Information about cost of capital.

1. LEARNING OBJECTIVES
• Explain the general concept of the opportunity cost of capital
• Distinguish between the project cost of capital and the firm’s
cost of capital
• Learn about the methods of calculating component cost of
capital and the weighted average cost of capital
• Recognize the need for calculating cost of capital for divisions
• Understand the methodology of determining the divisional beta
and divisional cost of capital
• Illustrate the cost of capital calculation for a real company
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2. 2
INTRODUCTION
• The project’s cost of capital is the minimum
required rate of return on an investment
project, which depends on the riskiness of its
cash flows.
• It is also known as cut-off rate or hurdle rate.
• The firm’s cost of capital will be the overall,
or average, required rate of return on the
aggregate of investment projects

3. 3
SIGNIFICANCE OF THE COST OF CAPITAL
• Evaluating investment decisions: methods uses
can be NPV, IRR, payback period methods etc
• Designing a firm’s debt policy: Proportion of debt
and equity in capital structure to minimize the
overall cost of capital and maximize firm’s value.
• Appraising the financial performance of top
management by comparing actual returns with
projections and actual cost of capital with its
projections.

4. THE CONCEPT OF THE OPPORTUNITY COST OF
CAPITAL
• The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable risk.
4
Risk-return relationships of various securities

5. 5
Shareholders’ Opportunities and
Values
• The required rate of return (or the opportunity cost of
capital) is shareholders is market-determined.
• In an all-equity financed firm, the equity capital of ordinary
shareholders is the only source to finance investment
projects, the firm’s cost of capital is equal to the opportunity
cost of equity capital, which will depend only on the business
risk of the firm.

6. 6
Creditors’ Claims and
Opportunities
• Creditors have a priority claim over the firm’s assets and
cash flows.
• The firm is under a legal obligation to pay interest and
repay principal.
• There is a probability that it may default on its obligation
to pay interest and principal.
• Corporate bonds are riskier than government bonds
since it is very unlikely that the government will default
in its obligation to pay interest and principal.

7. Formula for the Opportunity Cost of
Capital
• Opportunity cost of capital of firm is given by the following
formula:
• where Io is the capital supplied by investors in period 0 (it
represents a net cash inflow to the firm), Ct are returns
expected by investors (they represent cash outflows to the
firm) and k is the required rate of return or the cost of capital.
• The opportunity cost of retained earnings is the rate of
return, which the ordinary shareholders would have earned
on these funds if they had been distributed as dividends to
them
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8. 8
Cost of Capital
• Viewed from all investors’ point of view, the
firm’s cost of capital is the rate of return
required by them for supplying capital for
financing the firm’s investment projects by
purchasing various securities.
• The rate of return required by all investors
will be an overall rate of return — a weighted
rate of return.

9. 9
Weighted Average Cost of Capital vs.
Specific Costs of Capital
• The cost of capital of each source of capital is known as
component, or specific, cost of capital.
• The overall cost is also called the weighted average cost of
capital (WACC).
• Relevant cost in the investment decisions is the future cost or
the marginal cost.
• Marginal cost is the new or the incremental cost that the firm
incurs if it were to raise capital now, or in the near future.
• The historical cost that was incurred in the past in raising
capital is not relevant in financial decision-making.

10. DETERMINING COMPONENT COSTS
OF CAPITAL
• Generally, the component cost of a specific
source of capital is equal to the investors’
required rate of return, and it can be
determined by using
• But the investors’ required rate of return
should be adjusted for taxes in practice for
10
calculating the cost of a specific source of

11. COST OF DEBT – Irredeemable &
Redeemable
• Debt Issued at Par =before tax cost of
debt
INT = Amount of interest
•
• Debt Iss0
ued at Discount or Premium
INT
B
kd  i 
t n
11
n INTt Bn

B0  
t1 (1 kd ) (1 kd )
• Tax adjustment
After tax cost of debt  kd (1T)
B0
= Issue Price, i = coupon rate
Bn = Maturity value
kd

12. Short cut method–Cost of
Redeemable debt
= Cost of debt
n = duration of debt (years)
B
M
0V= Maturity value, INT = interest amount
= Issue price
12
2
1
( M V  B 0 )
k d
Short cut method for before- tax cost of debt in
case of discount, or premium
I N T 
1
( M V  B 0 )
 n
kd

13. • In bonds, face value or par value is commonly
referred to the amount paid to a bondholder
at the maturity date, given the issuer doesn't
default.
• However, bonds sold on the secondary
market fluctuate with interest rates.
• For example, if interest rates are higher than
the bond's coupon rate, then the bond is sold
at a discount (below par).
• Conversely, if interest rates are lower than the
bond's coupon rate, then the bond is sold at a
premium (above par).

