COST OF CAPITAL AND LEVERAGE

1.Describe the components of cost of capital. Discuss in detail how the cost of various
components of capital is calculated

The term cost of capital refers to the maximum rate of return a firm must earn on
its investment so that the market value of company’s equity shares does not fall. This is a
consonance with the overall firm’s objective of wealth maximization. This is possible only when
the firm earns a return on the projects financed by equity shareholders funds at a rate which is
at least equal to the rate of return expected by them. If a firm fails to earn return at the
expected rate, the market value of the shares would fall and thus result in reduction of overall
wealth of the shareholders. Thus, a firm’s cost of capital may be defined as “the rate of return
the firm requires from investment in order to increase the value of the firm in the market
place”.
The three components of cost of capital are:
1. Cost of Debt
Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. The
technique of computation of cost in each case has been explained later.
(a) Debt issued at par: The computation of cost of debt issued at par is comparatively an easy
task. It is the explicit interest rate adjusted further for the tax liability of the company. It may be
computed according to the following formula:
Kd = (l-T)R
Where,

 Kd = Cost of debt;

 T = Marginal tax rate;

 R = Debenture interest rate.

The tax is deducted out of the interest payable, because interest is treated as an expense while
computing the firm’s income for tax purposes. However, the tax adjusted rate of interest should
be used only in those cases where the “earning of the firm before interest and tax” (EBIT) is
equal to or exceed the interest. In case, EBIT is in negative, the cost of debt should be calculated
before adjusting the interest rate for tax.
(b) Debt issued at premium or discount: In case the debentures are issued at premium or
discount, the cost of debt should be calculated on the basis of net proceeds realized on account
of issue of such debentures or bonds. Such cost may further be adjusted keeping in view the tax
applicable to the company. Cost of debt can be calculated according to the following formula:
 Kd= I(1-T)/NP
Where,

 Kd = Cost of debt after tax.

 I = Annual interest payment.

 NP = Net proceeds of loans or debentures.

 T = Tax rate.

2. Cost of Preference Capital

The computation of the cost of preference capital however poses some conceptual problems. In
case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while in
case of preference shares, there is no such legal obligation. Hence, some people argue that
dividends payable on preference share capital do not constitute cost. However, this is not true.
This is because, though it is not legally binding on the company to pay dividends on preference
shares, it is generally paid whenever the company makes sufficient profits. The failure to pay
dividend may be better of serious concern from the point of view of equity shareholders. They
may even lose control of the company because of the preference shareholders getting the legal
right to participate in the general meetings of the company with equity shareholders under
certain conditions in the event of failure of the company to pay them their dividends. Moreover,
the accumulation of arrears of preference dividends may adversely affect the right of equity
shareholders to receive dividends. This is because no dividend can be paid to them unless the
arrears of preference dividend are cleared. On account of these reasons the cost of preference
capital is also computed on the same basis as that of debentures. The method of its
computation can be put in the form of the following equation:
Kp=Dp/Np
Where,

 Kp = Cost of preference share capital

 Dp = Fixed preference dividend

 Np = Net proceeds of preference shares.

In case of redeemable preference shares, the cost of capital is the discount rate that equals the
net proceeds of sale of preference shares with the present value of future dividends and
principal repayments.
3. Cost of Equity Capital
 The computation of the cost of equity capital is a difficult task. Some people argue, as observed
in case of preference shares, that the equity capital does not involve any cost. The argument put
forward by them is that it is not legally binding on the company to pay dividends to the equity
shareholders. This does not seem to be a correct approach because the equity shareholders
invest money in shares with the expectation of getting dividend from the company. The
company also does not issue equity shares without having any intention to pay them dividends.
The market price of the equity shares, therefore, depends upon the return expected by the
shareholders.
Conceptually cost of equity share capital may be defined as the minimum rate of return that a
firm must earn on the equity financed portion of an investment in a project in order to leave
unchanged the market price of such shares.
From the preceding discussion, it is implied that in order to find out the cost of equity capital,
one must be in a position to determine what the shareholders as a class expect from their
investment in equity shares. This is a difficult proposition because shareholders as a class are
difficult to predict or quantify. Different authorities have conveyed different explanations and
approaches.
In order to determine the cost of equity capital, it may be divided into new equity and existing
equity. The following are some of the appropriate according to which the cost of equity capital
can be worked out:
(a) Dividend price (D/P) approach
According to this approach, the investor arrives at the market price of an equity shares by
capitalizing the set of expected dividend payments. Cost of equity capital has therefore been
defined as “the discount rate that equates the present value of all expected future dividends
per share with the net proceeds of the sale (or the current market price) of a share”.
In other words, the cost of equity capital will be that rate of expected dividends which will
maintain the present market price of equity shares.
This approach rightly emphasizes the importance of dividends, but it ignores the fact that the
retained earnings have also an impact on the market price of the equity shares. The approach
therefore does not seem to be very logical.
The cost of new equity can be determined according to the following formula:
Ke =D/NP
Where,

 Ke= Cost of equity capital;

 D= Dividend per equity share;

 NP = Net proceeds of an equity share.

