Cost Of Capital


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Cost Of Capital

  1. 1. Cost of Capital
  2. 2. <ul><li>COST OF CAPITAL </li></ul><ul><li>The cost of capital for a firm is the weighted average cost of various sources of finance used by the firm. </li></ul><ul><li>VARIOUS SOURCES OF FINANCE </li></ul><ul><li>Debt (Non callable, non convertible Debt) </li></ul><ul><li>Preference Share Capital (Non callable, non convertible shares) </li></ul><ul><li>Equity Share Capital </li></ul><ul><li>Investor’s required rate of return </li></ul><ul><li>Minimum rate of return necessary to attract an investor to purchase or hold a security. </li></ul><ul><li>Why cost of capital is different from investor’s required rate of return </li></ul><ul><li>Taxes </li></ul><ul><li>Flotation Cost </li></ul>
  3. 3. <ul><li>Cost of Debentures (k d ) </li></ul><ul><li>Cost of Preference Share (k p ) </li></ul><ul><li>Cost of Equity (k e ) </li></ul><ul><li>Cost of Term Loan (k t ) </li></ul><ul><li>Cost of Retained Earnings (k r ) </li></ul><ul><li>Weighted Average Cost of Capital </li></ul><ul><li>WACC = k e w e + k p w p + k d w d + k t w t + k r w r </li></ul><ul><li>The weights (proportions) assigned in the above equation are the target capital structure weights stated in market value terms. </li></ul><ul><li>Target Capital Structure </li></ul><ul><li>Many Firms attempt to maintain a desired optimal mix of debt & equity financing. This mix is commonly called a Target Capital Structure. </li></ul>
  4. 4. <ul><li>Cost of Debentures (k d ) </li></ul><ul><li>Calculation Model used </li></ul><ul><li>Impact of Flotation Cost </li></ul><ul><li>Impact of Taxes </li></ul><ul><ul><li>Pre Tax Cost of Debenture </li></ul></ul><ul><ul><li>Post Tax Cost of Debenture </li></ul></ul><ul><li>Cost of Term Loan (k t ) </li></ul><ul><li>Calculation Model used </li></ul><ul><li>Cost of Preference Share (k p ) </li></ul><ul><li>Calculation Model Used </li></ul><ul><li>Cost of Retained Earning(k r ) </li></ul><ul><li>Cost of Equity(k e ) </li></ul><ul><li>Calculation Model Used </li></ul>
  5. 5. <ul><li>Firm’s Cost of Capital & Project’s Cost of Capital </li></ul><ul><li>A Firm represents the aggregate of Investment projects undertaken by it. The projects have their own individual cost of capital which are called as “Project cost of Capital&quot;. This is different from the Firm’s overall cost of capital. </li></ul><ul><li>To use its overall Firm’s cost of capital for evaluating a new Investment, following conditions should be satisfied: </li></ul><ul><li>1. Business Risk of New Investment is same as of all existing Investments. </li></ul><ul><li>2. The Capital Structure of the firm will not be affected by new Investment. </li></ul><ul><li>This proposition does not hold good always. Company will approach market to raise new additional capital and will have an optimal capital structure in future, which currently will be called “ Target Capital Structure &quot;. The Firm will raise additional funds in a different proportion other than the existing ones. This proportion is called as marginal weights. Using marginal weights to calculate the weighted average cost effectively means calculating the actual WACC of Incremental funds. This is also referred to as “ WMCC ”. </li></ul>
  6. 6. <ul><li>Capital Structure Weights </li></ul><ul><li>Historical Weights </li></ul><ul><ul><li>Book Value Weights </li></ul></ul><ul><ul><li>Market Value Weights </li></ul></ul><ul><li>2. Marginal Weights </li></ul><ul><li>Use of Historical Weights – When? </li></ul><ul><li>The firm would raise the additional resources required for financing the investment proposals ,in the same proportions in which they have been used in the existing financing mix. </li></ul><ul><li>Book Value Weights </li></ul><ul><li>Book Value weights are weights if the proportions of different sources of finances are determined on the basis of book value of various sources of funds. </li></ul><ul><li>Easy to determine as these are based on accounting information. </li></ul><ul><li>Logical as the firm may design its future financing mix as per the existing one. </li></ul><ul><li>Not consistent with the objective of firm which is to maximize the market value of the firm which book value weights ignore. </li></ul>
  7. 7. <ul><li>Market Value Weights </li></ul><ul><li>Market Value weights are calculated on the basis of market value of different sources. </li></ul><ul><li>Current Market Price of Securities is determined to calculate the market value weights. </li></ul><ul><li>Market Value weights are consistent with the firm’s objective and provide current estimate of Investor’s required rate of return. </li></ul><ul><li>4. Market Price of all securities is difficult to obtain. </li></ul><ul><li>5. Market Values are subject to change from time to time and optimal financing mix can not be obtained. </li></ul><ul><li>Marginal Weights </li></ul><ul><li>“ The Marginal weights refer to proportion in which the firm wants or intends to raise funds from different sources. The proportion in which Additional Funds are to be raised to finance the investment proposals are known as Marginal Weights .” </li></ul><ul><li>Why Marginal Weights </li></ul><ul><li>Return from Investment will be compared with the actual cost of Funds. </li></ul><ul><li>2. If a particular source which has been used in the past but is not being used now to raise additional funds, should not be allowed to enter the decision process. </li></ul>
  8. 8. <ul><li>Weighted Marginal Cost of Capital </li></ul><ul><li>The Firm’s WACC associated with its next rupee of total new Financing. </li></ul><ul><li>Break Point </li></ul><ul><li>The level of total new financing at which the cost of one of the financing component rises, thereby causing an upward shift in WMCC. </li></ul><ul><li>WMCC Schedule </li></ul><ul><li>Schedule that relates the firm’s WACC to the level of total new financing. </li></ul><ul><li>Investment Opportunities schedule (IOS) </li></ul><ul><li>A ranking of Investment possibilities from best (highest return) to worst (lowest return). </li></ul><ul><li>Using WMCC & IOS to make Financing/Investment Decision </li></ul><ul><li>Accept projects up to the point at which the marginal return on an investment equals its WMCC. </li></ul>