Ch.3.

1 COST OF CAPITAL

BY
M.P.NAIDU
 Role of The Financial Manager
(2) (1)

Firm's Financial Financial

(4a)
operations manager markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
 EQUITY
Source Issue: Selling securities to the public after approval from the Board of
(long) of directors.

Finance Underwriters:
Services provided by underwriters:
– Formulate method used to issue securities
from – Price the securities (below IPO)
– Sell the securities
Financial New Equity Issues and Price:
Markets Share prices tend to decline when new equity is issued.

Issuance Costs:
• Underwriting costs
• Other direct expenses – legal fees, filing fees, etc.
EQUITY CAPITAL • Indirect expenses – opportunity costs, i.e., management time
spent working on issue
• Abnormal returns – price drop on existing shares
• Underpricing – below market issue price on IPOs
 Bonds/debentures
– public issue of
Types of long-term debt

Long-term
Debt
Private issues
Term loans
 NATURE OF BUSINESS FINANCE
FINANCIAL MANAGEMENT ( DECISION MAKING ON)
TWO ASPECTS

PROCUREMENT OF FUNDS UTILIZATION OF FUNDS

FINANCING DECISIONS INVESTMENT DECISION

OBJECTIVE Minimize the Cost of fund

Maximize Return
or( cost of capital)

FIRM PROFIT/WEALTH MAXIMIZATION

GOAL
 The Short Story of WACC
What Costs are Measured?

• Costs associated with financing the firm’s invested

capital including:
– Debt Costs:
• Bank loans
• Long-term debt – bonds/debentures
– Equity Costs:
• Preferred equity costs
• Common equity costs

CHAPTER 20 – Cost of Capital 20 - 6

 Cost of Capital Meaning
• The cost of capital of a firm refers to the cost that
a firm incurs in retaining the funds obtained from
various sources. i.e.
• Source of Finance: in calculating the cost of
capital, therefore the focus is on long– term funds
which are:-
Sources
– Equity Shares
– Preference Shares
– Debt
– Retained Earnings
 Cost of Capital Meaning

Source of EQUITY CAPITAL PREFERENCE DEBENTURES

LOANS etc
Funds & R/E CAPITAL (BONDS)

SPECIFIC PREFERENCE
COST OF DIVIDEND INTEREST INTERESET
DIVIDEND
CAPITAL

OVERALL/
WEIGHTED
AVG COST
OF CAPITAL
COST OF CAPITAL (WACC)
 Cost of Capital
Components of Cost Capital:
The Overall cost of capital of a firm consists of the costs of various segments of
the total funds ( long term) , which may be:

A. Cost Debt Capital (Debentures or Loans from various

institutions) (Kd)

B. Cost of preference capital (Kp)

C. Cost of Equity (Ke)

D. Cost of Retained Earnings (Kr)

 Cost of Capital Meaning
• 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 .

10
 SIGNIFICANCE OF THE COST OF CAPITAL

• Evaluating investment decisions

• Designing a firm’s debt policy

• Appraising the financial performance of top

management.

11
THE CONCEPT OF THE OPPORTUNITY COST OF CAPITAL
• The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable risk.

12
Risk-return relationships of various securities
 The Short Story of WACC
Steps in Solving for the WACC

1. Identify the relevant sources of capital (debt

and equity).
2. Estimate the market values for the sources of
capital and determine the market value weights.
3. Estimate the marginal, after-tax, and after-
floatation cost for each source of capital.
4. Calculate the weighted average.

CHAPTER 20 – Cost of Capital 20 - 13

Weighted Average Cost of Capital &
Specific Costs of Capital
 Weighted Average Cost of Capital -Specific Costs of
Capital-Marginal cost of capital
• 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(additional cost for additional capital).
• 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.

15
 WACC Versus Marginal Cost of Capital
• The marginal cost of capital (MCC) is the weighted average cost
of the next dollar of financing to be raised
• At low levels of financing, WACC = MCC
• But, as a firm raises more and more capital in a given year, it will
exhaust the supply of lower cost sources of capital and then
have to access marginally higher cost sources of capital
• Therefore, MCC increases with the amount of capital to be
raised

16
 Why a Weighted Average?
• In most cases, the weighted average cost of
capital should be used in project
evaluation, NOT project-specific financing
costs
• This month: accept project with IRR of 9%
and is debt-financed at 8%
• Later this year: reject project with IRR of
12% that was to be equity financed at 15%
• This is not a value-maximizing strategy!

