Proj. Apprl. Cost Of Capital

The Cost of Capital  Capital, like any other factor of production, has a cost. A company’s cost of capital is the weighted average cost of the various sources of finance used by it, viz., equity, preference, long-term debt, and short-term debt.  In principle, short-term debt providers also have a claim on the operating earnings of the firm. So, if a company ignores this claim, it will mis-state the rate of return required by its investors.  Weighted Average Cost of Capital (WACC) is a central concept in financial management. It is used for evaluating investment projects, for determining the capital structure, for setting the rates that organizations can charge to their customers, so on and so forth.  In general, if a firm uses n different sources of capital its WACC is ∑ piri, Where, pi is the proportion of i th source of finance and ri is the cost of the i th source of finance.

 Two basic conditions should be satisfied for using the company’s WACC for evaluating new investment: • The risk of new investments is the same as the average risk of existing investment • The capital structure of the firm will not be affected by the new investments. However, WACC is used as a benchmark hurdle rate that is adjusted for variation in risk and financing patterns.  Since interest on debt is a tax-deductible expense, the pre-tax cost of the debt has to be adjusted for the tax factor to arrive at the post-tax cost of debt.  Preference capital carries a fixed rate of dividend and is redeemable in nature. Due to absence of tax deductibility, the cost of preference shares is simply equal to its yield.  For calculating the WACC we multiply the cost of each source of capital by the proportion applicable to it.

 WACC tends to rise as the firm seeks more and more capital. This happens because the supply schedule of the capital is typically upward sloping-as suppliers provide more capital, the rate of return required by them tends to increase.  A schedule or graph showing the relationship between additional financing and WACC is called the weighted marginal cost of capital  When a firm raises finance by issuing equity and debt, it almost invariably incurs floatation or issue costs, comprising items like underwriting costs, brokerage expenses, fees of merchant bankers, under-pricing costs so on and so forth.  There are two ways of handling floatation costs. One approach is to adjust the WACC to reflect the floatation costs. A better approach is to leave the WACC unchanged but to consider floatation costs as part of the project cost.

 Certain misconceptions characterize the application the concept of ‘the cost of capital’ in practice. They are: • The cost of capital is too academic or impractical. • The cost of equity is equal to the dividend rate or return on equity. • Retained earnings are either cost free or cost significantly less than external equity. • Depreciation has no cost. • The cost of capital can be defined in terms of accounting-based measure. • If a project is financed heavily by debt, its WACC is low.

Weighted Average Cost of Capital (WACC) : WACC can be calculated by multiplying the specific cost of each source of financing by its proportion in the capital structure and adding the weighted values. In symbols, WACC may be expressed as follows: WACC = E rE + P rP + D rD ( 1 – Tc ) V V V Where WACC = Weighted average cost of capital E = market value of equity V = market value of the firm rE = cost of equity P = market value of preference rP = cost of preference D = market value of debt rD = cost of debt Tc = corporate tax rate

Illustration: Rao Corporation has a target capital structure and cost of specific source as under: Source Cost Equity : 0.45 18 % Preference : 0.05 14 % Debt : 0.50 12 % If the relevant tax rate is 35 %, what is the Rao’s WACC ? Solution: Source of Capital Equity Preference Debt

Proportion (1) 0.45 0.05 0.50

[* 12% x (1-0.35) = 7.84% ]

Cost Weighted Cost (2) [(1) x (2)] 18 % 8.10 % 14% 0.70 % *7.84 % 6. 00 % WACC = 14.80 %

How Financial Institutions calculate cost of capital Financial institutions calculate cost of capital as post-tax weighted average cost of the mix of funds employed for the project. The cost for different sources of funds are taken as follows:  Equity share capital :15%  Cash accruals/Retained earnings :15%  Preference share capital :Dividend rate  Subsidy/Incentive loans :Zero cost  Debt : Post-tax rate ( long tern loans, deferred credits, of interest bank borrowings for working capital, unsecured loans from public)  Convertible debenture Convertible portion at: 15%, Non-convertible portion at post-tax interest rate.

