2. Cost of Capital
Minimum rate of return which a company is
expected to earn from a proposed project so as to
make no reduction in the earning per share to equity
shareholders and its market price.
In economic terms there are two approaches to
define CoC:
1. It is the borrowing rate of the firm, at which it can
acquire funds to finance the proposed project
2. It is the lending rate which the firm could have
earned if the firm would have invested elsewhere
CoC is a combined cost of each type of source
by which a firm raises funds.
3. CoC
Also referred to as cut-off rate, target rate,
hurdle rate, minimum required rate of return,
standard return, etc.
Assumption: that the firm’s business and
financial risks are unaffected by the acceptance
and financing of projects.
Business risk – is the risk to the firm of being
unable to cover fixed operating costs.
Measured by: (ΔEBIT/EBIT)/ (ΔSales/Sales)
Financial risk – is the risk of being unable to
cover required financial obligations such as
interest, preference dividends. Measured by:
(ΔEPS/EPS)/ (ΔEBIT/EBIT)
4. Importance of CoC
Capital Budgeting Decisions
Designing the Corporate Financial Structure
Deciding about the method of financing – in lieu with
capital market fluctuations
Performance of top management
Other areas – eg., dividend policy, working capital
5. Measuring CoC
A realistic measure of CoC should have the following
qualities of capital expenditure decisions:
1. It must account for the general uncertainty of
expected future returns from investment proposals.
2. It must allow for the various degrees of uncertainty
of expected future returns associated with different
uses of funds.
3. It must allow for the effects of uncertainty associated
with an incremental investment and the uncertainty
of returns from the entire asset portfolio of the firm.
4. It must account for a variety of financing means
available to a firm.
5. It must allow for the differential effects of financing
combination on the amount and quality of residual
net benefits accruing to shareholders.
6. It must reflect the changes in the capital market.
6. Basic costs of capital
1. Cost of Equity Capital: the cost of obtaining funds
through the sale of common stock.
2. Cost of Preference Shares
3. Cost of Debt
4. Cost of Retained Earnings
7. Cost of Equity Capital
Ke is defined as the minimum rate of return that a
firm must earn on the equity-financed portion of an
investment project in order to leave unchanged the
market price of the shares.
It is the rate at which investors discount the expected
dividends of the firm to determine its share value.
The two approaches to measure ke are i. Dividend
valuation approach and ii. Capital asset pricing
model.
8. Cost of Equity
Most difficult and controversial cost to work out.
Conceptually, the cost of equity ke may be defined as
the minimum rate of return that a firm must earn on
the equity financed portion of an investment project
in order to leave unchanged the market price of the
shares.
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.
9. 2 approaches to measure Ke
1. Dividend approach – dividend valuation model:
assumes that the value of a share equals the
present value of all future dividends that it is
expected to provide over an indefinite period.
Ke accordingly is defined as the discount rate that
equates the present value of all expected future
dividends per share with the net proceeds of the
sale (or the current market price) of a share.
10. The constant dividend growthconstant dividend growth
assumptionassumption reduces the model to:
ke = ( D1 / P0 ) + g
Assumes that dividends will grow at
the constant rate “g” forever.
Constant Growth ModelConstant Growth Model
11. Assume that Basket Wonders (BW) has
common stock outstanding with a current
market value of 64.80 per share, current
dividend of 3 per share, and a dividend growth
rate of 8% forever.
ke = ( D1 / P0 ) + g
ke = (3(1.08) / 64.80) + 0.08
kkee = 0.05 + 0.08 = 0.130.13 or 13%13%
Determination of the Cost ofDetermination of the Cost of
Equity CapitalEquity Capital
12. Risk to which security investment is exposed
to are of 2 types:
Diversifiable/unsystematic risk: is the portion of
the security’s risk that is attributable to firm-specific
random causes; can be eliminated through
diversification. Eg., management capabilities and
decisions, strikes, unique government regulations,
availability of raw materials, competition.
13. Systematic/Non-diversifiable risk: is the
relevant portion of a security’s risk that is
attributable to market factors that affect all firms;
cannot be eliminated through diversification. Eg.,
interest rate changes, inflation or purchasing
power change, changes in investor expectations
about the overall performance of the economy and
political changes.
