Cost of Capital Overview
Cost of Capital Overview
Cost of Capital Overview
overview
Cost of Capital
• Introduction
• Cost of Capital: Concept and its Meaning
• Importance of Cost of Capital
• Types of Cost of Capital
– Explicit Cost and Implicit Cost
– Future Cost and Historical Cost
– Specific Cost and Combine Cost
– Average Cost and Marginal Cost
• Factors Affecting the Cost of Capital
• Measurement of Cost of Capital
• Measurement of Specific Cost
– Cost of Bonds and Debentures
– Cost of Preference Shares
– Cost of Equity Share Capital
– Cost of Retained Earnings
• Weighted Average Cost of Capital (WACC)
• Marginal Cost of Capital
Introduction
• A firm raises funds from various sources of long
term finance like equity, preference, debt or
retained earnings.
• These are called the components of capital.
• Different sources of fund or the components of
capital have different costs.
• The cost of each source is the specific cost of
that source, the average of which gives the
overall cost for acquiring capital.
Introduction
• The firm invests the funds in various assets.
• These assets help in earning returns for the
enterprise.
• In order to achieve the objective of shareholders’
wealth maximization, it is important that the
firm earns a return on these assets that is higher
than the cost of raising the funds.
• Therefore, the minimum return a firm earns
must be equal to the cost of raising the funds.
Cost of Capital
• Cost of capital is the central concept in financial management.
• It is used for making all the business decisions related to
investing, financing and distribution of dividend.
– Milton H. Spencer says “cost of capital is the minimum required
rate of return which a firm requires as a condition for undertaking
an investment”.
– According to Ezra Solomon, “the cost of capital is the minimum
required rate of earnings or the cut-off rate of capital
expenditure”.
– L. J. Gitman defines the cost of capital as “the rate of return a firm
must earn on its investment so the market value of the firm
remains unchanged”
Cost of Capital
• Cost of capital is a composite cost of the
individual sources of funds including equity
shares, preference shares, debt and retained
earnings.
• The overall cost of capital depends on the cost
of each source and the proportion of each
source used by the firm.
• It is also referred to as weighted average cost
of capital.
Cost of Capital
It can be examined from the viewpoint of
– an enterprise and
– an investor
Explicit Cost
• It is the rate that the firm pays towards the
procurement of funds.
• The raising of funds involves both
– Cash inflows (receipt of funds raised) and
– Cash outflows (repayment of principal and the interest
thereon).
• It may be defined as the discount rate that equates
the present value of the funds raised by a firm with
the present value of expected cash outflows.
Explicit and Implicit Cost.
Implicit Cost
• This cost arises because of an ability of a
firm to have an alternative use of funds.
• It is also known as the opportunity cost
as it is the cost of the opportunity foregone in
order to take up a particular project
Difference between Explicit and Implicit Cost:
th
COP = Repa ym en t of pr in cipa l in 6 yea r .
6
Sh or t -cu t m et h od (Redeem a ble Deben t u r es) t o fin d a ppr oxim a t e cost of debt
wh en t h e deben t u r es a r e t o be r edeem ed a ft er a specific per iod of t im e.
= 78(4.486)+1000(.596)=349.91+596=945.91
This value is higher than LHS=940, Now apply a high er rate of say 10%;
Using 10% ra te, we get,
RHS = 78(4.355)+1000(.565)=339.69+565 = 904.69
Applying the interpolation , we get
945.91 − 940 5.91
Kd = 9% + = = 𝟗. 𝟏𝟒%
945.91 − 904.69 41.22
Observation
• The short-cut method of computing the cost
of debt provides a good approximation but
not a conclusive computation of this cost
component.
• Note: This short-cut method is not applicable
when the principal amount is repaid in many
installments
EXAMPLE:10.4.
• 2,00,000 debentures of `250 each are being
• issued at 5% discount.
• Coupon rate is 15%.
• Floatation costs are likely to be 5% of the face value.
• Redemption will be after 8 years at a premium of 5%.
• Tax rate is 40%.
Determine the cost of debt using the short cut method
Delhi Univ., B.Com (Hons) 2007 (Sol)
Solution
• Redemption value of debentures = Par value + 10%
Premium
= 250 + 5 % x 250 = 250 + 12.50 = `262.50
• Net proceeds from the issue
= Par value – discount – floatation cost
= 250 - 5% x 250 - 5% x 250 = `225
• Interest amount on debentures
= 250 x 15% = `37.50
Maturity period of debentures = 8 years
Corporate tax rate = 40%
Solution contd..