For calculating the post-tax rate of interest, the interest rate is multiplied by (1 – tax rate). The average applicable tax rate is calculated as follows: Total tax liability during the life of the project Total operating profit over the life of the project Illustration: The means of finance for a project are given below: o Equity and cash accruals : Rs. 900 million o Preference share capital : Rs. 100 million o Rupee term loans (@14%) : Rs. 800 million o Non convertible debentures (@12%) : Rs. 400 million o Non-convertible portion of convertible : Rs. 100 million debentures o Convertible portion of convertible : Rs. 100 million debentures o Bank borrowing for working capital : Rs. 200 million (@15%)

The average applicable tax rate for the project is estimated @ 25%. Calculate the cost of capital. The average cost of capital (post-tax) is 310/ 2600=11.92% No.

Means of Financing (A) Amount (Rs. in millions) (B)

Cost of funds (C)

Total Cost (post-tax) (D) = C x B

1.

Equity & cash accruals

900

15%

135

2.

Preference shares

100

10%

10

3.

Term Loans (@14%)

800

10.5%

84

4.

NCBs (@12%)

400

9%

36

5.

Con. Portion of CDs

100

15%

15

6.

NC portion of CDs (@10%)

100

7.5%

7.

Bank borrowing (@15%)

200

11.25%

Total

2600

7.5 22.5 310

If we wish to calculate WACC, then first find out the proportion of funds as under 1. Equity & cash accruals

900/2600 = 0.346

2. Preference shares 100/2600 = 0.038 3. Term Loans (@14%) 800/2600 = 0.307 4. NCBs (@12%) 400/2600 = 0.153 5. Con. Portion of CDs 100/2600 = 0.038 6. NC portion of CDs (@10%) 100/2600 = 0.038 7. Bank borrowing (@15%) 200/2600 = 0.076 Total 0.0996 say 1.00 Weighted average of each source: cost of fund x weight 1. 15% x 0.346 = 5.19 2. 10 % x 0.038 = 0.38 3. 10.5% x 0.307= 3.22 4. 9.0 % x 0.153 = 1.37 5. 15% x 0. 038 = 0.57 6. 7.5 % x 0.038 = 0.28 7. 11.25 % x 0.076 = 0.855 WACC = 12.065 %

WACC, Floatation cost and NPV: Illustration: ABC is currently at its target debt-equity ratio of 0.5:1. It is considering a proposal to expand capacity at the cost of Rs. 500 million and generate after-tax cash flow of Rs. 130 million per year for the next 8 years. The tax rate for the firm is 30%. There are two financing options: (i) Issue of equity stock with the required rate of return of 20% and issuance cost of 12%. (ii) Issue of debentures at a yield of 13% and issuance cost of 3%. (a) What is the WACC for ABC? (b) What is ABC’s weighted average floatation cost? (c) What is the NPV of the proposal after taking into account the floatation cost? Formula WACC = E rE + D rD (1 – Tc ) V V fA = E/V fE + D/V rD

WACC = 1/1.5 x 20% + 0.5/1.5 x 13%( 1 – 0.30) = 13.33% + 3.03% = 16.36% The NPV of the project ignoring floatation costs is: NPV = Present value of benefits – Investment = 130 million x PVIFA (16.36%, 8 years) – Investment = 130 million x 4.261 – 500 million = 562.39 million – 500 million = Rs.62.39 million What will be the effect of floatation costs? Since the floatation costs of equity and debt are 12% and 3% respectively, and the target debt-equity ratio is 0.5 : 1.0, the weighted average floatation cost, fA = 1/1.5 x 12% + 0.5/1.5 x 3% = 8% + 1% = 9% Given that the expansion project needs Rs. 500 million,the true cost including floatation cost, is Rs. 500 million/ 1- fA = Rs. 500 million/ 0.91= Rs. 549.45. million

Since the present value of cash inflows is Rs. 562.39 million, the expansion project, after considering floatation costs, has an NPV of Rs. 562.39 million - Rs. 549.45 million = Rs. 12.94 million. The project is still worthwhile.