 In case of existing equity shares, it will be appropriate to calculate the cost of equity on the
basis of market price of the company’s shares. In the present case, it can be calculated
according to the following formula:
Ke = D/MP
Where,

 Ke= Cost of equity capital;

 D= Dividend per equity share;

 MP = Market price of an equity share.

(b) Dividend price plus growth (D/P + g) approach

According to this approach, the cost of equity capital is determined on the basis on the
expected dividend rate plus the rate of growth in dividend. The rate of growth in dividend is
determined on the basis of the amount of dividends paid by the company for the last few years.
The computation of cost of capital according to this approach can be done by using the
following formula:
Ke = (D/NP) + g
Where,

 Ke = Cost of equity capital;

 D= Expected dividend per share;

 NP = Net proceeds of per share;

 g= Growth in expected dividend.

It may be noted that in case of existing equity shares, the cost of equity capital can also be
determined by using the above formula. However, the market price (MP) should be used in
place of net proceeds (NP) of the shares as given above.
(c) Earning price (E/P) approach
According to this approach, it is the earning per share which determines the market price of the
shares. This is based on the assumption that the shareholders capitalize a stream of future
earnings (as distinguished from dividends) in order to evaluate their share holdings. Hence, the
cost of capital should be related to that earnings percentage which could keep the market price
of the equity shares constant. This approach, therefore, takes into account both dividends as
well as retained earnings. However, the advocates of this approach differ regarding the use of
both earnings and the market price figures. Some simply use of current earning rate and the
 current market price of the share of the company for determining the cost of capital. While
others recommend average rate of earnings (based on the earnings of the past few years) and
the average market price (calculated on the basis of market price for the last few years) of
equity shares.
The formula for calculating the cost of capital according to the approach is as follows:
Ke =E/NP
Where

 Ke= Cost of equity capital;

 D= Earnings per share;

 NP = Net proceeds of an equity share.

However, in case of existing equity shares, it will be appropriate to use market price (MP)
instead of net proceeds (NP) for determining the cost of capital.
(d) Realized Yield Approach
According to this approach, the cost of equity capital should be determined on the basis of the
returns actually realized by the investors in a company on their equity shares. Thus, according to
this approach the past records in a given period regarding dividends and the actual capital
appreciation in the value of the equity shares held by the shareholders should be taken to
compute the cost of equity capital.
This approach gives fairly good results in case of companies with stable dividends and growth
records. In case of such companies, it can be assumed with reasonable degree of certainty that
the past behavior will be repeated in the future also.
2.Explain weighted average cost of capital. How it is computed? Illustrate with an example.

Weighted average cost of capital (WACC) is the average rate of return a company expects to
compensate all its different investors. The weights are the fraction of each financing source in
the company's target capital structure.

HOW IT WORKS (EXAMPLE):

Here is the basic formula for weighted average cost of capital:

WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = Market value of the company's equity

D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate

A company is typically financed using a combination of debt (bonds) and equity (stocks).
Because a company may receive more funding from one source than another, we calculate
a weighted averageto find out how expensive it is for a company to raise the funds needed to
buy buildings, equipment, and inventory.

Weighted Average Cost of Capital

Weighted average cost of capital (WACC) is the proportionate minimum after-tax required rate
of return which a company must earn for all of its security holders (i.e. common stock-holders,
preferred stock-holders and debt-holders). It is calculated by finding out cost of each
component of a company’s capital, multiplying it with the percentage proportion of that
component in total capital and then summing up the proportionate cost of components.
WACC is an important number for any company. It is a benchmark that can be used to evaluate
different projects in the capital budgeting process.
Formula

For a company which has two sources of finance, namely equity and debt, WACC is calculated
using the following formula:
WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity
In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common
stock of the company. It is the minimum rate of return which a company must earn to keep its
common stock price from falling. Cost of equity is estimated using different models, such as
dividend discount model (DDM) and capital asset pricing model (CAPM).
After-tax cost of debt
In the WACC formula, r(D) × (1 – t) represents the after-tax cost of debt i.e. the after-tax rate of
return which the debt-holders need to earn till the maturity of the debt. Cost of debt of a
company is based on the yield to maturity of the relevant instruments. If no yield to maturity is
available, the cost can be estimated using the instrument's current yield, etc. After-tax cost of
debt is included in the calculation of WACC because debt offers a tax shield i.e. interest expense
on debt reduces taxes. This reduction in taxes is reflected in reduction in cost of debt capital.
Weights
w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market
value of the company’s equity by sum of the market values of equity and debt.
w(D) is the weight of debt component in the company’s capital structure. It is calculated by
dividing the market value of the company’s debt by sum of the market values of equity and
debt.
Ideally, WACC should be estimated using target capital structure, which is the capital structure
the company’s management intends to maintain in the long-run. For practical purposes, market
values are usually used and where the market values are not available, book values may be used
to find out the weight.
Example

