COST OF CAPITAL

INTRODUCTION
When we talk about the cost of capital, we are talking about the required rate of return on invested funds It is also referred to as a hurdle rate because this is the minimum acceptable rate of return Any investment which does not cover the firm s cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth)

WHAT IS COST OF CAPITAL

JAMES C. VAN HOME: The cost of capital represents a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.

The Appropriate Hurdle Rate: An Example

The managers of Rocky Mountain Motors are considering the purchase of a new tract of land which will be held for one year. The purchase price of the land is $10,000. RMM s capital structure is currently made up of 40% debt, 10% preferred stock, and 50% common equity. This capital structure is considered to be optimal, so any new funds will need to be raised in the same proportions. Before making the decision, RMM s managers must determine the appropriate require rate of return. What minimum rate of return will simultaneously satisfy all of the firm s capital providers?

RMM example (contd)

Because the current capital structure is optimal, the firm will raise funds as follows:

Source of Funds
Debt Preferred Common Total

Amount
$4,000 $1,000 $5,000 $10,000

Dollar Cost
$280 $100 $600 $980

After-tax Cost
7% 10% 12% 9.8%

RMM example (contd)

The following table shows three possible scenarios:

Rate of Return
Total Funds Available Less: Debt Costs Less: Preferred Costs = Remainder to Common

8%

9.8%

11%
$11,100 $4,280 $1,100 $5,720

$10,800 $10,980 $4,280 $4,280 $1,100 $1,100 $5,420 $5,600

Obviously, the firm must earn at least 9.8%. Any less, and the common shareholders will not be satisfied.

ASSUMPTIONS
THE COST CAN BE EITHER EXPLICIT OR IMPLICIT. FINANCIAL AND BUSINESS RISKS ARE NOT AFFECTED BY INVESTING IN NEW INVESTMENT PROPOSALS. THE FIRM S CAPITAL STRUCTURE REMAINS UNCHANGED. COST OF EACH SOURCE OF CAPITAL IS DETERMINED AS AN AFTER TAX BASIS. COST OF PREVIOUSLY OBTAINED CAPITAL ARE NOT RELEVANT FOR COMPUTING THE COST FOR CAPITAL TO BE RAISED FROM A SPECIFIC SOURCE.

MEASUREMENT OF COST OF CAPITAL

IT INVOLVES : COST OF DEBT / COST OF PREFERENCE CAPITAL / COST OF EQUITY CAPITAL / COST OF RETAINED EARNINGS. COST OF DEBT : THE COST OF FUNDS RAISED THROUGH DEBT IN THE FORM OF DEBENTURES OR LOAN FROM FINANCIAL INSTITUTIONS .DEBT COULD BE PERPETUAL / IRREDEMABLE OR REEDEMABLE. COST OF PERPETUAL DEBT : IT IS THE IRREDEMABLE DEBT AND IS THE RATE OF RETURN WHICH THE LENDERS EXPECT.PRINCIPLE IS NOT REEDEMED. Kd = I/NP WHERE Kd = COST OF DEBT , I= ANNUAL INTEREST PAYMENT AND NP= NET PROCEEDS OF DEBT . AFTER TAX Kd=I/NP (1-t) WHERE t = TAX RATE. COST OF REEDEMABLE DEBT : THE PRINCIPLE HAS TO BE REEDEMED AFTER A SPECIFIC PERIOD FROM THE PAYMENT OF INTEREST. Kd = I+(P-NP)/n WHERE I= INTEREST RATE , P=PAR VALUE OF DEBT , (P+NP)/2 NP= NET PROCEEDS OF DEBT , n= NO. OF YEARS OF MATURITY. AFTER TAX Kd = ( 1-t) (I+(P-NP)/n) (P+NP)/2

REALISED YIELD APPROACH

THE COST OF EQUITY CAPITAL SHOULD BE DETERMINED ON THE BASIS OF RETURN ACTUALLY REALISED BY THE INVESTOR IN A COMPANY ON THEIR EQUITY SHARES.THE PAST RECORDS IN A GIVEN PERIOD REGARDING DIVIDENDS AND THE ACTUAL CAPITAL APPRECIATION IN THE VALUE OF EQUITY SHARES SHOULD BE TAKEN TO COMPUTE THE COST OF EQUITY CAPITAL.