17
DETERMINING COMPONENT COSTS OF CAPITAL

Specific Cost Of Capital

 DETERMINATION OF COST OF CAPITAL
COST OF DEBT(BONDS, DEBENTURES etc)

Factors affecting the Cost of Debt:

1. Fixed Interest Rate
2. Issue expenses like underwriting Commission, Brokerage
3. Discount/ Premium on issue or Redemption.
4. Income Tax Rate.
•The debt may have Explicit cost as well as Implicit Cost.
Explicit cost of Debt: interest rate as per contract plus cost of raising
debt ( flotation cost i.e. brokerage, commission etc )
Implicit Cost of Debt: cost of increase in expectations of equity
shareholders.
Increase in Debt Increase in Expectations
Capital Increase in Firm’s Risk of equity shareholders
 IMPLICIT COST & TAX SHEILD
ON DEBT
Company x Company Y
EC 100L @20% EC 50L @ 25% ( 5% implicit cost)
Dc 0 DC 50L @ 10% = 5L-2.5L=2.5L/50= 5%
Kd = I(1-tax rate)
Kd = 10% ( 1-0.5) = 5%
CE 100L
CE 100L

ROI = 20% (EBIT)

Tax = 50%
EBIT 20L
EBIT 20L
INTEREST 0 INTER 5L
EBT 20L EBT15L
TAX 10L TAX 7.5L
EAT 10L EAT7.5L
PD 0 PD 0
EAESH 10L EAESH 7.5
Advantages of debt finance compared to equity
Disadvantages of debt finance compared to equity
 DETERMINATION OF COST OF CAPITAL
COST OF DEBT(BONDS/DEBENTURES etc)

COST OF LONG-
TERM DEBT

COST OF
COST OF
REDEEMABLE
IRREDEEMABLE
DEBT
 COST OF DEBT/IRREDEEMABLE
Model : 1.1
Cost Of Capital Of Irredeemable /Perpetual Debt

NP: Net Sales Proceeds from issue of Debt =

Face value + Premium on issue ( or ) – Discount on
issue – Flotation cost like underwriting commission
or Brokerage.
 Flotation Cost:

• it is the cost regarding issuing securities, which consists

document charges, brokerage etc.
COST OF DEBT/IRREDEEMABLE
 COST OF CAPITAL OF REDEEMABLE DEBT

It can be calculated by using Two methods

Using IRR method

COST OF CAPITAL OF REDEEMABLE DEBT
( Redeemable at a Single Time)

SHORTCUT METHOD
 Cost of Capital of Debt Redeemable in Installments

The cost of Debt redeemable in installments is calculated using Present Value Method as
follows:
Net Sales Proceeds Debt ( VB) = Int1 (1– t ) + Principal1 + Int2 (1– t ) + Principal2 +
( 1+ Kd) 1 ( 1+ Kd) 2

Int3 (1– t ) + Principal3 Int4 (1– t ) + Principal4 Intn (1– t ) + Principal n

+ +
( 1+ Kd) 3 ( 1+ Kd) 4 ( 1+ Kd) n

C1 = Int1 (1– t ) + Principal1

To Calculate Kd the following steps may be followed:

Step 1: Calculate Total Present Value of Cash Outflow during the maturity period at two
discount rates so as to have positive and negative NPVs.
Step 2: Find Kd by interpolation technique as follows:
COST OF PREFERENCE SHARES
 Model – 2
COST OF PREFERENCE SHARES
Factors effecting Preference Shares
a. Fixed Dividend Rate
b. Issue expenses like underwriting commission, brokerage cost.
c. Discount / Premium on issue/ Redemption.
d. Dividend distribution tax

Redeemable IRREEDEMABLE

Us the concept of
perpetuity
IRR
COST OF PREFERENCE SHARES

IRREEDEMABLE
 COST OF EQUITY SHARE CAPITAL

Meaning :
it may be defined as minimum rate of return that the company
must earn on that portion of its total capital employed which is
financed by equity capital, so that the market price of the Shares of
the company remains unchanged.