Since diversifiable risks can be eliminated through
diversification, investors should be concerned with
only non-diversifiable risks.
14. Market Portfolio
Systematic risk can be measured in relation to
the risk of a diversified portfolio which is
commonly referred to as the market portfolio
of the market. According to CAPM, the non-
diversifiable risk of an
investment/security/asset is assessed in terms
of the beta coefficient.
Beta is the measure of the volatility of a
security’s return relative to the returns of a
broad-based market portfolio. Beta coefficient
of 1 would imply that the risk of the specified
security is equal to the market.
15. Formula
ke = rf + ß(rm – rf);
Where,
ke = cost of equity capital;
rf = the rate of return required on a risk free
asset/security/investment
rm = required rate of return on the market portfolio
of assets that can be viewed as the average rate of
return on all assets
ß = the beta coefficient.
ß for market portfolios is 1, while it is 0 for risk-free
investments.
16. Difference b/w CAPM and Dividend Valuation
method
Valuation model does not consider the risk as
reflected in beta.
CAPM model suffers from the problem of collection
of data.
Beta measures only systematic risk.
Example: ß=1.4, rf=8%, rm=12%
ke=8%+1.4(12%-8%)
=8%+1.4*4%=13.6%
17. Note: CAPM approach is theoretically sound but has
limitations:
1. It does not incorporate floatation costs.
2.Difficult to get ß values.
3. Poorly diversified investors would be concerned with
not only systematic but total risk.
So, dividend approach is better.
18. Cost of Preference Capital
They are a hybrid security between debt and equity.
The shareholders are paid a dividend yearly. Though,
this payment is not tax-deductible but the company is
required to make payments; since, if it does not pay, it
can’t pay dividends to the equity holders. Also,
preference dividend, if unpaid, gets accumulated over
years. Preference shares may be
redeemable/irredeemable. (now irredeemable
preference shares are not allowed. Have to be redeemed
in maximum 10 years)
Cost of preference share capital is the annual
preference share dividend divided by the net proceeds
from the sale of preference shares.
Perpetual security (irredeemable)
Cost of redeemable preference share
19. Cost of Preference Shares
The preference shareholders carry a prior right to
receive dividends over the equity shareholders.
Moreover, preference shares are usually cumulative
which means that preference dividend will keep
getting accumulated unless it is paid.
Further, non-payment of preference dividend may
entitle their holders to participate in the management
of the firm as voting rights are conferred on them in
such cases.
Above all, the firm may encounter difficulty in raising
further equity capital mainly because the non-payment
of preference dividend adversely affects the prospects
of ordinary shareholders.
20. A. Irredeemable (perpetual)
kp=dp/P0(1-f); where,
dp=constant annual dividend,
P0=expected sales price of preference share
f= floatation costs
Example: a 12% irredeemable preference share of face value
of Rs.100, f=5%. What is kp if preference share issued at i.
par, ii.10% premium, iii. 10% discount
i. At par, kp=12/100(1-0.05)=12/95=12.63%
ii.At 10% premium, kp=12/110(1-0.05)=11.48%
iii.At 10% discount, kp=12/90(1-0.05)=14.03%
21. Cost of Debt
Debt is the cheapest form of long-term debt from
the company’s point of view as:
It’s the safest form of investment from the point of
view of creditors because they are the first
claimants on the company’s assets at the time of
its liquidation. Likewise they are the first to be
paid their interest. Another, more important
reason for debt having the lowest cost if the tax-
deductibility of interest payments.
22. Cost of Debt
It is the interest rate which equates the present value
of the expected future receipts with the cost of the
project. The present value of tax-adjusted interest
costs plus repayments of the principal is equated with
the amount received at the time the loan is
consummated.
23. Cost of Debt
Cost of debt is the after-tax cost of long-term
funds through borrowing.
Net cash proceeds are the funds actually received
from the sale of security.
Flotation cost is the total cost of issuing and
selling securities.
Cost of perpetual/irredeemable debt
Cost of redeemable debt
24. Cost of Perpetual/Irredeemable debt
The nominal cost of debt is the periodical interest paid on it. The
interest rate/market yield is said to be cost of debt.
