Unit 5
COST OF CAPITAL
The financing decision relates to the composition of relative proportion of various sources of finance. The sources are;
1. Owned Capital - i.e. Equity Share Capital, Preference Share Capital, Accumulated profits.
2. Borrowed Capital – i.e. Debentures, Loans from financial institutions.
The financial management weighs the merits and demerits of different sources of finance while taking the financing decisions. Whether the companies choose shareholders fund or a combination of both, each type of fund carries a cost.
The cost of equity is the minimum return the shareholders would have received if they had invested elsewhere. Borrowed fund cost involves interest payment.
Both types of fund incur cost and this is the cost of capital to the company. This means, cost of capital is the minimum return expected by the company.
Whenever funds are to be raised to finance investments, capital structure decision is involved.
A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing.
In simple terms cost of capital refers to the discount rate that is used in determining the present value of the estimated future cash flows of the business/new project and eventually deciding whether the business/new project is worth undertaking or not.
It is also the minimum rate of return that a firm must earn on its investment which will maintain the market value of shares at its current level.
It can also be stated as the opportunity cost of an investment, i.e. the rate of return that company would otherwise be able to earn at the same risk level as the investment that has been selected. For example, when an investor purchases a stock in a company, he/she expects to see a return on that investment. Since the individual expects to get back more than his/her initial investment, the cost of capital is equal to this minimum return that the investor expects to receive which is termed as investor’s opportunity cost.
The cost of each source of capital is called specific cost of capital. When these specific costs are combined for all the sources of capital for a business, it is termed as overall cost of capital for a business.
The concept of cost of capital plays a vital role in decision-making process of financial management. The financial leverage, capital structure, dividend policy, working capital management, financial decision, appraisal of financial performance of top management etc. are greatly influenced by the cost of capital.
The significance or importance of cost of capital may be stated in the following ways:
1. Maximisation of the Value of the Firm:
For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital. There should be judicious mix of debt and equity in the capital structure of a firm so that the business does not to bear undue financial risk.
2. Capital Budgeting Decisions:
Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions. Generally cost of capital is the discount rate used in evaluating the desirability of the investment project. In the internal rate of return method, the project will be accepted if it has a rate of return greater than the cost of capital.
In calculating the net present value of the expected future cash flows from the project, the cost of capital is used as the rate of discounting. Therefore, cost of capital acts as a standard for allocating the firm’s investible funds in the most optimum manner. For this reason, cost of capital is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return etc.
3. Decisions Regarding Leasing:
Estimation of cost of capital is necessary in taking leasing decisions of business concern.
4. Management of Working Capital:
In management of working capital the cost of capital may be used to calculate the cost of carrying investment in receivables and to evaluate alternative policies regarding receivables. It is also used in inventory management also.
5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be formulated according to the nature of the firm— whether it is a growth firm, normal firm or declining firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth firm, normal firm and decline firm, respectively.
6. Determination of Capital Structure:
Cost of capital influences the capital structure of a firm. In designing optimum capital structure that is the proportion of debt and equity, due importance is given to the overall or weighted average cost of capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimised.
7. Evaluation of Financial Performance:
The concept of cost of capital can be used to evaluate the financial performance of top management. This can be done by comparing the actual profitability of the investment project undertaken by the firm with the overall cost of capital.
The first step in the measurement of cost of capital of the firm is the calculation of the cost of individual sources of raising funds. From the viewpoint of capital budgeting decisions, the long term sources of funds are relevant as they constitute the major sources of financing the fixed assets. In calculating the cost of capital, therefore, the focus on long-term funds which are: -
i. Long term debt (including debentures)
Ii. Preference shares
Iii. Equity Capital
Iv. Retained Earnings
The calculation of the cost of debt is relatively easy. A debt may be in the form of Bond or Debenture. A Bond is a long term debt instrument or security. Bonds are issued by the government. Therefore, they do not have any risk of default. The government honors obligations on its Bonds. Bonds of the public sector companies in India are generally secured, but they are not free from the risk of default.
The private sector companies also issue bonds, which are called as Debentures in India. A company in India can issue secured or unsecured debentures.
