Cost of Capital

Financial Management
EVA
• Economic Value Added
• Developed by consulting firm Stern Stewart &
Co.
• EVA measures corporates true profitability

EVA = EBIT — Tax — Cost of funds employed by the firm

Cost of Capital
• The cost of capital acts as a link between the
firm’s long-term investment decisions and the
wealth of the owners as determined by investors
in the marketplace.
• Formally, the cost of capital is the rate of return
that a firm must earn on the projects in which it
invests to maintain the market value of its stock.
Cost of Capital
• The project’s cost of capital is the minimum
required rate of return on funds committed to the
project, which depends on the riskiness of its
cash flows.
• The firm’s cost of capital will be the overall, or
average, required rate of return on the aggregate
of investment projects.
Cost of Capital
• Factors affecting cost of capital
• Level of Interest Rates
External
• Tax Policies
Factors
• Regulatory Environment
• Financing and investment policies
Internal
• Types of capital and uses
Factors
• Types of investment projects
Consider this…
• A firm is currently faced with an investment opportunity.
Project Details Project Details
Cost = Rs.100,000 Cost = Rs.100,000
Life = 20 years Life = 20 years
IRR = 7% IRR = 12%
Consider this…
• A firm is currently faced with an investment opportunity.
Project Details
Cost = Rs.100,000
Life = 20 years
IRR = 7%
Cost of least-cost financing
source available
Debt = 6%
Decision:
The firm undertakes the
opportunity because it can
earn 7% on the investment of
funds costing only 6%.
Project Details
Cost = Rs.100,000
Life = 20 years
IRR = 12%
Cost of least-cost financing
source available
Debt = 14%
Decision:
The firm rejects the opportunity
because the 14% financing
cost is greater than the 12%
expected return.
Consider this…
• If a firm accepts an investment proposal it will
also need funds to finance it. These funds can be
procured from the following sources:
• Equity Share Holders
• Preference Share Holders
• Debt Holders
• Depositors etc…
Significance of the Cost
of Capital

• Evaluating investment decisions,

• Designing a firm’s debt policy, and
• Appraising the financial performance of top
management.
The Firm’s Capital
Structure
Current Current
Assets Liabilities

Long-Term The Firm’s

Debt Capital
Structure
Equity & Cost of
Fixed Capital
Assets
Sources of Capital
• Basic sources of long-term funds for the business
firm:

1. Long-term debt
2. Preferred stock
3. Common stock
4. Retained earnings
Factors affecting CoC
• Risk – Free rate of interest

• Business Risk – riskier project implies increased

cost of funds

• Financial Risk – likelihood that the firm will not

be able to meet the financial charge
Factors affecting CoC
K = Irf + b + f
• K = Cost of capital from various sources
• b = Business Risk
• f = Financial Risk
Factors affecting CoC
• Explicit Cost of Capital
• Interest or dividend that the firm has to pay to the
suppliers of the funds

• Implicit Cost of Capital

• Retained earnings.
• Had these profits been distributed investors would
have earned money. This return is foregone by
investors
Opportunity Cost of
Capital
• The opportunity cost is the rate of return
foregone on the next best alternative
investment opportunity of comparable risk.
 Risk and Return
Return

Risk Equity Share Capital

premium Preference Share Capital

Private Sector Bonds and Debentures

Public Sector Bonds

Government Securities
Risk free
interest rate

Risk
Some Key Assumptions
• Business Risk
• Business Risk — the risk to the firm of being
unable to cover operating costs — is assumed to
be unchanged. This means that the acceptance of
a given project does not affect the firm’s ability
to meet operating costs.
Some Key Assumptions
• Financial Risk
• Financial Risk — the risk to the firm of being
unable to cover required financial obligations —
is assumed to be unchanged. This means that the
projects are financed in such a way that the firm’s
ability to meet financing costs is unchanged.
• After-tax costs are considered relevant—the cost
of capital is measured on an after-tax basis.
Cost 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).
Cost of Capital
• 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.
Cost of
DEBT
Net Proceeds
Net proceeds
funds actually received from the sale of security

Floatation costs
the total costs of issuing and selling a security-reduce
the net proceeds from the sale.
These costs apply to all public offerings of securities –
debt, preferred stock, and common stock.