As t h e r edem ption per iod a n d r edem pt ion va lu es a r e kn own , th e tr u e cost of debt
m a y be com pu ted u sin g th e followin g for m u la :
Intሺ1 − tሻ + (RV − NP) ÷ N
Kd =
(RV + NP) ÷ 2
The short cut method, approximating the cost of preference capital is:
PD + (RV − NP) ÷ n
Kp =
(RV + NP) ÷ 2
Where RV = Redemption Value
NP = Net proceeds from the issue
PD = annual preference dividend
EXAMPLE: 10.6.
• Bose Systems Ltd. has planned to issue 30,000
• 14% preference shares of `100 each
• that are redeemable after 10 years.
• Floatation costs are expected to be 2% of sale
proceeds of the issue.
• Calculate the cost of preference capital, using
the
– (a) short-cut method and
– (b) trial and error method.
Solution
Using per share calcu lation and applying the short -cut formula as given below:
PD + (RV − NP) ÷ n
Kp =
(RV + NP) ÷ 2
We get
14 100 98 10 14.2
Kp 0.1434 = 14.34%
100 98 2 99
Solution contd
N ow in or der t o a pply t r ia l a n d er r or m et h od, we ca n fin d t h e pr esen t va lu e of
r egu la r ca sh ou t flows a n d t er m in a l ou t flows t o com pa r e wit h t h e n et pr oceeds for
14% a n d 15%.
Applyin g t h e discou n t r a t e of 14% a n d 15% on t h e followin g m odel:
n
PDt Pn
P0 = +
(1 + K p )t (1 + K p )n
t=1
We get
At 14% P0 14 PVIFA14%,10 100 PVIF14%,10
=14(5.216) + 100(.27) =73.024 + 27 =100.024
At 15% P0 14 PVIFA15%,10 100 PVIF15%,10
=14(5.019) + 100(.247) = 70.266 + 24.7 = 94.966
U sin g In t er pola t ion
100 .024 −98
K p = 14% + 100 .024 −94.966
2.024
= 14% + % = 14.4%
5.058
It m a y be n ot ed t h a t t h e sh or t -cu t m et h od h a s given a good a ppr oxim a t ion of
t h e ou t com e obt a in ed u sin g t h e t r ia l a n d er r or m et h od.
Cost of Equity Share Capital
Ma t h em a t ica lly,
D1 D2 Dn Pn
P0 = + + ………….+ +
(1+K e )1 (1+K e )2 (1+K e )n (1+K e )n
Wh er e
P0 = Current market price of share
Pn = Market price of share while liquidating the shares
Dt = Dividend in different years: t = 1, 2,……n
K e = Cost of Equity Capital
Approaches for computation of cost of
equity capital
• Dividend–Price Approach
• Dividend–growth Approach: both uniform and
varying growth rates
• Earnings-Price Approach
• Capital Asset Pricing Model (CAPM)
• Realized Yield Approach
Dividend–Price Approach
• The cost of equity share may be calculated on
the basis of dividend and current market price
of shares.
• Accordingly, cost of equity (Ke) is defined as
the 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.
Cost of Equity Share Capital
Therefore, when the dividend per share or total equity dividend is given and
there is no information regarding the growth rate, the cost of equity is measured by:
𝐷1
𝐾𝑒 =
𝑃0
Where 𝐾𝑒 = Cost of equity capital
𝐷1 =Expected dividend per share
𝑃0 =Net proceeds from new issue of equity after adjusting for any discount,
premium and floatation cost or current market price per share, net of
any brokerage in case of existing equity.
EXAMPLE: 10.7
• . M/s Mukund Purifier Ltd. has issued equity
shares of `10 each at a premium of 10%, after
incurring a floatation cost of 4% of issue price.
In keeping with the dividend paid by similar
companies, shareholders expect a dividend of
15% per share. Determine the cost of equity
capital.
Solution
• The cost of equity is defined as that rate of return to the firm that
must be earned on its equity financed portion of investment so as to
leave unchanged the market price of the stock.
• Accordingly, the rate of return (or discount rate) that equates the
present value of future stream of earnings and (not just dividend)
with the price of shares is the cost of equity capital.
Earnings Price approach
• When the earning per share or net income
after tax is known and there is no information
regarding the dividend on equity share, the
formulation to compute the cost of equity is:
𝑬𝟎 𝟏
𝑲𝒆 = =
𝑷𝟎 𝑷
𝑬
(P /E ra tio is a p e rfo rm a n c e in d ic a to r in th e m a rk e t)
Wh e re 𝑲𝒆 = Co s t o f e qu ity c a p ita l
𝑬𝟎 = Cu rre n t e a rn in g s p e r s h a re th a t is to c o n tin u e
p e rp e tu a lly .
