example, tech companies often have higher
betas, reflecting higher growth potential and risk, while some sectors may have lower Betas,
indicating stability.
Limitations:
➢ Beta is not constant: Beta can change over time due to shifts in a company's operations, financial
leverage, or the overall market environment.
➢ Assumption of Linear Relationship: Beta assumes a linear relationship between the stock and the
market, which might not hold in all market conditions, particularly during extreme events.
 Possibility of Negative Βeta (β)
➢Inverse Relationship with the Market:
Since Beta measures the volatility of an asset relative to the market, a
negative beta implies the stock tends to move in the opposite
direction to market. If the market goes up, the asset's value typically
goes down, and vice versa.
➢Hedge against Market Risk:
Assets with negative beta can be seen as a hedge against market
downturns. They might be useful in diversifying a portfolio because
they could perform well when the market is declining.
➢Uncommon Scenario:
Negative beta values are rare, as most assets tend to have a positive
or near-zero beta. Certain types of assets, such as gold or certain
bonds, might exhibit negative beta characteristics because they are
considered safe havens during market turbulence.
Sometimes companies with very high volatile return (High +ve or
-ve Volatility of returns) or companies that succeed during economic
downturns may experience -ve Beta.
Negative Beta (β) to Negative CAPM or (Ke):
A negative Capital Asset Pricing Model (CAPM) implies an expected
return on a security or portfolio that is below the risk-free rate, which is
unusual and typically interpreted as a sign of anomaly or mispricing.
• Negative Beta: A negative CAPM could result if the security has a
negative beta, meaning it moves inversely with the market. In this
case, the security is expected to have a lower return because it is seen
as reducing the risk in a portfolio, like a hedge.
• Expected Loss: If the expected return according to CAPM is negative,
it suggests that the security is expected to lose value. This might
happen in distressed situations or with assets that are perceived to be
highly risky.

• Incorrect Model Assumptions: The assumptions behind the CAPM,

such as the risk-free rate, market risk premium, or beta, might be
incorrect or not applicable in the specific context, leading to a
misleading negative result.
 Weighted Average Cost of Capital (WACC)

➢ The WACC is the average cost of the company's various sources of capital, each weighted
by its proportion in the company's capital structure.
➢ It is used as a discount rate for evaluating a firm (or) the net present value (NPV) of a
project.
Importance of WACC
• Investment Decisions: It is used as a discount rate to
calculate the net present value (NPV) of projects.
• Valuation: WACC is critical in discounted cash flow
(DCF) valuation models.
• Capital Structure: Helps in understanding the impact of
changes in a company's capital structure on its overall cost
of capital.
✓A lower WACC indicates that the company is able to raise
capital at a lower cost, which is generally seen as
favorable.
✓A higher WACC suggests that it is more expensive for the
company to finance its operations.
Thank you