Cost of Debentures
The cost of debentures and long term loans is the contractual interest rate adjusted further for the tax liability of the company. For a company, the higher the interest charges, the lower the amount of tax payable by the company. The interest on debentures or bonds is debited to the profit and loss account. Therefore, the taxable profit of the company is reduced. It is an indirect saving to the company. Therefore, the cost of debt capital is reduced to the extent of the tax liability.
Illustration 1: Two companies X and Y are having their capital structure as follows;
| Company X | Company Y |
Earnings before interest and taxes (EBIT) | 100 | 100 |
(Rs. In lakhs) |
|
|
Interest (I) (12%) | 40 | - |
Profit before tax (PBT) | 100 | 60 |
Tax (T) | 35% | 21% |
Profit after Tax (PAT) | 65 | 39 |
The tax rate applicable to the company is 35 percent.
Solution:
Cost of Debt=(I-t) where I=interest rate and t= tax rate
Cost of debt of X=0, there is no debt.
Cost of debt of Y= (I-T) = (12-35%) =12-4.2=7.8%
The important point to remember, while calculating the average cost of capital, is that the post-tax cost of debt should be used and not the pre-tax cost of debt.
Cost of Irredeemable Debentures
Cost of debentures not redeemable during the life time of the company.
Kd = I (1-t)
NP
Where, Kd = cost of debt after tax
I = Annual interest payment
NP = Net proceeds of debentures
t = Tax rate
Illustration 2: A company issues 1,000, 15% debentures of the face value of Rs. 100 each at a discount of Rs. 5. The under-writing and other costs are Rs. 5000 /- for the total issue. The interest per annum is Rs 15000. The income tax rate is 40%. Calculate the cost of Debt.
Solution:
Cost of debt = 15(1-0.40)/90
= 15 x 0.60/90
=0.10 or10%
The net proceeds of the debenture =1000 x 95 =Rs 95000
Rs 95000-5000 =90000
Net proceeds per debenture=90000/1000= Rs 90
Though the interest on debenture is 15%, the net cost of debenture is 10%.
Cost of Redeemable Debentures
If the debentures are redeemable after the expiry of a fixed period, the cost of debentures would be:
Kd = I (1-t) + (RV-NP)/N
(RV + NP)/ 2
Where, I = Annual interest payment
NP = Net proceeds of debentures
RV = Redemption values of debentures
t = Tax rate
N = Life of debentures
Illustration 3: A company issued 10,000, 10% debentures of Rs 100 each on 1.4.2007 to be matured on 1.4.2012. If the market price of the debenture is Rs.80. Compute the cost of debt assuming 35% tax rate.
Solution:
Kd = I (1-t) + (RV-NP)/N
(RV + NP)/ 2
= 10 x (1-0.35) + (100-80)/5
(100+80)/2
= 605 + 4
90
= 0.1166 OR 0.12 OR 12%
Illustration 4: Five years ago, Sonata Limited issued 12 per cent irredeemable debentures at Rs. 103, at Rs. 3 premium to their par value of Rs 100. The current market price of these debentures is Rs. 94. If the company pays corporate tax at a rate of 35 per cent what is its current cost of debenture capital?
Solution:
Kd = 12/94 = 12.8%
Kd (after tax) = 12.8 x (1-0.35) = 8.3%
It is easy to find out the present value of a bond since its cash flows and the discount rate can be determined easily. If there is no risk of default, then there is no difficulty in calculating the cash flows associated with a bond. The expected cash flows consist of annual interest payments plus repayment of principal. The appropriate capitalization or discount rate would depend upon the risk of bond. The risk in holding the government bond is less than the risk associated with a debenture issued by a company. Therefore, a lower discount rate would be applied to the cash flows of the government bond and a higher rate to the cash flows of the company debenture.
The cost of preference share capital is the dividend expected by its holders. Though payment of dividend is not mandatory, non- payment may result in exercising of voting rights by them.
The payment of preference dividend is not adjusted for taxes as they are paid after taxes and is not deductible.
The cost of preference share capital is calculated by dividing the fixed dividend per share by the price per preference share.