(1) Underwriting costs – (2) Administrative costs –

compensation earned by issuer expenses such as legal,
investment bankers for selling accounting, printing, and other
the security expenses
Cost of Debt
• Variables determining the cost of debt:
• General level of interest rates
• Default risk of the firm
• Tax advantage associated with debt
Cost of Debt
• Important information required to find the cost of debt
• A) Net proceeds from the issue
• This is the net cash inflow at the time of the debt

Bo = FV + Pm — D — F
• Bo = Net proceeds
• FV = Face Value of debt
• Pm = Premium charged on issue of debt
• D = Discount allowed at the time of issue of debt
• F = Floatation cost  underwriting, brokerage, issue expenses
Net Proceeds... E.g.
• ABC Ltd., a major hardware manufacturer, is
contemplating selling Rs.10 lakh worth of 20-year, 9%
bond at par value of Rs.1,000. Because similar risk bonds
earn returns greater than 9%, the firm must offer a
discount of Rs.20 to compensate for the lower interest
rate. The floatation costs are 2% of the par value of the
bond. Find the net proceeds.

• The net proceeds to the firm from the sale of each bond
is…
• Flotation cost is 0.02 X Rs.1,000 or Rs.20. Therefore, net
proceeds = FV – D – FC = Rs.1000-Rs.20-Rs.20
Cost of Debt
• Periodic payment of interest
• To simplify the calculation, the interest amount is
assumed to be paid annually
• Note: Interest on debentures is always paid on the
Face Value irrespective of the issue price
• Maturity Payment
• The principal amount is paid by the firm on the
maturity.
Cost of Debt
• Cost of Perpetual Debt
• Periodic adjustments are not taken
• Theoretical concept
Ki = I / Bo
Cost of Debt
• Tax Adjustments:
• Interest on debt is tax deductible as a result of this, the
firm gets a saving in its tax liability.
• Interest works as a tax shield
• The effective cost of debt is lower than the interest paid
out
• Real cost is determined by:

Kd = Ki (1 — t)
Cost of Debt
• Cost of Capital of Redeemable Debentures (RD)
• The cost of these RDs may be ascertained by the
following equation:

n
Bo = ∑ I (1 - t) / (i+kd)i + COPi / (1+kd)i + COPn / (1+kd)n
i=1
Cost of Debt
n
Bo = ∑ I (1 - t) / (i+kd)i + COPi / (1+kd)i + COPn / (1+kd)n
i=1

• Bo = ?
• I = Interest amount per annum
• t = tax rate
• COPi = Regular cash outflow on account of amortization
• COPn = Cash outflow on account of repayment at
maturity
• Kd = After tax cost of debt
Cost of Preference Share Capital

• (i) Entitled to receive dividends at fixed rate in

priority over equity shares;

• (ii) Preference share holders get a preference will

get the capital repayment in priority
Cost of Preference Share Capital
• Cost of Capital of Redeemable Preference Shares
n
Po = ∑ PDi / (i+kp)i + Pn / (1+kp)n
i=1

• Po = Net proceeds on the issue of preference shares

• PD = Annual preference dividend at fixed rate of
dividend
• Pn = Amount payable at the time of redemption
• Kp = Cost of preference share capital
• n = Redemption period for the preference shares
Cost of Preference Share Capital
• Cost of Capital of Irredeemable Preference Shares
kp = PD/ Po

• Po = Net proceeds on the issue of preference shares

• PD = Annual preference dividend at fixed rate of dividend
• Kp = Cost of preference share capital
Cost of Equity Capital
• No Coupon Rate
• No starting point is available for equity share
capital
• No commitment to pay equity dividend
• Equity shareholders are the last claimants on the
profits of the company.
• The return in case of equity share holders is
available in the form of dividends
Cost of Equity Capital
• Potential investors must estimate the expected
stream of dividend from the firm.
• This stream of dividend is then discounted to get
the present value of the expected dividend.
• Investors provide funds to the firm in expectation
of receiving combination of dividend return and
appreciated market value.
Cost of Equity Capital
• Present Market Value of Share:
• Expected Returns + Risk Associated
• Market Price of a share =
• the present value of all expected future dividends
+
• sale proceed realized when the share is sold
 Cost of Equity Capital
Po = D1/(1+ke)1 + D2/(1+ke)2 +…..+ Dn/(1+ke)n + Pn/(1+ke)n

