COST OF CAPITAL

The chapter covers

Meaning of cost of capitalImportance of cost of capitalClassification of cost Computation of Cost of capital

Computation of specific cost Cost of Debt Cost of Preference share Cost of Equity share Overall cost of capital

Meaning of Cost of Capital

The cost of capital to a firm is the minimum return, which the suppliers of capital require.For a firm it is a price for obtaining cash. In other words, COC means that rate which is paid for the use of capital.Each source of funds has different cost,such as cost of equity share capital, cost of preference share capital, cost of debt, cost of retained earning.

Meaning of Cost of Capital

From the view point of investor:- COC is the reward for the amount he is investing which could have otherwise been used for consumption or for investment at some other place.

Importance of Cost of Capital

As determination of the COC is very important in the area of financial management :-Capital Budgeting Capital Structure DecisionDividend Policy DecisionHelpful in Evaluation of financial efficiency of Top mgt.Helpful in comparative Analysis of various sources of finance

Classification of Cost

Specific or component cost :- refers to the cost of individual components of capital viz. equity share, preference share,debentures, retained earning.

Combined cost/WACC :- refers to the combined cost (or weighted avg COC) of the various individual components.It is also called the average /weighted cost of capital or overall cost of capital.

Classification of Cost

Explicit and Implicit cost :- Explicit cost is the one which is attached with the source of capital explicitly or apparently while implicit cost is the hidden cost which is not incurred directly.

Example of explicit and Implicit cost

Eg. debt capital :- the interest is explicit cost.

if the company increase debt then investment in the company becomes risky investors will expect more return These increased expectations of the investor may be considered to be implicit cost of debt capital.

Classification of Cost

Historical and Future Cost :- Historial cost means the cost that has been paid in the past for financing a specific project.Future cost is the estimated cost to be incurred to finance a project.Future cost is important for taking financial decision.

Computation of Cost of Capital

It includes:-Computation of cost of specific source of finance.

- Cost of Debt- Cost of Preference share capital- Cost of Equity share capital- Cost of Retained Earnings

Computation of weighted average cost of capital

Cost of Debt

Debt fund can be in the form of debentures or loans from financial institution. Debt can be of 2 types:-

Irredeemable or perpetual DebtRedeemable Debt

Cost of Irredeemable Debt

Calculation of Irredeemable Debt, before tax :-

Kd = Int NP where Kd = Cost of Debt before tax

Int = Interest NP = Net Proceeds

Example of Cost of Debt, before tax:-

X Ltd. issues Rs 15 lakh, 8% debentures (a) at par, (b) at a discount of 7 % and ( c) at a premium of 10%

You are required to calculate the cost of Debt to the company.

Cost of Irredeemable debt, after tax

Formula:- Kda = Int(1- t) * 100

NPExample:- X Ltd has 8% perpetual debt of

Rs 20 Lakh. The tax applicable to the company is 40%. Determine the cost of capital after tax assuming the debt is issued (a) at par, (b) at 10% discount,and © at 10% premium

Example of Cost of Irredeemable Debt

X Ltd.issues 40,000, 8% debentures of Rs 100 each and incurred the following expenditure:

Underwriting Commission 2% of issue priceBrokerage 0.5% of issue pricePrinting and other expense Rs 20,000Calculate cost of Debt assuming debt is issued At 10% premium At 10% discountTax rate is 40%

Cost of Redeemable Debt

Before tax :-Kdb = Int +1/n( RV – NP ) *100

½(RV+ NP)After tax :-

Kda = kdb X (1-t)

Example of Redeemable debt

A company issues Rs 5,00,000 , 10% redeemable debentures redeemable at par after 5 years .The cost of Floatation amount to 4% of face value. Tax rate is 35%

You are required to calculate before tax and after tax cost of debt if debentures are issued at par,at a discount of 10%, at a premium of 5%

Example

A company issues 20,000, 7.5% debentures of Rs. 100 each at a discount of 2% t be redeemed after 10 years at a premium of 5% .The cost of floatation amount to Rs 50,000.. Calculate cost of debt assuming tax rate at 40%

Cost of Preference Share Capital

2 types of Preference share capital is there:- Irredeemable Preference shareRedeemable Preference shareFormula of computing cost

(irredeemable) Kp = D / NP

where:- Kp = cost of preference

share D = Dividend NP = Net proceed

Redeemable Preference share

Formula of computing:- Kpr = D+ (MV-NP)/ n

½ ( MV + NP )where:-

Kpr= cost of redeemable preference Share

D = DividendMV = Market valuen = no of years

Example of preference share

A company issues 10,000, 10% preference share of Rs 100 each. Cost of issue is Rs 2 per share. Calculate cost of preference capital if these are issued at par, at a premium of 10 % , at a discount of 5%.