COST OF RETAINED EARNINGS

COST OF RETAINED EARNINGS REPRESENT AN OPPORTUNITY COST IN TERMS OF THE RETURNS ON THEIR INVESTMENT IN ANOTHER ENETRPRISE BY THE FIRM WHOSE COST OF RETAINED EARNINGS HAS TO BE CONSIDERED. SUPPOSE THE EARNINGS ARE NOT RETAINED BY THE COMPANY AND PASSED TO THE SHAREHOLDERS AND THEY ARE INVESTED BY THE SHAREHOLDERS IN THE NEW EQUITY SHARES OF THE SAME COMPANY , THE EXPECTATIONS OF THE SHAREHOLDERS FROM THE NEW EQUITY SHARES WOULD BE TAKEN AS THE OPPORTUNITY COST OF THE RETAINED EARNINGS.

WEIGHTED AVERAGE COST OF CAPITAL

THIS IS TERMED AS OVERALL COST OF CAPITAL . CALCULATION INVOLVES CALCULATION OF THE COST OF EACH SPECIFIC SOURCE OF FUNDS / ASSIGNING WEIGHTS TO SPECIFIC COST / MARGINAL WEIGHTS METHOD / HISTORICAL WEIGHTS METHOD.

NUMERICAL:
CALCULATE OVERALL COST OF CAPITAL SOURCE BOOK VALUE MARKET VALUE EQUITY SH. CAP. 45000 90000 RETAINED EARNINGS 15000 NIL PREF. SH. CAPITAL 10000 10000 DEBENTURES 30000 30000 AFTER TAX COST OF SOURCE OF FINANCE IS AS FOLLOWS: EQUITY SH. CAP. = 14% , RETAINED EARNINGS = 13%, PREF. SH. CAP. = 10% AND DEBENTURES = 5%.

SOLVED PROBLEM
THE CAPITAL STRUCTURE OF XYZ LTD. IS AS UNDER 2000 6% DEBENTURES OF RS.100/ EACH RS.200000 1000 7% DEBENTURES OF RS 100/ EACH RS.100000 2000 8% CUMULATIVE PEREFERNCE SHARES OF RS. 100 / EACH RS.200000 4000 EQUITY SHARES OF RS 100/ EACH RS 400000 RETAINED EARNINGS RS 100000 EPS OF THE CO. IN PAST FEW YEARS IS RS 15 / . THE SHARES OF THE CO. ARE SOLD IN MARKET AT BOOK VALUE. TAX RATE IS 50% AND SHAREHOLDERS PERSONAL TAX LIABILITY IS 10 %.FIND OUT WACC.

Debt to Equity Ratio Definition YCharts Calculation: Debt to Equity = (Long Term Debt + Current Portion of Long Term Debt) / Total Shareholders' Equity The debt to equity ratio is a leverage ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. It reveals how a company has financed its assets. A low debt to equity ratio indicates lower risk because shareholder's have claims on a larger portion of the company's assets. A high debt to equity ratio usually means that a company has been aggressive in financing growth with debt and often results in volatile earnings. It is also known as Debt/Equity Ratio, Debt-Equity Ratio, and D/E Ratio. Formula Debt to Equity Ratio = Debt / Shareholders' Equity Note: Some sources will calculate Debt to Equity as Total Debt / Shareholders' Equity, and some sources calculate Shareholders' Equity at market value as opposed to book value. YCharts calculates Shareholder's Equity at book value, not at market value. For Debt, we use (Current Portion of Long Term Debt + Long Term Debt) instead of total debt.