Cost of capitalCost of capitalCost of capitalCost of capital

Meaning & definition• To a firm, it is the cost of obtaining funds

• To an investor, it is the minimum rate of return expected by it without which the market value of shares would fall

• In accounting sense, it is the weighted average cost of various sources of finance used by a firm

DefinitionDefinition

James C Van Horne ,”It is the James C Van Horne ,”It is the cut-off cut-off raterate for the allocation of capital to for the allocation of capital to investments of projects. It is the rate investments of projects. It is the rate of return on a project that will leave of return on a project that will leave unchanged the market price of the unchanged the market price of the stock”stock”

DefinitionDefinition

Solomon Ezra, “Cost of Capital is the Solomon Ezra, “Cost of Capital is the minimum required rate of minimum required rate of earningsearnings or the cut-off rate of or the cut-off rate of capital expenditures”.capital expenditures”.

DefinitionDefinition

John J. Hampton , “Cost of capital is John J. Hampton , “Cost of capital is the rate of return the firm requires the rate of return the firm requires from the investment in order to from the investment in order to increase the value of the firm in increase the value of the firm in the market placethe market place”.”.

Significance of cost of capital

• The acceptance criterion in capital budgeting (in NPV, as a discounting factor and in IRR it is used as a cut off rate to compare with)

• The determinant of optimum capital mix in capital structure decision (ie., the mix that minimizes the overall cost of capital)

Significance of cost of capital

• A basis for evaluating the financial performance (ie., Economic value added = capital employed (ROI – cost of capital) )

• A basis for taking other financial decisions (dividend policy, making rights issue , working capital decisions)

Computation of cost of Computation of cost of capitalcapital

Computation of cost of specific source of Computation of cost of specific source of finance finance

Computation of weighted average cost of Computation of weighted average cost of capitalcapital

Cost of debt (rate of Cost of debt (rate of interest basis)interest basis)

Cost of debt (rate of Cost of debt (rate of interest basis)interest basis)

Cost of debt (rate of interest basis)

• Kdb=I / P• Kdb= Before tax cost of debt• I = Interest• P = Principal• Where debt is issued at premium or discount• Kdb=I / NP• NP = net proceeds ie cost + premium –

floatation cost

Cost of debt (rate of interest basis)

• Kda=Kdb(1-t)• Or Kda=Int (1-t) / NP• Kda= after tax cost of debt• Cost of redeemable debt• Kdb = Int + 1/n (RV-NP)

------------------------½ (RV + NP)

• RV = Redeemable value of debt

Cost of debt• After tax Cost of redeemable debt• Kda = Int (1 – t) + 1/n (RV-NP)

-------------------------------- ½ (RV + NP)

• Cost of debt redeemable in instalments• n• Vd = ∑ (It + Pt) / (1 + kd) t

• t = 1

• Cost of existing debt : MP is taken as NP

Cost of debt• Cost of Zero coupon bonds is

found by method similar to IRR method

• Zero coupon bonds are the bonds or debentures issued at a discount from their maturity value having zero interest rate

Cost of debtCost of debt

Real or inflation adjusted cost of Real or inflation adjusted cost of debt = debt =

1 + NOMINAL COST OF DEBT1 + NOMINAL COST OF DEBT

------------------------------------------------ 1 + INFLATION RATE1 + INFLATION RATE

Cost of PREFERENCE CAPITAL

• KP=D / P• KP=D / NP• KP = D + 1/n (MV-NP)

------------------------ ½ (MV + NP)

Cost of Equity Share Cost of Equity Share CapitalCapital

Cost of Equity Share Cost of Equity Share CapitalCapital

Dividend Yield Method or Dividend/Price Ratio method• According to this method, ‘the cost

of equity capital is the ‘discount rate that equates the present value of expected future dividends per share with the net proceeds or current market price of a share’

• Ke=D / NP• Ke=D / MP

basic assumptions

• the investors give prime importance to dividends and

• risk in the firm remains unchanged

limitations

• It does not consider the growth in dividends

• It does not consider future earnings or retained earnings

• It does not take into account capital gains

suitability

• This method is suitable only when the company has stable earnings and stable dividend policy over a period of time