Example

A company issues 10,000 , 10% preference share of Rs 100 each redeemable after 10 years at a premium of 5%. The cost of issue is Rs 2 per share. Calculate the cost of preference capital.

Cost of Common Stock

Is Equity Capital free of cost ??????????

Cost of Common StockCost of Common Stock

There are 2 sources of Common Equity:

1) Internal common equity (retained earnings), and

2) External common equity (new common stock issue)

Do these 2 sources have the same cost?

Cost of Equity share capital

The cost is difficult to measure, as the rate of return fluctuates every yearIts not legally binded to pay dividend to equity share holder.As the future earning and dividend are expected to grow overtime.

Cost of Equity

The cost of equity can be computed with the following methods:-

Dividend yield methodDividend yield method plus growth in

dividendEarning yield methodEarning yield method plus growth in

earningCAPM Approach

Dividend Yield Method

It is also known as Dividend/ Price method. This method is based on the assumption that when an investor invests in the equity shares of a company he expect to get a payment at least equal to the rate of return prevailing in the market.This method is suitable only when the company has stable earnings and stable dividend policy.

Cost of Equity Share Capital

Formula of computing Cost of Equity:- (Dividend yield method)

Ke = DPS/ MP * 100 where:-

ke = cost of equity DPS= Dividend Per

share MP = Market Price

Example of Equity Share Capital

Equity capital of a company consists of 5,00,000 equity shares of Rs 10 each issued at a premium of Rs 2.5 per share.The average rate of dividend paid by the company has been Rs 3 per share .The market value of the share is Rs 25.Calculate the cost of equity capital.

Dividend yield plus growth in dividend method

This method takes care of the future growth in the rate of dividend .hence, when dividend are expected to grow at constant rate,we compute cost by:-

Ke = DPS/ MP *100+GEx:- X Ltd pays a dividend of Rs 12 per

share initially and the growth in dividend is expected to be 5 % . Compute the cost of equity share if the current market price of an equity share is Rs 150.

Earning Yield Method

Formula:- Ke = EPS/ MP * 100Example:- A company plans to incur an

expenditure of Rs 80 lakhs for expanding its operations. The relevant operation is as follows:-

No of existing share = 20 lakhsNet earning = Rs 160 lakhsMarket value of existing share = 40 sCompute the cost of equity capital.

Earning yield plus growth in Earning Method

Formula:-Ke= EPS/ MP *100 + G

Ex:- The current market price of the equity share of a company is Rs 60 per share .The expected earning per share after one year is Rs 9 per share .Thereafter EPS is expected to grow constantly at 4% per annum .Find out the cost of equity capital.

Capital Assets Pricing Model or CAPM Approach

Ke = Rf + b (Km – Rf)where:-

Rf = risk free returnb = beta coeff.

Km= req return on market return

Ex :- Calculate the cost of equity capital where the beta factor (Risk) is 1.5. Risk free rate of interest on Government Securities is 8% . Return on market portfolio is 12%

The Weighted Average Cost of Capital

We now need a general way to determine the minimum required returnRecall that 40% of funds were from debt. Therefore, 40% of the required return must go to satisfy the debtholders. Similarly, 10% should go to preferred shareholders, and 50% to common shareholders This is a weighted-average, which can be calculated as:

Weighted Cost of CapitalWeighted Cost of Capital

The weighted cost of capital is just the weighted average cost of all of the financing sources.

Calculating RMM’s WACC

Using the numbers from the RMM example, we can calculate RMM’s Weighted-Average Cost of Capital (WACC) as follows:

Note that this is the same as we found earlier

WACC 0 40 0 07 010 010 050 012 0 098. ( . ) . ( . ) . ( . ) .

Finding the Weights

The weights that we use to calculate the WACC will obviously affect the resultTherefore, the obvious question is: “where do the weights come from?”There are two possibilities: Book-value weights Market-value weights

Book-value Weights

One potential source of these weights is the firm’s balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equityWe can calculate the weights by simply determining the proportion that each source of capital is of the total capital

Book-value Weights (cont.)

The following table shows the calculation of the book-value weights for RMM:

Market-value Weights

The problem with book-value weights is that the book values are historical, not current, valuesThe market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriateCalculation of market-value weights is very similar to the calculation of the book-value weightsThe main difference is that we need to first calculate the total market value (price times quantity) of each type of capital

Calculating the Market-value Weights

The following table shows the current market prices:

Market vs Book Values

It is important to note that market-values is always preferred over book-valueThe reason is that book-values represent the historical amount of securities sold, whereas market-values represent the current amount of securities outstandingFor some companies, the difference can be much more dramatic than for RMMFinally, note that RMM should use the 10.27 WACC in its decision making process

The Costs of Capital

As we have seen, a given firm may have more than one provider of capital, each with its own required returnIn addition to determining the weights in the calculation of the WACC, we must determine the individual costs of capital To do this, we simply solve the valuation equations for the required rates of return