Cost of Capital

Cost of Capital
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 Cost of Capital
Cost of capital refers to the cost of a firm's funds (debt,
preference and equity capital).Optimal capital structure refers
to the best debt-equity ratio for a company that enhances its
value and decreases the company’s cost of capital.
Factors affecting Cost of Capital
Following are the elements influencing cost of capital:
a) Risk free rate
b) Business risk premium
c) Financial risk premium
d) Other factors like liquidity, profitability, tax rate
 Continued
Significance of Cost of capital:
a) Evaluating investment proposals/ Capital budgeting
decisions
b) Designing the debt policy or the firm’s capital structure
c) Performance appraisal of top management
d) Other like dividend decisions, working capital policy etc.
Explicit and Implicit cost of capital:
Explicit cost of capital to a company involves an explicit payment
made by the business to the suppliers of funds such as interest
payments to debenture holders and dividend payments to
preference and equity shareholders. On the contrary, implicit
costs of capital do not require any cash outflow to the providers
of funds. This is related with retained earnings.
 Continued
Marginal cost of capital:
Marginal cost of capital is the average cost of new or incremental
funds raised by the firm. It tends to increase proportionately as the
amount of debt increases. The overall marginal cost of additional
funds is calculated on the basis of market value weights because the
new funds are to be raised at the market values.

Cost of Debt:
The cost of debt refers to the cost associated with using fixed
interest bearing securities like debentures, long term loans and
bonds in the firm’s capital structure. In other words, it is the rate of
return demanded by the lenders who loan money to the company .
 Continued
In the case of debt, the return paid to the debt holders is not the same as the
cost to the firm. This is due to the tax-deductibility of interest paid on debt.
Thus, the actual cost of debt is less than the yield to maturity.

• Cost of Irredeemable or Perpetual Debt (Kd)

Before Tax Kd = Interest / Net Proceed
After Tax Kd = [Interest / Net Proceed]*(1- Tax rate)

Net Proceed = Par Value – (discount on issue & floatation cost) + Premium on
issue
Example:
Par Value = 100, Int = 5% * 100 = 5, NP = 100 – (20%*100) = 80, Tax = 50%
Before Tax Kd = 5 / 80 = .0625 or 6.25%
After Tax Kd = 6.25 * (1- .50) = 3.125%
 Continued

• Cost of Redeemable Debt

For calculating the cost of redeemable debt, the issue price is
equated with a series of cash outflows associated with the
payment of fixed interest charges and the repayment of
principal amount.
Formula: As discussed in the class (Also given at page 7 in the e- content)
Before Tax Kd = [Interest + {MV – NP}/N] / [{MV + NP}/2]
After Tax Kd = Before Tax Kd * (1-Tax Rate)
Issues in Calculation of Cost of Debt
• It is not easy to find out the market price of those bonds or debentures
which do not trade in the secondary market.
• The cost of floating-rate debt is difficult due to its dependence on current
rates and on future rates as well.
• Calculating the cost of debt having Option-like features like Callability,
Putability, convertibility, etc is also a little cumbersome.
Continued
Cost of Preference Share Capital:
Company has to pay preference dividend to preference share holders. Shares may be redeemable as
well as irredeemable (only in special conditions as marked by Companies Act). However New
companies act laid down provisions regarding redeemable preference shares. Cost of irredeemable
preference share capital is the annual preference share dividend divided by the net proceeds from the
sale of preference shares. It may be calculated by the following:
After tax Kp = Preference Dividend / Net Proceed
Before Tax Kp = After Tax Kp * [1/(1-Tax Rate)]
For calculating the cost of redeemable preference share capital, the issue price is equated with a series
of cash outflows associated with the payment of fixed dividend and the repayment of principal amount.
After tax Kp = [PD + {MV – NP}/N] / [{MV + NP}/2]
Before Tax Kp = After Tax Kp * [1/(1-Tax Rate)]

Where,
MV or Pn = Maturity Value or Redemption value ;
PD = Annual Dividend payments;
Kp = Cost of preference share capital;
n = life of preference share capital
NP = Net Proceed
After tax Kp = [PD + {MV – NP}/N] / [{MV – NP}/2]
After tax Kp = [10 + {110 – 98}/5] / [{110 – 98}/2]
 Continued
Cost of Equity Share Capital
Equity Share Capital is also referred to as ordinary shares.
Equity shareholders are the real risk takers and care takers of
the company and they enjoy the right of voting. The cost of
equity is more difficult and demanding to compute as equity
does not have an ‘Explicit’ cost. The cash flow streams
associated with Equity investment are not certain.
Cost of Equity can also be defined as the rate at which investors
discount the expected dividends of the firm to determine the
true value of the share.
The cost of equity capital is higher than that of preference and
debt because of greater uncertainty of receiving dividends and
repayment of principal at the end of the holding period of
investment.
 Continued
There are different methods which are most commonly used to
roughly calculate the cost of common stock:
• Dividend Model: Ke = (DPS / MP)*100
• Earning Model Ke = (EPS / MP)*100
• Growth Model Ke = [(EPS / MP)*100 ] + G or [(DPS / MP)*100 ] + G
• Capital Asset Pricing Model
Continued:
In the same example if growth rate is 4%, what will be your
answer?