14. WACC Vs. Specific Costs of Capital
• The cost of capital of each source of capital is
known as component, or specific, cost of capital.
• The overall cost is also called the weighted
average cost of capital (WACC).
• Relevant cost in the investment decisions is the
future cost or the marginal cost.
• Marginal cost is the new or the incremental cost
that the firm incurs if it were to raise capital now,
or in the near future.
• The historical cost that was incurred in the past
in raising capital is not relevant in financial
decision-making.

15. Question: Cost of debt
• X Ltd Co. issues Rs.50,000, 8% debentures at
par. The tax rate applicable to the company is
50%. Calculate cost of debt?
• Kda=I/NP(1-t)
• 4000/50000(1-0.5)=4%

16. Question – Cost of debt issued at
prem.
• X Ltd Co. issues Rs.50,000, 8% debentures at a
premium of 10%. The tax rate applicable to
the company is 60%. Calculate cost of debt?
• Kda = 4000 X (1-0.6) = 2.91%
50000+5000

17. Question – Cost of debt issued at
Disc.
• X Ltd Co. issues Rs.50,000, 8% debentures at a
discount of 5%. The tax rate applicable to the
company is 50%. Calculate cost of debt?
• Kda= 4000 X(1-0.5)=4.21%
47500

18. Question: Cost of debt issue at
Disc and Redeemable at Premium
18
Now,


19. Question – Cost of debt –
Floatation cost
• A co. issues Rs.10,00,000, 10% debentures at
a discount of 5%.The cost of floatation
amount to Rs.30,000.The debentures are
redeemable after 5 years. Cal before tax and
after tax cost of debt assuming tax 50%.
N=5
• INT = Rs 1,00,000
• MV= Rs.10,00,000
• NP= Rs 9,20,000 (10,00,000-50,000-30,000)
Kdb=12.09% & Kda=12.09(1-0.5)=6.045%

20. COST OF PREFERENCE CAPITAL
• Irredeemable Preference Share
• or
0

PDIV
P
Kp
n
(1 kp )
Pn
t
PDIVt
n
P0  
t1 (1 kp )

20
2
1
( M V  B 0 )
k p
• Redeemable Preference Share
P D I V 
1
( M V  B 0 )
 n

21. Solution to previous question
• Int =14
• N=5
• RV=105
• NP=96.50
• Kda=15.58(1-0.4) = 9.348%

22. Cost of redeemable debt at
premium
• A 5 year, Rs.100 debentures of a firm can be
sold for a net price of Rs.96.50.The coupon
rate of interest is 14% per annum, debenture
will be redeemed at 5% premium on maturity
.
Tax rate = 40% to be taken. Compute after tax
cost of debenture
• Kdb= INT+1/n(MV-NP)
• ½(MV+NP)

23. Cost of Pref Share: Issue at Disc &
Prem.
23

24. Ques: Cost of Pref. Share -
Floatation
• A co issues 10,000, 10% preference shares of
Rs 100 each .cost of issue is Rs 2 per share,
Calculate Kp if these shares are issued at
• (a) par
• (b) at premium of 10%
• (c) at discount of 5%
• Kp= D+ 1/n(MV-NP)
½(MV+NP)
•

25. Solution to previous question
• D = Rs.1,00,000 (10,00,000*10%)
• (a) NP=10,00,000-20,000
• kp=10.2%
• (b) NP=10,00,000-1,00,000-20,000
• 9.26%
• © NP=10,00,000-50000-20000
• 10.75%

26. Q - Cost of pref. share - floatation
• A company issues 10,000, 10% preference
shares of Rs.100 each redeemable after 10
years at a premium of 5% . The cost of issues
is Rs 2 per share. Find cost of preference
shares.
• D=1,00,000
• NP=9,80,000
• Ans: 10.54%
MV=10,50,000
= [10,00,000 – (2*10,000)]

27. COST OF EQUITY CAPITAL
• Is Equity Capital Free of Cost? No, it has an
opportunity cost.
• Cost of Internal Equity: The Dividend-Growth
Model
– Normal growth
– Supernormal growth
– Zero-growth
(ke  g)
DIV1
0
P 
 (1ke )n


t1
0
DIVn1
ke  gn
0 s
(1ke )t
– g=br (b=retention ratio,r=RO
nED
)IV (1g )t
P 
1
(since g  0)
ke 
DIV1 
EPS1
P0 P0
27

28. COST OF EQUITY CAPITAL
• Cost of External Equity: The Dividend Growth
Model
– Earnings–Price Ratio and the Cost of Equity
 g
P0
ke  1
D IV
(b  0)
28
P0

EPS1
(g  br)

E P S1 (1  b )
 br
0
P
k e

29.  Earnings–Price Ratio can be used as cost of equity
 1.In case of no growth firms Because g will be zero
 2. In case of expansion ,rather than growth faced by firm.A firm is said
to be expanding not growing ,if investment opportunity available to it
are expected to earn a rate of return equal to the cost of equity.
D I V  E P S (1  b ) / k  rb
r ( R O E )  K
29
P 
e
( k  g )
D I V 1
0

