Cost of Capital and Capital Structure PlanningNeetu SinghaniaCA,MBA,Mcom

Cost of Capital

Meaning The cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure. It refers to the cost that is incurred in retaining the funds obtained from various sources and employed in business.

Components of Cost of Capital 1)Cost of Debt2)Cost of Equity Share Capital3)Cost of retained Earnings4)Cost of Preference Share Capital

Cost of Debt Capital Cost of debt is the interest rate mentioned in the instrument subject to the adjustment for taxes .Cost of debt can be expressed as :

Kd=I(1-T)Where:I= the interest rateT=the tax rate

Cost of Equity Share Capital Since there is no fixed rate of returns in case of equity shares, its measurement is very difficult. The cost of equity can be measured according to different approaches like

1)Dividend approach, 2)Capital asset pricing model approach, 3)Earning price approach .

Dividend Approach Dividends can grow at a uniform rate perpetually, this is called a perpetuity of dividends . Ke=D1 +g P0 D1=Dividend per share P0=Current market price or net proceeds per share g=growth in constant dividends

Capital Asset Pricing ModelIt measures the risk of the capital i.e systematic risk and unsystematic risks.Systematic risk is due to a broad spectrum of uncontrollable risks. It is measured by which measures change in market value of equity shares relative to change in market index. Unsystematic risk is a unique risk related to the company like management,staff,losses ,strikes etc.The market price of a share is influenced by systematic and unsystematic risks.

Capital Asset Pricing ModelThe CAPM model calculates cost of equity through the following equation:

Ke=Kf+(Km-Kf)Where Ke=Cost of equity capital Kf=Cost of risk free asset =Coefficient of systematic risk Km=Cost of market portfolio

Earning Price Approach It takes into consideration dividends and retained earnings. The cost of capital is measured through the equation :

Ke=E/NPE=earnings per share & np is net proceeds .

Cost of Preference Share CapitalIt may defined as the dividend expected by the preference shareholders .Preference shares may either be redeemable or irredeemable and the cost of capital has to be determined accordinglyThe formula is :

Kp= d/Po(1-f)Where Kp = Cost of preference share capital D=Annual dividend payment Po=Expected sale price of preference shares F=Floatation costs as % of sale price

Cost of retained Earnings They do not have explicit cost rather have implicit costs .The cost of retained earnings is in this sense considered to be having the same cost as that of equity shares but generally since there is no expense of brokerage ,dividend or tax on retained earnings it is considered to have a less cost as compared to cost of equity share capital.Formula is:

Kr=Ke(1-t)(1-b)Kr=Cost of retained earningsT=tax B=Brokerage cost

Weighted Average cost of CapitalAfter calculating the specific costs the next step is to calculate the overall cost of capital i.e weighted average cost of capital

WACC=wKe+wKd+wKpWhere wKe=weighted cost of capital wKd=weighed cost of debt wKp=weighted cost of preference shares.

Basis of Assigning WeightsWeights are of four types:1)Historical Weights: To base the weights on the existing proportions of various forms of capital in the firms Balance sheet.2)Book Value Weights: To base the weights on the face value of difference sources of capital .3)Market Value Weights: Weights are assigned on the basis of market price of the security.4)Marginal Weights :Weights are assigned on the basis on which the current capital budget is to be financed.

Marginal Cost of CapitalWhen new projects are taken up then marginal cost of capital must be calculated.

It is thus used :1)When there is requirement of additional funds2)When there is no external financing and only retained earnings are used for financing new projects .3)When external financing is done with the existing sources of cost of capital in the same proportion as the existing one.

Capital Structure Planning

Meaning

A mix of debt, preferred stock, and common stock with which the firm plans to finance its investments.Objective is to have such a mix of debt, preferred stock, and common equity which will maximize shareholder wealth or maximize market price per share.WACC depends on the mix of different securities in the capital structure. A change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least.An optimal capital structure means a mix of different securities which will maximize the stock price share or minimize WACC.

Components of Capital structure

Owned Funds being share capital,free reserves and surplus.Borrowed Funds being debentures,bonds,long term loans and term lending institutions.

Essentials of an Optimum capital structure FlexibilityEconomySolvencyEfficiencySimplicitySafetyControl

Indifference Point The indifference between the two alternative methods is calculated using the formulae:

EPS Plan 1 = EPS Plan 2(EBIT-I1)(1- t)-Pd1 = (EBIT-I2)(1-t)-PD2 E1 E2Where ,EBIT=Earning before interest & taxI1=Interest charges in plan 1 I2=Interest charges in plan 2 t=Rate of tax Pd1=Preference dividend in Plan 1 Pd2=Preference Dividend in Plan 2 E1=Number of equity shares in Plan 1 E2=Number of equity shares in Plan 2

Financial Break Even At financial break even level of EBIT the firms EPS is just equal to zero.

If EBIT is more than the financial break even point then EPS is positive.

If EBIT is less than the financial break even point then EPS is negative.

Earning per share Y Debt Equity Indifference point

0 EBIT (Rs) X

The capital Structure may be any of the following patterns: 1)Capital Structure with equity shares only.2)Capital structure with both equity shares and preference shares .3)Capital structure with equity shares and debentures .4)Capital structure with equity shares , debentures & preference shares .

Theories of Capital Structure Net Income Approach

Net Operating Income Approach

The traditional Approach

Modigliani Miller Approach

Net Income Approach Net Income approach proposes that there is a definite relationship between capital structure and value of the firm.The capital structure of a firm influences its cost of capital (WACC), and thus directly affects the value of the firm.NI approach assumptions NI approach assumes that a continuous increase in debt does not affect the risk perception of investors.Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ]Corporate income taxes do not exist.

Net Operating Income Approach Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach.As per NOI approach, value of a firm is not dependent upon its capital structure.Assumptions WACC is always constant, and it depends on the business risk.Value of the firm is calculated using the overall cost of capital i.e. the WACC only.The cost of debt (Kd) is constant.Corporate income taxes do not exist.

Traditional Approach The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm.Traditional approach (intermediate approach) is a compromise between these two extreme approaches.Traditional approach confirms the existence of an optimal capital structure; where WACC is minimum and value is the firm is maximum.As per this approach, a best possible mix of debt and equity will maximize the value of the firm.

Traditional Approach The approach works in 3 stages Value of the firm increases with an increase in borrowings (since Kd < Ke). As a result, the WACC reduces gradually. This phenomenon is up to a certain point. At the end of this phenomenon, reduction in WACC ceases and it tends to stabilize. Further increase in borrowings will not affect WACC and the value of firm will also stagnate.Increase in debt beyond this point increases shareholders risk (financial risk) and hence Ke increases. Kd also rises due to higher debt, WACC increases & value of firm decreases.

Modigliani-Miller ApproachIt states that there is no correlation between cost of capital and debt equity ratio.

The average cost of any firm is independent of its capital structure and equal to capitalization rate of pure equity stream of its class.

Assumptions:Perfect Capital MarketsGiven the assumption of perfect information and rationality ,all investors have the same expectation of firms net operating income (EBIT) with which to evaluate the value of a firm.There does not exist any transaction costs .The dividend payout ratio is 100%There are no taxes.Business risk is equal among all firms within similar operating environment.

MM Model proposition

Value of a firm is independent of the capital structure.Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the appropriate rate (i.e. WACC).Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt= Expected EBIT Expected WACC

MM Model proposition

As per MM, identical firms (except capital structure) will have the same level of earnings.As per MM approach, if market values of identical firms are different, arbitrage process will take place. In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.