Ans: Dividend Model 5%,

Earning Model = 6.25%,
Dividend based Growth Model = 9%,
Earning Based Growth Model = 10.25%
CONTINUED

Capital Asset Pricing Model

The CAPM was presented by Jack Treynor (1961, 1962),
William Sharpe (1964), John Lintner (1965) and Ian Mossin
(1966) separately, constructing on the earlier work of Harry
Markowitz on diversification and modern portfolio theory.
The CAPM elaborates the connection between risk and
expected return on a security. It assumes that the investors
hold a expanded portfolio which eliminates the unsystematic
risk different securities are negatively correlated. However
systematic risk i.e. market risk, cannot be eliminated through
diversification. The same is measured by beta.
 Continued

Assumptions of CAPM:
• All investors are Rational and Risk averse.
• They have homogeneous expectations regarding the expected
returns, variances and correlation of returns among all securities;
• All information about securities is available to all the investors
• There are no restrictions on investments;
• There are no taxes;
• There are no transaction costs; and
• No single investor can affect the market price significantly. They
are only price takers.
• There is no restriction on lending and borrowing at risk
 Continued
Ke = RF+ β (Risk Premium)
Ke = RF + β (Rm – Rf )
Where,Ke = Cost of Equity; Rf = Risk Free Rate; Rm= Rate of return on
Market portfolio or average return on all the assets; Rm - Rf = Market
risk premium; β = Beta coefficient (Systematic risk)

• Risk-free rate – It is the return earned on investing in risk free

securities like Government bonds. The interest rate on 91-days
Treasury bills is often taken as a proxy for Risk free rate.
• Beta is a measure of systematic risk. It is also referred to as non
diversifiable risk or market risk.
• Risk Premium is the excess of market return over the risk free
return. It represents the extra return expected by investors over the
risk free return to compensate them for taking extra risk by investing
in the stock market over and above the risk-free rate.
 Continued
Limitations of CAPM:
• It is very difficult to gather the historical values for those
companies which are not listed or whose shares are not
publicly traded.
• The value of Beta is not easy to calculate. Estimates of beta
can vary widely depending upon the market index and time
period chosen.
• It does not incorporate floatation costs.
• The model does not offer any guidance on the appropriate
choice for the risk-free rate. Risk-free rate may vary widely
depending on the Treasury security chosen.
• · It is also very difficult to assume the value for Market return.
 Cost of Retained earnings
Retained Earnings are a very important origin of finance for
the company. It is that part of a firm’s earnings which are not
dispensed to equity shareholders as dividend.
Although there is no explicit cost of utilizing the retained
earnings but there is opportunity cost associated with the
use of these undistributed earnings, because if they were in
the hands of the investors (shareholders) they could have
earned on these by investing somewhere else at the
identical level of risk.

Formulas as discussed in the class

 Overall or Combined Cost of Capital
The overall or combined Cost of Capital refers to the cost that would be
undertaken by the firm on an average to raise money. Cost of capital is
very important to analyze the capital budgeting decisions of a firm to see
whether a future project will yield profits or not. It’s the key factor in
evaluating and deciding the project to be chosen out of various alternative
proposals that the management have. A project having return on
investment less than the cost of capital shouldn’t be accepted. It can be
used as a tool by investors to take their investment decision.
The overall or combined Cost of Capital can be computed through simple
or weighted average cost of capital. The simple average cost of capital may
not be appropriate because there is hardly a firm that employs equal
proportion of various sources of finance. Therefore, weighted average cost
of capital is better.
 Continued
The WACC can be computed through following steps:
1. Calculate the specific cost of each source of fund
2. Find out the weight or proportion of each source of fund in the
total capital structure of the firm.
3. Multiply the specific cost of each source of funds with their
respective proportion.
4. Add the weighted component cost calculated in Step 3 above to
get WACC.
The weights can be further divided into two types namely Book
Value Weights and Market Value Weights. Book Value Weights are
the weights that use accounting values to measure the proportion of
each type of capital in the firm’s financial structure. Market Value
Weights are the are weights that use market values to measure the
proportion of each type of capital in the firm’s financial structure.
 Continued: Example 1
Capital After tax Book Value Market
Cost of Value
capital
Equity Share Capital 15.77 % 2,50,000 4,50,000
(25,000 shares of Rs. 10 each)
Reserves and Surpluses 15.77 % 1,50,000 -
Preference Share Capital 16.84 % 50,000 45,000
(500 shares of Rs. 100 each)
Debentures 6.66 % 1,50,000 1,45,000
(1500 Debenture of Rs.100
each)

Calculate combined cost of capital from the above.

Source: epgpathshala
 Continued
WACC is 13.572 as per Book value method and 13.782% as per market value method

Source After tax Book BV Market MV w1x w2x

Cost (x) value Weights value weights
(w1) (w2)
Equity 15.77 % 250,000 .417 450,000 0.7031 6.570 11.0878

Reserves 15.77 % 150,000 .250 - - 3.940 -

Preference 16.84 % 50,000 .083 45,000 0.0704 1.397 1.1855

Debenture 6.66 % 150,000 .250 145,000 0.2265 1.665 1.5085

600,000 1.000 640,000 13.572 13.782

 Continued: Example 2
Sanstreet, Inc. went public by issuing 1 million shares of
common stock @ $25 per share. The shares are currently
trading at $30 per share. Current risk free rate is 4%, market
risk premium is 8% and the company has a beta coefficient of
1.2.
During last year, it issued 50,000 bonds of $1,000 par paying
10% coupon annually maturing in 20 years. The bonds are
currently trading at $950. If the tax rate is 30%, calculate the
weighted average cost of capital on market value basis.

Source: https://xplaind.com/965210/cost-of-capital
 Continued
Estimating Cost of Equity
After Tax Cost of Equity = RF+ [Beta × (Market Risk Premium)]
= 4% + 1.2 × 8% = 13.6%
Estimating Cost of Debt
After-tax Cd= 10.61% × (1 − 30%) = 7.427%
Calculating WACC

Source Market value After tax Cost (x) Weights (w) wx

Equity 1,000,000 × $30 = 13.6 % .3871 5.2646 %
30,000,000
Debt 50,000 × $950 = 7.427 % .6129 4.5520 %
47,500,000
77,500,000 1.000 9.8166 %