•Cost Equity Represents Dividend

Factors affecting the cost of equity share:

a. Price of an Equity share in the beginning of year

b. Expected Equity Dividend at the end of the year
c. Growth rate
 COST OF EQUITY SHARE CAPITAL
DETERMINATION OF COST OF EQUITY SHARECAPITAL
 3.1 Cost of equity –Dividend Yield Approach/perpetuity
No growth rate in Dividends or Zero Growth in Dividends

•Investors is interested in cash Dividends. i.e. Distributed profits only

•Dividends are paid at a constant rate till winding – up of the Company.

•It is suitable for stable income and stable Dividend policy companies.
 COST OF EC
Dividend price appraoch- No growth

Q.1. A company anticipates long run levle of future earning of Rs.7.00 per share.
The price of the company share is Rs. 55.45, floatation costs for the sale of equity
share would average about 10% of the price of the shares. What is the cost of new
equity capital of the company.
 3.1 Cost of equity – Constant growth rate in Dividends
perpetuity

• Investor is interested in present dividends, and also future

prospects of growth in EPS and Dividends (if retained earing
exists)
• EPS ( Earning price per share), DPS ( Dividend price per share)
and MPS ( Market price per share) all grow at the same rate.

•It is useful for growth companies with focus on dividend and

internal financing.
3.2 Cost of equity – Constant growth rate in Dividends
perpetuity
 Example—Constant Growth Dividend
Company XYZ has just paid a dividend of 15 cents per share, which is
expected to grow at 5 per cent per annum. What price should you pay for the
share if the required rate of return on the investment is 10 per cent?

1-51
 Non-constant Growth Dividend
• The growth rate cannot exceed the required rate of
return indefinitely but can do so for several years.
• Allows for ‘super normal’ growth rates over some
finite length of time.
• The dividends must grow at a constant rate at some
point in the future.

1-53
Example—Non-constant Growth Dividend
• A company has just paid a dividend of 15 cents per share and that
dividend is expected to grow at a rate of 20 per cent per annum for the
next three years, and at a rate of 5 per cent per annum forever after that.
• Assuming a required rate of return of 10 per cent, calculate the current
market price of the share.

1-54
Solution—Non-constant Growth Dividend

1-55
Solution—Non-constant Growth Dividend
(continued)

1-56
Solution—Non-constant Growth Dividend
(continued)

1-57
 3.3 Cost of Equity – Realized yield Approach

Yield approach/ realized yield approach.

According to this return on equity shareholders will depends on

Dividend yield ( current gain) and capital gain( market price
increase) Yield.

Then, return on Equity =

The yield of equity for the year is: DPS1 + ( P1 – P0) x 100
P0
 COST OF EC
Realized yield approach

A share is selling for Rs.50 on which a dividend of Rs.3 per

share is expected at the end of the year. The expected market
price after the dividend declaration is Rs.60.
Compute
1. The return on investment (r) in shares
2. Dividend yield and
3. Capital gain yield.
Risk based-Capital Asset pricing Model Approach (CAPM)
Determines cost of equity based on risk:

Ke = Rf +  ( Rm – Rf)
 Required Rates of Return (RADR)
Components

• The risk-free rate is Required

equal to the real rate of Return (%) SML
return plus expected Risk Adjusted
inflation (Fisher Discount Rate
Equation)
Risk Premium
• The risk premium is
based on an estimate of
the risk associated with RF Real Return
the project. Expected Inflation Rate

Beta of the
Risk
Project

14 - 62
 Risk Adjusted Discount Rates
Using the CAPM

Required Return

ERProject

M
ERM Risk Premium
for project
systematic risk

RF
Real rate of return

Premium for expected inflation

βMarket = 1 βProject = 1.5

β

14 - 63
3.4 Capital Asset pricing Model Approach (CAPM)
Measuring Systemic Risk
Understanding beta:
• What does beta tell us? If an investment is risk free, then β = 0. (no
volatility)
- A beta of 1 implies the
asset has the same If an investment is equal to average (i.e., the
returns are equal to the average market returns)
systematic risk as the overall then the β = 1.
market.
- A beta < 1 implies the If an investment is less risky than average (i.e. the
asset has less systematic returns are less volatile than the average market
risk than the overall market. returns) then the β < 1.

- A beta > 1 implies the

asset has more systematic If an investment is riskier than average (i.e. the
risk than the overall market. returns are more volatile than the average market
returns) then the β > 1.