𝑷𝟎 = Cu rre n t m a rk e t p ric e p e r s h a re , n e t o f a n y bro k e ra g e
(o r n e t p ro c e e d s in c a s e o f n e w e qu ity )
EXAMPLE: 10.11.
• The current market price of a share is `100.
• The firm’s current earnings are `21 crores and
its share outstanding are `2 crores.
• It is contemplating to raise additional funds of
`6 crores by issuing equity at a premium of
10%.
• The floatation cost is `5 per share.
• Compute the cost of equity capital.
Solution
𝑬𝟎
Using the above mentioned formulation, the cost of equity is 𝑲𝒆 =
𝑷𝟎
E = Earnings ÷ Existing shares
0
Th e c o s t o f e qu ity , u s in g CAP M is c o m p u te d as :
𝑲𝒆 = 𝑲𝒇 + 𝜷(𝑲𝒎 − 𝑲𝒇 )
Wh e re
𝑲𝒆 = c os t o f e qu ity
𝑲𝒇 = 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐫𝐞𝐭𝐮𝐧 𝐨𝐧 𝐫𝐢𝐬𝐤 𝐟𝐫𝐞𝐞 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲
𝐊 𝐦 = Ex p e c te d re tu rn fro m th e m ark e t
𝛃 = 𝐂𝐨𝐞𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐭 𝐨𝐟 𝐬𝐲𝐬𝐭𝐞𝐦𝐚𝐭𝐢𝐜 𝐫𝐢𝐬𝐤
Cost of Retained Earnings
Given that
RV = Redemption value of preference share at par = `100
NP = Net proceeds from the issue =106 x (1- 0.03) = `102.82
PD= Annual preference dividend = 100 x 11% = `11
n = Maturity period (in years) = 10
11 (100 102.82) 10 11 0.282 10.718
Kp =0.1057 = 10.57%
(100 102.82) 2 101.41 101.41
Solution contd
iii. Calculating Market Price, when cost of equity, growth rate and DPS are
known:
Given that Ke =16%, D2 =2.42 and g =10%, we compute
D1= (1D g ) (12.42
2
0.1)
2.2 and therefore, P0 =
D1
Ke - g
= 2.2
2.2
0.16 0.1 0.06
= `36.67
Breaks in specific cost of capital:
Ba sed u pon above com pila tion s, we can deter m in e specific cost at differ en t
level of fu n din g.
Overall Source of
funding Funds (`lakhs) Specific Cost
(`lakhs) Debt Equity Debt Equity
10 4 6 4.80% 12%
15 6 9 6.00% 12%
20 8 12 6.00% 15%
25 10 15 6.00% 15%
30 12 18 7.20% 18%
35 14 21 7.20% 18%
Computation of WACC at different level of funding
Funding Level WACC
(in Lakhs) %
10 0.4(4.8%) + 0.6(12%) = 0.0192+.072 = 0.0912 = 9.12%
15 0.4(6.0%) + 0.6(12%) = 0.024 +.072 = 0.096 = 9.60%
20 0.4(6.0%) + 0.6(15%) = 0.024 +0.09 = 0 .114 = 11.40%
25 0.4(6.0%) + 0.6(15%) = 0.024 +0.09 = 0 .114 = 11.40%
30 0.4(7.2%) + 0.6(18%) = 0.0288+0.108 = 0.1368 = 13.68%
35 0.4(7.2%) + 0.6(18%) = 0.0288+0.108 = 0.1368 = 13.68%
0-10, 10-15, 15-25 a n d 25-35 a r e t h e br ea k poin t r a n ges a s t h e va lu es of
WACC a r e differ en t for t h e u pper va lu es of t h ese r a n ges fu n din g r a n ges.
Solution
Break Points in debt financing:
Maximum Overall funding at 8% cost of debt (after tax K = 4.8%)
d
4Lakhs
= = `10 Lakhs
40%
Maximum Overall funding at 10 % cost of debt (after tax K = 6%)
d
10 Lakhs
= = `25 Lakhs
40%
Maximum Overall funding at 12% cost of debt (after tax K = 7.2%)
d
14 Lakhs
= = `35 Lakhs
40%
Therefore, `10 Lakhs, `25 Lakhs, `35 Lakhs are respective break points at
4.8%, 6% and 7.2% after tax cost of debt.
Solution
Break Points in equity financing:
Maximum Overall funding at 12% cost of equity
9 Lakhs
= = `15 Lakhs
60%
Maximum Overall funding at 15% cost of equity
15 Lakhs
= = `25 Lakhs
60%
Maximum Overall funding at 18% cost of equity
21 Lakhs
= = `35 Lakhs
60%