30. Cost of equity - Dividend yield
method
• Ke = DIV1 or DIV1 (For no growth)
NP
With growth:
• Ke= DIV1 + G
NP
MP
or DIV1 + G
MP
• Ke= DIV0(1+G) + G
NP
or DIV1 + G
MP

31. Ques: Cost of equity – Simple (no
growth)
• A co issues 1,000 equity shares of Rs.100 each
at a premium of 10%. The co has been paying
20% dividend to equity shareholders for the
past 5 years and expects to maintain/pay the
same in future also. Calculate Ke.
Will it make any difference if the market price of
the share is Rs.160?
• DIV1=20, NP=110, MP=160
• Ke= DIV1/NP & Ke= DIV1/MP
31

32. Ques: Dividend + growth - with
Floatation
• A company plans to issue 2,000 new shares of
Rs.100 each at par. The floatation costs are
expected to be 5% of the share price. The
company pays a dividend of Rs.10 per share
initially and the growth in dividends is expected
to be 5%. (a) Compute the cost of new equity
shares. (b) If market price of an existing equity
share is Rs 150, calculate the cost of existing
equity share capital.
• DIV1 = 10, G = 5%
• NP=100-5 = 95 [FV- Floatation cost]
• Ans: 15.53% & Ke = 11.67%

33. Ques: Dividend + growth
• Raj plastic has been in operation for the last
15 years and its shares in the stock market are
currently trading at Rs 120.The most recent
dividend by the firm was Rs.10 per share.
Historically, the dividend of raj plastic has
been growing at 10% . It is expected to
maintain the same growth rate. what would
be cost of equity?
• 10*1.10 + 0.10 = 19.17%
120

34. Cost of Equity - Earning yield
method
• Ke=EPS/NP or
• Ke=EPS/MP

35. Example
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36. Example: EPS
• A firm is currently earning Rs 100,000 and its share is selling
at a market price of Rs 80. The firm has 10,000 shares
outstanding and has no debt. The earnings of the firm are
expected to remain stable, and it has a payout ratio of 100
per cent. What is the cost of equity?
• We can use expected earnings-price ratio to compute the
cost of equity. Thus:
• EPS= Earnings/ Number of shares = 1,00,000/10,000 = Rs.10
36

37. The Capital Asset Pricing Model
(CAPM)
• As per the CAPM, the Required Rate of Return
on equity (Cost of equity) is given by the
following formula:
• Equation requires the following three
parameters to estimate a firm’s cost of equity:
– The risk-free rate (Rf)
– The market risk premium (Rm – Rf)
– The beta of the firm’s share ()
e f m f j
k R (R R )

38. Example
• Suppose in the year 2002 the risk-free rate is
6 per cent, the market risk premium is 9 per
cent and beta of L&T’s share is 1.54. The cost
of equity for L&T is:
38

39. 39
Question - CAPM
• Sunlite company want to calculate its cost of
equity and the firms cost of capital. The
equity beta is 1.18. Historical average of stock
market return is estimated as 21.5% and risk
free return as 8.5%.
• Calculate Cost of equity.
• Ke = 8.5% + (21.5% - 8.5%) * 1.18
ke Rf (Rm Rf )
j

40. Cost of equity under CAPM
40

41. THE WEIGHTED AVERAGE COST
OF CAPITAL
• WACC is the composite or overall cost of
capital.
• The following steps are involved for
calculating the firm’s WACC:
– Calculate cost of specific component (Kd, Ke, Kp
etc)
– Multiply the cost of each source by its proportion
in the capital structure (weights).
– Add the weighted component costs (calculated at
step 2 above) to get the WACC.

42. 42
WACC question
• L C ltd. Has the following book value capital
structure on 31 march 2012: Calculated
WACC.
Sources of
finance
Amount (Rs.
'000)
Proportion
%
After tax cost
%
Equity share
capital 450,000 45 18
Reserve and
surplus 150,000 15 18
Preference Share
Capital 100,000 10 11
Debt 300,000 30 8
1,000,000 100

43. 43
Sources of finance
(1)
Amount
(Rs. '000)
(2)
Proportion %
(3)
After tax cost %
(4)
Weighted cost
% (5= 3 * 4)
Equity share capital 450,000 45 18 8.1
Reserve and surplus 150,000 15 18 2.7
Preference Share
Capital 100,000 10 11 1.1
Debt 300,000 30 8 2.4
1,000,000 100 WACC 14.3

44.  WACC is in fact the weighted marginal cost of capital
(WMCC); that is, the weighted average cost of new capital
given the firm’s target capital structure.
ko  kd (1T)wd  kd we
44
D
ko  kd (1T)  k
E
D  E e
D  E