Cost Of Capital

Cost of capital

Meaning & definition

• To a firm, it is the cost of obtaining funds • To an investor, it is the minimum rate of return expected by it without which the market value of shares would fall • In accounting sense, it is the weighted average cost of various sources of finance used by a firm

Definition  James

C Van Horne ,”It is the 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”

Definition  Solomon

Ezra, “Cost of Capital is the minimum required rate of earnings or the cut-off rate of capital expenditures”.

Definition  John

J. Hampton , “Cost of capital is the rate of return the firm requires from the investment in order to increase the value of the firm in the market place”.

Significance of cost of capital • The acceptance criterion in capital budgeting (in NPV, as a discounting factor and in IRR it is used as a cut off rate to compare with) • The determinant of optimum capital mix in capital structure decision (ie., the mix that minimizes the overall cost of capital)

Significance of cost of capital • A basis for evaluating the financial performance (ie., Economic value added = capital employed (ROI – cost of capital) ) • A basis for taking other financial decisions (dividend policy, making rights issue , working capital decisions)

Co mputation o f cost of capit al  Computation of cost of specific source of finance  Computation of weighted average cost of capital

Cost of debt (rate of interest basis)

Cost of debt (rate of interest basis) • • • • • • •

Kdb=I / P Kdb= Before tax cost of debt I = Interest P = Principal Where debt is issued at premium or discount Kdb=I / NP NP = net proceeds ie cost + premium – floatation cost

Cost of debt (rate of interest basis) • • • • •

Kda=Kdb(1-t) Or Kda=Int (1-t) / NP Kda= after tax cost of debt Cost of redeemable debt Kdb = Int + 1/n (RV-NP) -----------------------½ (RV + NP)

• RV = Redeemable value of debt

Cost of debt • After tax Cost of redeemable debt • Kda = Int (1 – t) + 1/n (RV-NP) -------------------------------½ (RV + NP)

• Cost of debt redeemable in instalments • n • Vd = ∑ (It + Pt) / (1 + kd) t •

t = 1

• Cost of existing debt : MP is taken as NP

Cost of debt • Cost of Zero coupon bonds is found by method similar to IRR method • Zero coupon bonds are the bonds or debentures issued at a discount from their maturity value having zero interest rate

Cost of debt 

Real or inflation adjusted cost of debt = 1 + NOMINAL COST OF DEBT

-----------------------1 + INFLATION RATE

Cost of PREFERENCE CAPITAL • KP=D / P • KP=D / NP D + 1/n (MV-NP) • KP =

-----------------------½ (MV + NP)

Cost of Equity Share Capital

Dividend Yield Method or Dividend/Price Ratio method • According to this method, ‘the cost of equity capital is the ‘discount rate that equates the present value of expected future dividends per share with the net proceeds or current market price of a share’ • Ke=D / NP • Ke=D / MP

basic assumptions • the investors give prime importance to dividends and • risk in the firm remains unchanged

limitations • It does not consider the growth in dividends • It does not consider future earnings or retained earnings • It does not take into account capital gains

suitability • This method is suitable only when the company has stable earnings and stable dividend policy over a period of time

Dividend Yield Plus growth Method • This method is used when the dividends of the firm are expected to grow at a constant rate and the dividend payout ratio is constant • Ke=(D1 / NP) + G • D1 = D0 (1 + G ) • Ke=(D1 / MP) + G

• Ke=(D1 / NP) + G • D1 = D0 (1 + G ) • Ke=(D1 / MP) + G • Ke= cost of equity • D1 = expected dividend at the end of the year • MP = market price per share • G = rate of growth in the dividend • D0 = Previous year dividend

Earning Yield Method • Cost of equity capital is the discount rate that equates the present value of expected future earnings per share with the net proceeds (or current market price) of a share • Earning Yield Method = EPS / NP or MP •

EARNINGS PER SHARE

---------------------------MARKET PRICE PER SHARE or NP

Earning Yield Method • This method is used when • The earnings per share are expected to remain constant • When the dividend payout ratio is 100% or when the retention ratio is zero • When the firm is expected to earn an amount on new equity shares capital, which is equal to the current rate of earnings • The market price is influenced only by earnings per share

Realised yield method ie RE/MP or NP In this method instead of estimating the future dividends the past earning are considered. Realised Earnings = average past earnings + capital gain The assumptions are : 3. The firm will remain in the same risk class over the period 4. The shareholders’ expectations are based on the past realised yield 5. The investors get the same rate of return as the realised yield even if they invest elsewhere 6. The market price of shares does not change significantly

Cost of retained earnings

Cost of retained earnings • Though the firm is not required to pay dividends on retained earnings but the shareholders expect a return on retained profits. As this is the amount sacrificed by the shareholders. • Thus, its cost can be computed as the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal quality.

Cost of retained earnings • • • • •

Kr=(D1 / NP) + G Kr=(D1 / MP) + G Kr=Ke (1-t) (1-b) t = tax rate on dividends b = brokerage costs

Supernormal growth • If the dividends of a firm are expected to grow at a super normal rate during the periods when it is experiencing very high demand for its products and then, the dividends grow at a normal rate when the demand reaches the normal level, Ke is estimated from the following formula by trial and error method Supernormal growth n

• P0 = ∑ (D0 (1+gs)t t = 1 (1 + Ke)t

normal growth

+

∞

∑

t = n +1

(Dn (1+gn)t-n (1 + Ke)t OR

n

• P0 = ∑

t = 1

(D0 (1+gs)t (1 + Ke)t

+

Dn+1___ x 1_ Ke – gn (1+Ke)n

CAPM Capital Asset Pricing Model • The value of an equity share is a function of cash inflows expected by the investors and the risk associated with the cash inflows. It is calculated by discounting the future stream of dividends at the required rate of return, called the capitalisation rate. The required rate of return depends upon the element of risk associated with investment in shares. It will be equal to the risk free rate of interest plus the premium for risk. Thus the required rate of return will be:

CAPM Capital Asset Pricing Model • Ke = Risk free rate of interest + Premium for risk • Ke = Rf + BI ( Rm – Rf) • Rf = Risk free rate of return • BI = Beta coefficient of firm’s portfolio • Rm = Market return of a diversified portfolio

Composite Cost of Capital Or overall cost of capital Or average cost of capital

Weighted Average Cost of Capital • Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion of the various sources of funds to the total. • The weights may be given either by using the book value of the source or the market value of the source.

Weighted Average Cost of Capital • The market value weights get preference due the the fact that they represent the true value of the investors however they suffer from the following limitations: • It is very difficult to determine the market values because of frequent fluctuations • Secondly, with the use of market value weights, equity capital gets greater importance

Weighted Average Cost of Capital • Kw = ∑XW / ∑W • Kw = Weighted average cost of capital • X = Cost of specific source of finance • W = weight ie proportion of specific source of finance

Marginal Cost of Capital • It is the weighted average cost of new capital calculated by marginal weights

the end