Dividend Yield Plus growth Method

• This method is used when the dividends of the firm are expected to grow at a constant rate and the dividend payout ratio is constant

• Ke=(D1 / NP) + G• D1 = D0 (1 + G ) • Ke=(D1 / MP) + G

• Ke=(D1 / NP) + G• D1 = D0 (1 + G ) • Ke=(D1 / MP) + G

• Ke= cost of equity• D1 = expected dividend at the end

of the year• MP = market price per share• G = rate of growth in the dividend• D0 = Previous year dividend

Earning Yield Method• Cost of equity capital is the discount

rate that equates the present value of expected future earnings per share with the net proceeds (or current market price) of a share

• Earning Yield Method = EPS / NP or MP

• EARNINGS PER SHARE

---------------------------- MARKET PRICE PER SHARE or NP

Earning Yield Method

• This method is used when• The earnings per share are expected to remain

constant• When the dividend payout ratio is 100% or when

the retention ratio is zero• When the firm is expected to earn an amount on

new equity shares capital, which is equal to the current rate of earnings

• The market price is influenced only by earnings per share

Realised yield method ie RE/MP or NP

In this method instead of estimating the future dividends the past earning are considered. Realised Earnings = average past earnings + capital gain

The assumptions are : 1. The firm will remain in the same risk class over the

period2. The shareholders’ expectations are based on the past

realised yield3. The investors get the same rate of return as the

realised yield even if they invest elsewhere4. The market price of shares does not change

significantly

Cost of retained Cost of retained earningsearnings

Cost of retained Cost of retained earningsearnings

Cost of retained earnings

• Though the firm is not required to pay dividends on retained earnings but the shareholders expect a return on retained profits. As this is the amount sacrificed by the shareholders.

• Thus, its cost can be computed as the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal quality.

Cost of retained earnings

• Kr=(D1 / NP) + G• Kr=(D1 / MP) + G• Kr=Ke (1-t) (1-b)• t = tax rate on dividends• b = brokerage costs

Supernormal growth• If the dividends of a firm are expected to grow at a

super normal rate during the periods when it is experiencing very high demand for its products and then, the dividends grow at a normal rate when the demand reaches the normal level, Ke is estimated from the following formula by trial and error method

Supernormal growth normal growth

n ∞

• P0 = ∑ (D0 (1+gs)t + ∑ (Dn (1+gn)t-n

t = 1 (1 + Ke)t t = n +1 (1 + Ke)t

OR

n • P0 = ∑ (D0 (1+gs)t + Dn+1___ x 1_ t = 1 (1 + Ke)t Ke – gn (1+Ke)n

CAPM Capital Asset Pricing Model

• The value of an equity share is a function of cash inflows expected by the investors and the risk associated with the cash inflows. It is calculated by discounting the future stream of dividends at the required rate of return, called the capitalisation rate. The required rate of return depends upon the element of risk associated with investment in shares. It will be equal to the risk free rate of interest plus the premium for risk. Thus the required rate of return will be:

CAPM Capital Asset Pricing Model

• Ke = Risk free rate of interest + Premium for risk

• Ke = Rf + BI ( Rm – Rf)• Rf = Risk free rate of return• BI = Beta coefficient of firm’s portfolio• Rm = Market return of a diversified

portfolio

Composite Cost of Composite Cost of CapitalCapital

Composite Cost of Composite Cost of CapitalCapital

Or overall cost of capital Or overall cost of capital Or average cost of capitalOr average cost of capital

Weighted Average Cost of Capital

• Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion of the various sources of funds to the total.

• The weights may be given either by using the book value of the source or the market value of the source.

Weighted Average Cost of Capital

• The market value weights get preference due the the fact that they represent the true value of the investors however they suffer from the following limitations:

• It is very difficult to determine the market values because of frequent fluctuations

• Secondly, with the use of market value weights, equity capital gets greater importance

Weighted Average Cost of Capital

• Kw = ∑XW / ∑W• Kw = Weighted average cost of

capital• X = Cost of specific source of

finance• W = weight ie proportion of specific

source of finance

Marginal Cost of Capital

• It is the weighted average cost of new capital calculated by marginal weights

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