KP = P.D
MP (1-f)
Where, KP = Cost of Preference Shares
P. D = Preference dividend
MP = Market Price of Preference shares
f = Floatation cost
Illustration 5: Suzlon Energy has issued preference shares at Rs. 100 per share, with a stated dividend of Rs. 12% and a flotation cost of 3%, what is the cost of preference share?
Solution:
KP = P.D
MP (1-f)
= Rs. 12
Rs. 100(1-0.03)
= 12/97
= 12.37%
Cost of Irredeemable Preference Shares
Cost of irredeemable preference shares KP = PD
NP
Where,
PD = Annual preference dividend
NP = Net proceeds in issue of preference shares.
Cost of irredeemable preference shares where Dividend Tax is paid over the actual dividend payment will be
KP = PD (1+Dt)
NP
Where, PD = Annual preference dividend
NP = Net proceeds in issue of preference shares
Dt = Tax on preference dividend
Illustration 6: X Ltd. Issued 2,000 10% preference shares of Rs 100 each at Rs 95 each. Calculate the cost of preference shares.
Solution:
KP = PD
NP
= 10
95
= 0.1053 OR 10.53%
Cost of Redeemable Preference Shares
If the preference shares are redeemable after the expiry of a fixed period, the cost of preference shares would be:
KP = PD + (RV-NP)/N
(RV + NP)/ 2
Where, PD = Annual Preference Dividend
RV = Redemption value of Preference Shares
NP = Net proceeds on issue of Preference Shares
N = Life of Preference Shares
However, since dividend of preference shares is not allowed as deduction from income for e tax purposes, there is no question of tax advantage in the case of cost of preference shares.
The cost of redeemable preference share could also be calculated as the discount rate that equates the net proceeds of the sale of preference shares with the present value of the future dividends and principal payments.
Thus, in the case of debt as well as preference shares, cost of capital is calculated by reference to the obligations incurred and proceeds received.
Illustration 7: Y Ltd. Issued 2,000 10% preference shares of Rs 100 each at Rs 95 each. The company proposes to redeem the preference shares at the end of 10 years. Calculate the cost of preference shares.
Solution:
KP = PD + (RV-NP)/N
(RV + NP)/ 2
= 10 + (100-95)/10
(100+95)/2
= 10 + 0.5
97.5
= 0.1076 OR 10.76%
It may prima facie appear that equity capital does not carry any cost. But this is not true. The market share price is a function of return that equity shareholders expect and get. If the company does not meet their requirements, it will have an adverse effect on the market share price. Also, it is relatively the highest cost of capital. Since expectations of equity holders are high, higher cost is associated with it.
In simple words cost of equity capital is the rate of return which equates the present value of expected dividends with the market share price. In theory the management strives to maximize the position of equity holders and the effort involves many decisions.
Different methods are employed to compute the cost of equity capital.
- DIVIDEND PRICE APPROACH
Here, cost of equity capital is computed by dividing the current dividend by average market price per share. However, this method cannot be used to calculate cost of equity of units suffering losses.
This dividend price ratio expresses the cost of equity capital in relation to what yield the company should pay to attract investors.
Ke = D1
P0
Where, Ke = Cost of Equity
D1 = Annual dividend
P0 = Market price of equity
This model assumes that dividends are paid at a constant rate to perpetuity. It ignores taxation.
Earnings and dividends do not remain constant and the price of equity shares is also directly influenced by the growth rate in dividends. Where earnings, dividends and equity share price all grow at the same rate, the cost of equity capital may be computed as follows:
Ke = (D1/P0) + G
Where, D1 = [D0 (1+G)] i.e. next expected dividend
P0 = Current Market price per share
G = Constant Growth Rate of dividend
Cost of newly issued shares, Kn, is estimated with the constant dividend growth model so as to allow for flotation costs.
Kn = (D1/P0-F) + G
Where, F = Amount of flotation cost per share
Illustration 8: A company has paid a dividend of Rs 1 per share (of face value of Rs 10 each) last year and it is expected to grow @10% next year. Calculate the cost of equity if the market price of share is Rs 50.
Solution:
Ke = (D1/P0) + G
= 1(1+0.10) + 0.10
50
= 0.12 or 12%
2. EARNING/PRICE APPROACH
This approach co-relates the earnings of the company with the market price of its share.