Suppose a bond is issued to procure perpetual debt. Then,
ki=I/SV; where I is annual interest payment (coupon payment);
SV is sale proceeds of bond/debenture.
kd=I(1-T)/SV; where T is tax rate.
Example: A 12% perpetual debt of nominal value of Rs.100000. Tax
rate is 50%. Cost of debt when issued at i. Par, ii. At discount of
5% and iii. premium of 10%.
i. At par ki=12000/100000=12%
kd=12%(1-0.5)=6%
ii. At discount of 5%, that is value received is 95,000.
ki=12000/95000=12.63%
kd=12.63%(1-0.5)=6.32%
25. iii. At a premium of 10%, that is value received is
110,000.
ki=12000/110,000=10.91%
kd=10.91%(1-0.5)=5.45%
So here (ii) 6.32% is highest cost followed by (i) 6%
or (iii) 5.45%.
26. Cost of Retained Earnings
May be defined as the opportunity cost in terms of
dividends foregone by/withheld from the equity
shareholders.
Cost of retained earnings is the same as the cost of an
equivalent fully subscribed issue of additional shares,
which is measured by the cost of equity capital.
Retained earnings are “dividends withheld”, that is, if
were in the hands of the investors (shareholders) they
could have earned on these by investing somewhere
else. The assumption is that the firm is earning “at
least equal to ke on these retained earnings. So the
cost kr is approximately equal to ke (a little less than
ke because of floatation costs are not there, kr<ke)
27. Weighted Average Cost of
Capital (WACC)
This gives us the overall cost of capital. Weight
age is given to the cost of each source of funds by
assessing the relative proportion of each source of
fund to the total, and is ascertained by using the
book value or the market value of each type of
capital. The cost of capital of the market value is
usually higher than it would be if the book value is
used.
28. Steps in Calculation of WACC
(Ko)
Assigning weights to specific costs.
Multiplying the cost of each sources by the
appropriate weights.
Dividing the total weighted cost by the total weights.
29. Weighting can be using marginal or historical
weights
Why marginal weights? Because it is the new capital
being raised for new investment that is important so
the weighted cost of new capital is of relevance. Else,
projects with costs higher than managerial costs may
be accepted, giving negative results and vice-versa.
But the problem is that if we go by marginal weighting,
we may resort to too much borrowing and accept
many projects because of lower cost at the moment.
But, at a later date, company may have the problem of
raising more finance. Marginal weights ignore long
term view.
Thus, the fact that today’s financing affects tomorrow’s
costs, is not considered in using marginal weights.
30. Historical weights take a long term view and try to
raise financing also in the proportion of existing
capital structure – considered superior.
Historical weights can be divided into book value
weights and market value weights.
Calculations based on the book value weights are more
easy operationally while those based on market values
are more sound theoretically since the sale price of
securities is going to be more close to the market
value. But the problem is how to choose the market
value because they fluctuate widely sometimes and
almost everyday their values are different.
31. Example: capital structure (book value based)
Debt 30% (Rs.6000) cost kd=8%
Preference shares 30% (Rs.6000) cost kp=13%
Equity 40% (Rs.8000) cost k=14%
Ko=WACC= Σwiki=30%*8%+30%*13%+40%*14%
=2.4%+3.9%+5.6%=11.9%
Note: ko calculated on the basis of market value is likely to
be greater than the one calculated on the basis of book
value since market values of equity and preference shares
is usually higher than book value and hence their weight is
more with respect to debt. For example, in the above
example, market values are:
33. Market Value vs. Book Value
Weights
MV sometimes preferred to BV for the MV
represents the true expectations of the investors.
However, it suffers from the following
limitations:
1. MV undergoes frequent fluctuations and have to
be normalized;
2. The use of MV tends to cause a shift towards
larger amounts of equity funds, particularly
when additional financing is undertaken.
34. MV more appealing than BV as:
Market values of securities closely approximate the
actual amount to be received from their sale
Costs of specific sources of finance which constitute
the capital structure of the firm are calculated using
prevalent market prices.
35. Advantages of BV weights
1. The capital structure targets are usually fixed in
terms of book value.
2. It is easy to know the book value.
3. Investors are interested in knowing the debt-
equity ratio on the basis of book values.
4. It is easier to evaluate the performance of a
management in procuring funds by comparing
on the basis of book values.