• Po = Current market price of equity share

• Pn = Share market price after year n
• Di = Dividends receivables over different years
• ke = Required rate of return of the shareholders or the
cost of equity share capital
Cost of Equity Capital

• Dividend Approach
• CAPM Approach
Cost of Equity Capital
Dividend Approach

• Zero Growth Dividends

• Dividend remain constant and pegged at the current level

for the assumed perpetual life of the firm.
• Perpetuity Dividends
Cost of Equity Capital
Dividend Approach
ke = Di/ Po
• Perpetuity Dividends
• ke = Cost of equity share capital
• Di = Expected dividend at the end of year
• Po = Current market price of the share
Cost of Equity Capital
Dividend Approach

• Zero Growth Dividends

• The firm is following the policy of 100% dividend payout
ratio and no profits are retained in the firm.
• This means that the dividends paid out becomes the
earnings of the shareholders
Cost of Equity Capital
Dividend Approach

• Zero Growth Dividends

• Consider this…
D1 = D2 = D3 = …… Dn
E1 = E2 = E3 = …… En
Cost of Equity Capital
Dividend Approach
ke = Ei/ Po
• Perpetuity Dividends
• ke = Cost of equity share capital
• Ei = Earnings of the equity share holders
• Po = Current market price of the share
Cost of Equity Capital
Dividend Approach
ke = 1 / (Po / Ei)
• (Po / Ei) = Price Earnings Ratio
• ke = inverse of P-E Ratio
 Cost of Equity Capital
Dividend Approach

• Constant Growth Dividends

• Dividends grow at a constant rate, say, ‘g’ percent per
annum.
Dn = D0 (1 + g)
Po = D0(1+g) /(1+ke)1 + D0(1+g)2/(1+ke)2 +………+
D0(1+g)n/(1+ke)n + …. + D0(1+g)∞/(1+ke)∞
Cost of Equity Capital
Dividend Approach

• Constant Growth Dividends

ke = D1 / P0 + g
• Ke = Cost of Equity
• D1 = Dividend to be received
• P0 = Price of the share
• g = Growth rate
Cost of Equity Capital
Dividend Approach
• Constant Growth Dividends
• D1 = D0 (1 + g)
• ke = [D0 (1 + g) / P0] + g
• ke – g = D0 (1 + g) / P0
• P0 = D0 (1 + g) / ke – g
• P0 = D1 / ke – g
Cost of Equity Capital
Dividend Approach
• Constant Growth Dividends
ke = [D0 (1 + g) / P0] + g
P0 = D1 / ke – g
• Assumptions : -
• Current market price of the share is a function of expected
future dividends
• D0 > 0 i.e. present dividend is positive
• Dividend payout ratio is constant
Cost of Equity Capital
• Estimating the Future Growth in Dividend:

• Past Growth in Dividends

• Current Retained Earnings

Cost of Equity Capital
• Past Growth in Dividends
• Consider this…
• Dividend paid in the past years by a company are:—
• Rs.18, Rs.17, Rs.20, Rs.24 and Rs.25 for the years
2005 to 2009
• Rs.18 * (1+g)4 = Rs.25
• g = (25/18)1/4 — 1
• g = 8.56%
Cost of Equity Capital
• Current Retained Earnings
• Why does earnings of a company rise?
• Increase in investments…
• in investments and more investments would
lead to…?
• Growth in earnings
Cost of Equity Capital
• Current Retained Earnings
• Annual growth rate:—
• g = r * b (0 <= b <= 1)
• r = Rate of return obtained on new investments
• b = Proportion of earnings retained
Cost of Equity Capital
• Varying Growth Rates in Dividends
• For the first 5 years dividend grew at the rate of
10% per annum, then for the next five years at
the growth rate may be 15% per annum and
thereafter the dividend may grow at 20% per
annum infinitely.
 Cost of Equity Capital
• Varying Growth Rates in Dividends
5
P0 = ∑ D0 (1+g1)i / (1+ke)i P0 = Current market price of equity share
i=1
D0 = Dividend just paid by the company
10 +
D5 = Div. payable at the end of year 5
∑ D5 (1+g2)i-5 / (1+ke)i
i=6
D10 = Div. payable at the end of year 10
∞ + g1, g2, g3 = Different growth rates
∑ D10 (1+g3) / (1+ke)
i-10 i
i = 11 ke = Cost of equity share capital
Cost of Equity Capital
• Zero Dividends
• Investors expect a capital gain and it will be in
the form of increase in market price.
• How do you calculate cost of capital in such a
case?
P0 = Pn / (1 + ke)n
Cost of Equity Capital
• Newly Issued Capital or External Equity
• Expect same quantum of returns as received by the
previous existing shareholders
• Net proceeds received will be equal to the current
market price minus the flotation cost.
kn = (D1 / NP) + g
• NP = Net proceeds from the issue
• kn = Cost of new equity
Cost of Equity Capital

