this topic is all about cost of capital how company finance

1. FIN 2732 Fundamental of Financial
Management
Cost of Capital
1

2. Coverage
14.1 Introduction
14.2 Cost of Debt and Preference
14.3 Cost of Equity
14.4 Determining the properties
14.5 Weighted Average Cost of capital (WACC)
14.10 Factors Affecting WACC
Reference: Chapter 14 (Financial Management: Prasanna Chandra 8e)
2

3. 3
Introduction
• What
• Why
• How

4. 4
Cost of Term Loans
Cost of term loans = i (1-t)
where i = interest rate
t = tax rate
Example: X Ltd has borrowed a term loan @ 9%. The corporate tax
rate is 40%. What is the cost of term loan?
Solution: Cost of term-loan = i (1-t) = 0.09 x (1-0.40) = 0.054 = 5.4%.

5. 5
COST OF DEBENTURES
The rate which equates the net amount realized to the expected cash
outflows (i.e. interest & principal repayments).
where, kd = post-tax cost of debenture capital.
I = interest payment
t = corporate tax rate
F = redemption price
P = amount realized / Market price
n = maturity period.

 




n
1
t
n
d
t
d )
k
(1
F
)
k
(1
t)
I(1
P

6. 6
Approximate value of cost of debenture capital
Example: A debenture having face value of Rs. 100 is sold below par
at Rs. 94. it carries an interest rate of 11% and has a maturity period
of 6 years. It is redeemable at par, what is the cost of debt, if the
corporate tax rate is 45%?
2
P
F
n
P
F
t)
I(1
k d






7. 7
2
94
100
6
94
100
)
45
.
0
11(1




Solution: kd = = 0.0727 i.e. 7.27%

8. 8
Cost of Preference Capital
It is computed as:
where, kp = cost of preference capital.
D = preference dividend per share
F = redemption price
P = net amount realized per share.
n = maturity period.

 



n
1
t
n
p
t
p )
k
(1
F
)
k
(1
D
P

9. 9
Approximate Value of Cost of Preference Capital
Example: A company has issued 8% preference shares. The face
value per share is Rs.100 but the issue price is Rs.95. If the maturity
period is 5 years and the preference share is redeemable at premium
of 5%, what is the cost of preference shares?
2
P
F
n
P
F
D
k p





10. 10
Solution: kp= = 0.10 i.e. 10%.
2
95
105
5
95
105
8




11. 11
COST OF EQUITY CAPITAL
Methods For Computing Cost of Equity Capital
1. Capital Asset Pricing Model (CAPM)
2. Bond-Yield Plus Risk Premium Approach
3. Earnings-Price Ratio Approach
4. Dividend Capitalization Approach

12. 12
COST OF EQUITY CAPITAL
1. Capital Asset Pricing Model: Establishes linear relationship
between return on security and systematic risk
• It is mathematically expressed as:
)
R
(k
β
R
k f
m
j
f
j 


Market Risk
Premium
Security’s Risk Premium
Risk-free rate

13. 13
COST OF EQUITY CAPITAL
2. Bond-yield Plus Risk Premium Approach
Return on equity = Yield on the long-term bonds of the company +
Risk premium for bearing the higher risk involved in equity.
3. Earnings Price Ratio Approach
Cost of Equity =
Where, E1 = Current EPS (1+growth rate)
share)
the
of
price
(Market
P
year)
next
for the
EPS
Expected
(
E1

14. 14
COST OF EQUITY CAPITAL
4. Dividend Capitalization Approach: Cost of equity capital is the
discount rate that equates the current market price of the stock to
the stream of dividends receivable by the shareholder.
where,
Pe is the price per equity share
Dt is the expected dividend per share
ke is the rate of return required by the equity shareholders

 

n
1
t
t
e
t
e
)
k
(1
D
P

15. 15
Example: The price per share for Alpha Ltd. is Rs. 115 and the
expected dividend is Rs. 8. What is the equity capitalization rate if
the growth rate of the firm is 6%?
=
= = 0.1295 i.e. 12.95%
g
P
D
k
0
1
e 

06
.
0
115
8


16. 16
WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
Product of the costs of various sources of finance and their proportions
in the capital structure
where,
wi is the proportion of a source of finance in the capital structure
ki is the cost of a source of finance


i
i
ik
w
capital
of
cost
average
Weighted

17. Calculation of WACC
• Example:
cost of equity = 20%
cost of debt = 10%
weight of equity = 0.6
weight of debt = 0.4
17

18. Calculation of WACC
• Example:
cost of equity = 20%
cost of preference = 15%
cost of debt = 10%
equity capital = 50,000
preference capital = 20,000
debt capital = 30,000
18

19. 19
Example: Dunlop Ltd. has the following capital structure in terms of
book values and market values:
Source Book Value (Rs.) Market Value (Rs.)
Paid-up equity Capital
Reserves and Surplus
Preference capital
Debentures
20,00,000
30,00,000
10,00,000
40,00,000
40,00,000
-
12,00,000
42,00,000
Calculate weighted average cost of capital (WACC) using book
value and market value, assuming the cost of various sources of
finance used by the firm is as follows:
Sources Cost of Capital
Equity
Debentures
Preference capital
12.5%
11.4%
7.64%

20. 20
Source Proportion
Equity (we) =
Retained Earnings (wr) =
Preference Capital (wp) =
Debenture Capital (wd) =
0.20
0.30
0.10
0.40
000
,
00
,
100
000
,
00
,
20
000
,
00
,
100
000
,
00
,
10
000
,
00
,
100
000
,
00
,
40
Weighted average cost of capital using market value weights
= weke + wpkp + wrkr + wdkd
=(0.2) 12.5 + (0.3) 12.5 + (0.1) 7.64 + (0.4) 11.40 = 11.57%
Solution: (a) WACC using book value weights
000
,
00
,
100
000
,
00
,
30

21. 21
Source Proportion
Equity (We) =
Preference Capital (Wp) =
Debenture Capital (Wd) =
0.4255
0.1277
0.4468
000
,
00
,
94
000
,
00
,
40
000
,
00
,
94
000
,
00
,
12
000
,
00
,
94
000
,
00
,
42
Weighted average cost of capital using market value weights
= weke + wpkp + wdkd
=(0.4255) 12.50 + (0.1277) 7.64 + (0.4468) 11.40= 11.39%.
(b) WACC using market value weights

22. 14.10 Factor affecting WACC
• Factors outside a firm’s control
– Level of interest rate
– Market risk premium
– Tax rates
• Factor within a firm’s control
– Investment policy
– Capital structure policy
– Dividend policy
22