1-65
Beta at Different Corporations
GO TO LIVE MARKET FOR Beta
The current average market return being paid on
risky investments is 12%, compared with 5% on
Treasury bills. G Co has a beta of 1.2.
What is the required return of an equity
investor in G Co?
 Model 4
Cost of Retained Earnings
 WEIGHTED AVERAGE COST OF CAPITAL

•It is weighted average costs of various sources of funds where the weights
are being the proportion of each source of funds in the capital structure.
•It is overall cost of capital of the company while rising various sources of
funds accepting at specific cost.
• it also called overall cost of capital ( Ko)
Relevance:
• since there is relationship between methods of financing and their costs ( i.e. if
debt increases (as low cost) cost of equity increases), weighted Average Cost of
capital gives better result rather specific cost of capital .

•The simple average cost of capital is not appropriate to use since firm need not
necessarily use various sources of funds in equal proportion in the capital
structure.
WACC = Ke . W1 + Kd. W2 + Kp. W3
WACC : Method of Computation
 Model 5
WEIGHTED AVERAGE COST OF CAPITAL
 Model 5
WEIGHTED AVERAGE COST OF CAPITAL
CHOICE OF WEIGHTS

There is choice between the Book Value weights and Market Value Weights.

While the book value weights may be

Book Value operationally convenient, the market value basis is
Weights theoretically more consistent, sound and a better
indicator of firm’s capital structure.

The desirable practice is to employ market weights

to compute the firm’s cost of capital. This rationale
rests on the fact that the cost of capital measures
Market Value the cost of issuing securities – stock as well as
Weights bonds– to finance projects , and that these are
issued at market value, not book value.
 Model 5
WEIGHTED AVERAGE COST OF CAPITAL

Book Value Weights Vs Market Value Weights

Book Value Weights: (BVW) ( it does not show true economic value (i.e. on historical)
It represents Values as per Balance sheet and are calculated as follow
BVW For:
Equity shares = Face value of an equity share x No. of Equity shares
Preference shares = Face Value of a preference Shares x No. of Preference shares
Debenture(Debt) = Face value of a Debenture x No. of Debentures
Retained Earnings = Same amount as appear in the Balance Sheet
Market Value Weights: It does show true economic value. Share has to traded at market

It represent values as per market Quotations and are calculated as follows

MVW For:
Equity shares = Current Market price of an equity share x No. of Equity shares
Preference shares = Current Market price of a preference Shares x No. of Preference shares
Debenture(Debt) = Current Market price of a Debenture x No. of Debentures

Notes:
1. Flotation Cost is not be deducted from Market price (while computing market weights)
2. Retained earnings are not shown separately , because market price absorps R/E.
 Market Value & Book(Nominal) Values

IMPACT ON SHAREHOLDERS:
Using the nominal values is therefore against the
principle of shareholder wealth maximisation.
 CONCEPT OF PRICE EARNING RATIO

PE ratio is nothing but price earning ratio which shows the relation between
market price (MP) of security and Earnings Per Share (EPS).

MP
P/E ratio =
EPS
 WACC Vs MCC
Floatation Costs and the Marginal Cost of Capital (MCC)

• The Marginal Cost of Capital (MCC) is the weighted average cost of

the next dollar of financing to be raised.
• At low levels of financing the WACC = MCC
• As a firm raises more and more capital in a given year, it will exhaust
the supply of lower cost sources, and then have to access
marginally higher cost sources.
– Therefore MCC increases with the amount of capital to be raised.
 Marginal Cost of Capital

• Gallagher’s weighted average cost will change if one

component cost of capital changes.
• This may occur when a firm raises a particularly large
amount of capital such that investors think that the
firm is riskier.
• The WACC of the next dollar of capital raised in called
the marginal cost of capital (MCC).

83
Should our
analysis
• The cost of capital is used
focus on
primarily to make decisions
historical
that involve raising new
costs or
capital. So, focus on today’s
new marginal costs (for WACC).
(marginal)
costs?
•Cost of capital curve
 The Short Story of WACC
Summary
• WACC measures the firm’s cost of financing future growth
today, based on current capital market conditions, and
assuming the firm use a long-term average of financing
sources.
• WACC is an estimate.
• WACC is used to make capital investment decisions.
• WACC is used to set performance targets for sales, and ROE.
• WACC is used to assess management’s performance,
answering the question, “has management added value?”
THE END