Cost of Capital Minimum rate of return which a company isexpected to earn from a proposed project so as tomake no reduction in the earning per share to equityshareholders and its market price. In economic terms there are two approaches todefine CoC:1. It is the borrowing rate of the firm, at which it canacquire funds to finance the proposed project2. It is the lending rate which the firm could haveearned if the firm would have invested elsewhereCoC is a combined cost of each type of sourceby which a firm raises funds.
CoCAlso referred to as cut-off rate, target rate,hurdle rate, minimum required rate of return,standard return, etc.Assumption: that the firm’s business andfinancial risks are unaffected by the acceptanceand financing of projects.Business risk – is the risk to the firm of beingunable to cover fixed operating costs.Measured by: (ΔEBIT/EBIT)/ (ΔSales/Sales)Financial risk – is the risk of being unable tocover required financial obligations such asinterest, preference dividends. Measured by:(ΔEPS/EPS)/ (ΔEBIT/EBIT)
Importance of CoCCapital Budgeting DecisionsDesigning the Corporate Financial StructureDeciding about the method of financing – in lieu withcapital market fluctuationsPerformance of top managementOther areas – eg., dividend policy, working capital
Measuring CoCA realistic measure of CoC should have the followingqualities of capital expenditure decisions:1. It must account for the general uncertainty ofexpected future returns from investment proposals.2. It must allow for the various degrees of uncertaintyof expected future returns associated with differentuses of funds.3. It must allow for the effects of uncertainty associatedwith an incremental investment and the uncertaintyof returns from the entire asset portfolio of the firm.4. It must account for a variety of financing meansavailable to a firm.5. It must allow for the differential effects of financingcombination on the amount and quality of residualnet benefits accruing to shareholders.6. It must reflect the changes in the capital market.
Basic costs of capital1. Cost of Equity Capital: the cost of obtaining fundsthrough the sale of common stock.2. Cost of Preference Shares3. Cost of Debt4. Cost of Retained Earnings
Cost of Equity CapitalKe is defined as the minimum rate of return that afirm must earn on the equity-financed portion of aninvestment project in order to leave unchanged themarket price of the shares.It is the rate at which investors discount the expecteddividends of the firm to determine its share value.The two approaches to measure ke are i. Dividendvaluation approach and ii. Capital asset pricingmodel.
Cost of EquityMost difficult and controversial cost to work out.Conceptually, the cost of equity ke may be defined asthe minimum rate of return that a firm must earn onthe equity financed portion of an investment projectin order to leave unchanged the market price of theshares.The cost of equity capital is higher than that ofpreference and debt because of greater uncertainty ofreceiving dividends and repayment of principal at theend.
2 approaches to measure Ke1. Dividend approach – dividend valuation model:assumes that the value of a share equals thepresent value of all future dividends that it isexpected to provide over an indefinite period.Ke accordingly is defined as the discount rate thatequates the present value of all expected futuredividends per share with the net proceeds of thesale (or the current market price) of a share.
The constant dividend growthconstant dividend growthassumptionassumption reduces the model to:ke = ( D1 / P0 ) + gAssumes that dividends will grow atthe constant rate “g” forever.Constant Growth ModelConstant Growth Model
Assume that Basket Wonders (BW) hascommon stock outstanding with a currentmarket value of 64.80 per share, currentdividend of 3 per share, and a dividend growthrate of 8% forever.ke = ( D1 / P0 ) + gke = (3(1.08) / 64.80) + 0.08kkee = 0.05 + 0.08 = 0.130.13 or 13%13%Determination of the Cost ofDetermination of the Cost ofEquity CapitalEquity Capital
Risk to which security investment is exposedto are of 2 types:Diversifiable/unsystematic risk: is the portion ofthe security’s risk that is attributable to firm-specificrandom causes; can be eliminated throughdiversification. Eg., management capabilities anddecisions, strikes, unique government regulations,availability of raw materials, competition.
Systematic/Non-diversifiable risk: is therelevant portion of a security’s risk that isattributable to market factors that affect all firms;cannot be eliminated through diversification. Eg.,interest rate changes, inflation or purchasingpower change, changes in investor expectationsabout the overall performance of the economy andpolitical changes.Since diversifiable risks can be eliminated throughdiversification, investors should be concerned withonly non-diversifiable risks.
Market PortfolioSystematic risk can be measured in relation tothe risk of a diversified portfolio which iscommonly referred to as the market portfolioof the market. According to CAPM, the non-diversifiable risk of aninvestment/security/asset is assessed in termsof the beta coefficient.Beta is the measure of the volatility of asecurity’s return relative to the returns of abroad-based market portfolio. Beta coefficientof 1 would imply that the risk of the specifiedsecurity is equal to the market.
Formulake = rf + ß(rm – rf);Where,ke = cost of equity capital;rf = the rate of return required on a risk freeasset/security/investmentrm = required rate of return on the market portfolioof assets that can be viewed as the average rate ofreturn on all assetsß = the beta coefficient.ß for market portfolios is 1, while it is 0 for risk-freeinvestments.
Difference b/w CAPM and Dividend ValuationmethodValuation model does not consider the risk asreflected in beta.CAPM model suffers from the problem of collectionof 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%
Note: CAPM approach is theoretically sound but haslimitations:1. It does not incorporate floatation costs.2.Difficult to get ß values.3. Poorly diversified investors would be concerned withnot only systematic but total risk.So, dividend approach is better.