Sanstreet, Inc. went public by issuing 1 million shares of common stock @ $25 per share. The
shares are currently trading at $30 per share. Current risk free rate is 4%, market risk premium
is 8% and the company has a beta coefficient of 1.2.
During last year, it issued 50,000 bonds of $1,000 par paying 10% coupon annually maturing in
20 years. The bonds are currently trading at $950.
The tax rate is 30%. Calculate the weighted average cost of capital.
Solution:
First we need to calculate the proportion of equity and debt in Sanstreet, Inc. capital structure.
Current Market Value of Equity = 1,000,000 × $30 = $30,000,000
Current Market Value of Debt = 50,000 × $950 = $47,500,000
Total Market Value of Debt and Equity = $77,500,000
Weight of Equity = $30,000,000 / $77,500,000 = 38.71%
Weight of Debt = $47,500,000 / $77,500,000 = 61.29%, or
Weight of Debt = 100% minus cost of equity = 100% − 38.71% = 61.29%
Now, we need estimates for cost of equity and after-tax cost of debt.
We can estimate cost of equity using either dividend discount model (DDM) or capital asset
pricing model (CAPM).
Cost of equity (DDM) = expected dividend in 1 year /current stock price + growth rate
Cost of equity (CAPM) = risk free rate + beta coefficient × market risk premium
In the current example, the data available allow us to use only CAPM to calculate cost of equity.
Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%
Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find that
yield to maturity is 10.61%. It is calculated using hit and trial method. We can also estimate it
using MS Excel RATE function.
For inclusion in WACC, we need after-tax cost of debt, which is 7.427% [= 10.61% × (1 − 30%)].
Having all the necessary inputs, we can plug the values in the WACC formula to get an estimate
of 9.82%.
WACC = 38.71% × 13.6% + 61.29% × 7.427% = 9.8166%
It is called weighted average cost of capital because as you see the cost of different components
is weighted according to their proportion in the capital structure and then summed up.
Importance of WACC
Weighted average cost of capital is the discount rate used in calculation of net present value
(NPV) and other valuations models such as free cash flow valuation model. It is the hurdle
rate in the capital budgeting decisions.
WACC represents the average risk faced by the organization. It would require an upward
adjustment if it has to be used to calculate NPV of projects which are riskier than the company's
average projects and a downward adjustment in case of less risky projects. Further, WACC is
after all an estimation. Different models for calculation of cost of equity may yield different
values.

3.Describe in details leverage. Discuss the various types of leverages and its uses
Leverage is any technique that amplifies investor profits or losses. It's most commonly used to describe the use of
borrowed money to magnify profit potential (financial leverage), but it can also describe the use of fixed assets to
achieve the same goal (operating leverage).

Meaning of Leverage:

The word ‘leverage’, borrowed from physics, is frequently used in financial management.

The object of application of which is made to gain higher financial benefits compared to the
fixed charges payable, as it happens in physics i.e., gaining larger benefits by using lesser
amount of force.

In short, the term ‘leverage’ is used to describe the ability of a firm to use fixed cost assets or
funds to increase the return to its equity shareholders. In other words, leverage is the
employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of
interest obligation—irrespective of the level of activities attained, or the level of operating
profit earned.

Leverage occurs in varying degrees. The higher the degree of leverage, the higher is the risk
involved in meeting fixed payment obligations i.e., operating fixed costs and cost of debt
capital. But, at the same time, higher risk profile increases the possibility of higher rate of
return to the shareholders.
Types of Leverage:
Leverage are the three types:
(i) Operating leverage

(ii) Financial leverage and

(iii) Combined leverage

1. Operating Leverage:

Operating leverage refers to the use of fixed operating costs such as depreciation, insurance
of assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it
does not include interest on debt capital. Higher the proportion of fixed operating cost as
compared to variable cost, higher is the operating leverage, and vice versa.

Operating leverage may be defined as the “firm’s ability to use fixed operating cost to
magnify effects of changes in sales on its earnings before interest and taxes.”

In practice, a firm will have three types of cost viz:

(i) Variable cost that tends to vary in direct proportion to the change in the volume of
activity,

(ii) Fixed costs which tend to remain fixed irrespective of variations in the volume of activity
within a relevant range and during a defined period of time,

(iii) Semi-variable or Semi-fixed costs which are partly fixed and partly variable. They can
be segregated into variable and fixed elements and included in the respective group of costs.