• CAPM
• Capital Asset Pricing Model
CAPM
• Based directly on the risk consideration
• Risk – Return trade off
• Total risk is classified into two classes:
• 1) Diversifiable Risk (Unsystematic Risk)
• Can be eliminated
• 2) Non-Diversifiable Risk (Systematic Risk)
• Cannot be eliminated
CAPM — Capital Asset
Pricing Model
• As per the CAPM, the required rate of return on
equity is given by the following relationship:
ke  R f  ( Rm  R f )  j
• 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 (β) – measures non-
diversifiable risk
CAPM Vs. Dividend Growth
Model
• The dividend-growth approach has limited
application in practice
• It assumes that the dividend per share will grow at
a constant rate, g, forever.
• The expected dividend growth rate, g, should be
less than the cost of equity, ke, to arrive at the
simple growth formula.
• The dividend–growth approach also fails to deal
with risk directly.
CAPM Vs. Dividend Growth
Model
• CAPM has a wider application although it is
based on restrictive assumptions:
• The only condition for its use is that the
company’s share is quoted on the stock exchange.
• All variables in the CAPM are market determined
and except the company specific share price data,
they are common to all companies.
CAPM Vs. Dividend Growth
Model
• CAPM has a wider application although it is
based on restrictive assumptions:
• The value of beta is determined in an objective
manner by using sound statistical methods. One
practical problem with the use of beta, however, is
that it does not probably remain stable over time.
Cost of Retained Earnings

• This is often taken as equal to the cost of

equity share capital
WACC
• WACC
• Weighted Average Cost of Capital

• Calculates the overall cost of capital

• Calculates the minimum required rate of return
WACC
• WACC is defined as the weighted average cost of various
sources and is described as below:
WACC (ko) = ke * w1 + kd * w2 + kp * w3

• ke = Cost of equity capital

• kd = After tax cost of debt
• kp = Cost of preference shares
• w1 = Proportion of equity capital in capital structure
• w2 = Proportion of debt in capital structure
• w3 = Proportion of preference capital in capital structure
WACC
• Calculate the cost of specific sources of funds
• Multiply the cost of each source by its proportion in
the capital structure.
• Add the weighted component costs to get the WACC.
ko (overall cost of capital) = ke * (E / D+E+P)
+
kd * (D / D+E+P)
+
kp * (P / D+E+P)
WACC
• Book Value Weights
• Proportion of different sources are ascertained on the
basis of the accounting values
• Market Value Weights
• The firm has to find out the current market price of the
security in each categories
Book Value vs. Market Value
• Managers prefer the book value weights for
calculating WACC:
• Firms in practice set their target capital structure in
terms of book values.
• The book value information can be easily derived from
the published sources.
• The book value debt—equity ratios are analyzed by
investors to evaluate the risk of the firms in practice.
Book Value vs. Market Value
• The use of the book-value weights can be
seriously questioned on theoretical grounds:
• First, the component costs are opportunity rates and are
determined in the capital markets. The weights should
also be market-determined.
• Second, the book-value weights are based on arbitrary
accounting policies that are used to calculate retained
earnings and value of assets. Thus, they do not reflect
economic values.
Book Value vs. Market Value
• Market-value weights are theoretically superior
to book-value weights:
• They reflect economic values and are not influenced by
accounting policies.
• They are also consistent with the market-determined
component costs.
Book Value vs. Market Value
• The difficulty in using market-value weights:
• The market prices of securities fluctuate widely and
frequently.
• A market value based target capital structure means
that the amounts of debt and equity are continuously
adjusted as the value of the firm changes.
Thank you