Cost of Preference CapitalThey 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 isrequired to make payments; since, if it does not pay, itcan’t pay dividends to the equity holders. Also,preference dividend, if unpaid, gets accumulated overyears. Preference shares may beredeemable/irredeemable. (now irredeemablepreference shares are not allowed. Have to be redeemedin maximum 10 years)Cost of preference share capital is the annualpreference share dividend divided by the net proceedsfrom the sale of preference shares.Perpetual security (irredeemable)Cost of redeemable preference share
Cost of Preference SharesThe preference shareholders carry a prior right toreceive dividends over the equity shareholders.Moreover, preference shares are usually cumulativewhich means that preference dividend will keepgetting accumulated unless it is paid.Further, non-payment of preference dividend mayentitle their holders to participate in the managementof the firm as voting rights are conferred on them insuch cases.Above all, the firm may encounter difficulty in raisingfurther equity capital mainly because the non-paymentof preference dividend adversely affects the prospectsof ordinary shareholders.
A. Irredeemable (perpetual)kp=dp/P0(1-f); where,dp=constant annual dividend,P0=expected sales price of preference sharef= floatation costsExample: a 12% irredeemable preference share of face valueof Rs.100, f=5%. What is kp if preference share issued at i.par, ii.10% premium, iii. 10% discounti. 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%
Cost of DebtDebt is the cheapest form of long-term debt fromthe company’s point of view as:It’s the safest form of investment from the point ofview of creditors because they are the firstclaimants on the company’s assets at the time ofits liquidation. Likewise they are the first to bepaid their interest. Another, more importantreason for debt having the lowest cost if the tax-deductibility of interest payments.
Cost of DebtIt is the interest rate which equates the present valueof the expected future receipts with the cost of theproject. The present value of tax-adjusted interestcosts plus repayments of the principal is equated withthe amount received at the time the loan isconsummated.
Cost of DebtCost of debt is the after-tax cost of long-termfunds through borrowing.Net cash proceeds are the funds actually receivedfrom the sale of security.Flotation cost is the total cost of issuing andselling securities.Cost of perpetual/irredeemable debtCost of redeemable debt
Cost of Perpetual/Irredeemable debtThe nominal cost of debt is the periodical interest paid on it. Theinterest 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. Taxrate is 50%. Cost of debt when issued at i. Par, ii. At discount of5% 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%
iii. At a premium of 10%, that is value received is110,000.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%.
Cost of Retained EarningsMay be defined as the opportunity cost in terms ofdividends foregone by/withheld from the equityshareholders.Cost of retained earnings is the same as the cost of anequivalent fully subscribed issue of additional shares,which is measured by the cost of equity capital.Retained earnings are “dividends withheld”, that is, ifwere in the hands of the investors (shareholders) theycould have earned on these by investing somewhereelse. The assumption is that the firm is earning “atleast equal to ke on these retained earnings. So thecost kr is approximately equal to ke (a little less thanke because of floatation costs are not there, kr<ke)
Weighted Average Cost ofCapital (WACC)This gives us the overall cost of capital. Weightage is given to the cost of each source of funds byassessing the relative proportion of each source offund to the total, and is ascertained by using thebook value or the market value of each type ofcapital. The cost of capital of the market value isusually higher than it would be if the book value isused.
Steps in Calculation of WACC(Ko)Assigning weights to specific costs.Multiplying the cost of each sources by theappropriate weights.Dividing the total weighted cost by the total weights.
Weighting can be using marginal or historicalweightsWhy marginal weights? Because it is the new capitalbeing raised for new investment that is important sothe weighted cost of new capital is of relevance. Else,projects with costs higher than managerial costs maybe 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 acceptmany projects because of lower cost at the moment.But, at a later date, company may have the problem ofraising more finance. Marginal weights ignore longterm view.Thus, the fact that today’s financing affects tomorrow’scosts, is not considered in using marginal weights.
Historical weights take a long term view and try toraise financing also in the proportion of existingcapital structure – considered superior.Historical weights can be divided into book valueweights and market value weights.Calculations based on the book value weights are moreeasy operationally while those based on market valuesare more sound theoretically since the sale price ofsecurities is going to be more close to the marketvalue. But the problem is how to choose the marketvalue because they fluctuate widely sometimes andalmost everyday their values are different.
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 tobe greater than the one calculated on the basis of bookvalue since market values of equity and preference sharesis usually higher than book value and hence their weight ismore with respect to debt. For example, in the aboveexample, market values are:
Market Value vs. Book ValueWeights MV sometimes preferred to BV for the MVrepresents the true expectations of the investors.However, it suffers from the followinglimitations:1. MV undergoes frequent fluctuations and have tobe normalized;2. The use of MV tends to cause a shift towardslarger amounts of equity funds, particularlywhen additional financing is undertaken.
MV more appealing than BV as:Market values of securities closely approximate theactual amount to be received from their saleCosts of specific sources of finance which constitutethe capital structure of the firm are calculated usingprevalent market prices.
Advantages of BV weights1. The capital structure targets are usually fixed interms 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 amanagement in procuring funds by comparingon the basis of book values.