Importance of Operating Leverage:

The importance of operating leverage:
1. It gives an idea about the impact of changes in sales on the operating income of the firm.

2. High degree of operating leverage magnifies the effect on EBIT for a small change in the
sales volume.

3. High degree of operating leverage indicates increase in operating profit or EBIT.

4. High operating leverage results from the existence of a higher amount of fixed costs in the
total cost structure of a firm which makes the margin of safety low.

5. High operating leverage indicates higher amount of sales required to reach break-even
point.

6. Higher fixed operating cost in the total cost structure of a firm promotes higher operating
leverage and its operating risk.

7. A lower operating leverage gives enough cushion to the firm by providing a high margin of
safety against variation in sales.

8. Proper analysis of operating leverage of a firm is useful to the finance manager.

2. Financial Leverage:

Financial leverage is primarily concerned with the financial activities which involve raising
of funds from the sources for which a firm has to bear fixed charges such as interest
expenses, loan fees etc. These sources include long-term debt (i.e., debentures, bonds etc.)
and preference share capital.

Long term debt capital carries a contractual fixed rate of interest and its payment is
obligatory irrespective of the fact whether the firm earns a profit or not.

As debt providers have prior claim on income and assets of a firm over equity shareholders,
their rate of interest is generally lower than the expected return in equity shareholders.
Further, interest on debt capital is a tax deductible expense.

These two facts lead to the magnification of the rate of return on equity share capital and
hence earnings per share. Thus, the effect of changes in operating profits or EBIT on the
earnings per share is shown by the financial leverage.

According to Gitman financial leverage is “the ability of a firm to use fixed financial charges
to magnify the effects of changes in EBIT on firm’s earnings per share”. In other words,
financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing
the return to the equity shareholders.
Favourable or positive financial leverage occurs when a firm earns more on the assets/
investment purchased with the funds, than the fixed cost of their use. Unfavorable or
negative leverage occurs when the firm does not earn as much as the funds cost.

Thus shareholders gain where the firm earns a higher rate of return and pays a lower rate of
return to the supplier of long-term funds. The difference between the earnings from the
assets and the fixed cost on the use of funds goes to the equity shareholders. Financial
leverage is also, therefore, called as ‘trading on equity’.

Financial leverage is associated with financial risk. Financial risk refers to risk of the firm
not being able to cover its fixed financial costs due to variation in EBIT. With the increase in
financial charges, the firm is also required to raise the level of EBIT necessary to meet
financial charges. If the firm cannot cover these financial payments it can be technically
forced into liquidation.

Importance of Financial Leverage:

The financial leverage shows the effect of changes in EBIT on the earnings per share. So it
plays a vital role in financing decision of a firm with the objective of maximising the owner’s
wealth.

The importance of financial leverage:

1. It helps the financial manager to design an optimum capital structure. The
optimum capital structure implies that combination of debt and equity at which overall cost
of capital is minimum and value of the firm is maximum.

2. It increases earning per share (EPS) as well as financial risk.

3. A high financial leverage indicates existence of high financial fixed costs and high
financial risk.

4. It helps to bring balance between financial risk and return in the capital structure.

5. It shows the excess on return on investment over the fixed cost on the use of the funds.

6. It is an important tool in the hands of the finance manager while determining the amount
of debt in the capital structure of the firm.
3. Combined Leverage:

Operating leverage shows the operating risk and is measured by the percentage change in
EBIT due to percentage change in sales. The financial leverage shows the financial risk and
is measured by the percentage change in EPS due to percentage change in EBIT.

Both operating and financial leverages are closely concerned with ascertaining the firm’s
ability to cover fixed costs or fixed rate of interest obligation, if we combine them, the result
is total leverage and the risk associated with combined leverage is known as total risk. It
measures the effect of a percentage change in sales on percentage change in EPS.

Importance of Combined Leverage:

The importance of combined leverage are:
It indicates the effect that changes in sales will have on EPS.

2. It shows the combined effect of operating leverage and financial leverage.

3. A combination of high operating leverage and a high financial leverage is very risky
situation because the combined effect of the two leverages is a multiple of these two
leverages.

4. A combination of high operating leverage and a low financial leverage indicates that the
management should be careful as the high risk involved in the former is balanced by the
later.

5. A combination of low operating leverage and a high financial leverage gives a better
situation for maximising return and minimising risk factor, because keeping the operating
leverage at low rate full advantage of debt financing can be taken to maximise return. In this
situation the firm reaches its BEP at a low level of sales with minimum business risk.

6. A combination of low operating leverage and low financial leverage indicates that the firm
losses profitable opportunities.