The cost of ordinary share capital would be based upon the expected rate of earnings of a company. The argument is that each investor expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests.
If an investor expects that the company in which he is going to subscribe for shares should have at least a 20% rate of earning, the cost of ordinary share capital can be construed on this basis. Suppose the company is expected to earn 30%, the investor will be prepared to pay Rs 150 Rs30 x 100 for each share of Rs 100.
So cost of equity will be given by:
Ke = (E/P)
20
Where, E = Current earnings per share
P = Market share price
Since earnings do not remain constant and the price of equity shares is also directly influenced by the growth rate in earning, we need to modify the above calculations with an element of growth.
So, cost of equity will be given by:
Ke = (E/P) + G
Where, E = Current earnings per share
P = Market share price
G = Annual growth rate of earnings
The calculation of ‘G’ (the growth rate) is an important factor in calculating cost of equity capital. The past trend in earnings and dividends may be used as an approximation to predict the future growth rate if the growth rate of dividend is fairly stable in the past.
G = 1.0 (1+G)n
Where n is the number of years
The Earning Price Approach is similar to the dividend piece approach; only it seeks to nullify the effect of changes in the dividend policy.
3. REALISED YIELD APPROACH
According to this approach, the average rate of return realized in the past few years is historically regarded as ‘expected return’ in the future. The yield of equity for the year is:
Yt = Dt + Pt-1
Pt-1
Where, Yt = Yield for the year t
Dt = Dividend for share for end of the year t
Pt = Price per share at the end of the year t
Pt-1 = Price per share at the beginning and at the end of the year t
This approach provides a single mechanism of calculating cost of equity. It has unrealistic assumptions. If the earnings do not remain stable, this method is not practical.
4. CAPITAL ASSET PRICING MODEL APPROACH (CAPM)
CAPM model describes the risk-return trade-off for securities. It describes the linear relationship between risk and return for securities. The risks to which a security is exposed are divided into two groups, diversifiable and non-diversifiable.
The diversifiable risk can be eliminated through a portfolio consisting of large number of well diversified securities.
The non-diversifiable risk is attributable to factors that affect all businesses. Such risks are: -
Interest rate changes Inflation
Political changes etc.
Thus, the cost of equity capital can be calculated under this approach as:
Ke = Rf + b (Rm-Rf)
Where, Ke = Cost of equity capital
Rf = Rate of return on security
b = Beta coefficient
Rm = Rate of return on market portfolio
Therefore, required rate of return = risk free rate + risk premium
The idea behind CAPM is that investors need to be compensated in two ways-time value of money and risk.
The time value of money is represented by the risk-free rate in the formula and compensates the investors for placing money in any investment over a period of time.
The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) which compares the returns of the asset to the market over a period of time and compares it to the market premium.
Illustration 9: Calculate the cost of equity capital of Shanthi ltd, whose risk free rate of return equals 10%. The firm’s beta equals 1.75 and the return on the market portfolio equals to 15%.
Solution:
Ke = Rf + b (Rm - Rf)
Ke = 0.10 + 1.75 (0.15 – 0.10)
= 0.10 + 1.75(0.05)
= 0.1875 OR 18.75%
Like other sources of fund, retained earnings involve cost. It is the opportunity cost of dividends forgone by shareholders.
The given future depicts how a company can either keep or reinvest cash or return it to the shareholders as dividends. If the cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.
There are two approaches to measure this opportunity cost. One approach is by using discounted cash flow (DCF) method and the second approach is by using capital asset pricing model.
- By DCF Method
Ks = D1 + G
P0
Where, Ks = Cost of Retained Earnings
D1 = Dividend
P0 = Current Market Price
G = Growth Rate
2. By CAPM
Ks = Rf + b (Rm – Rf)
Where, Ks = Cost of Retained earnings
Rf = Rate of return on security
b = Beta coefficient
Rm = Rate of return on market portfolio
Illustration 10: A Ltd provides the following details:
D0 = Rs 4.19 P0 = Rs 50 G= 5%
Calculate the cost of retained earnings based on DCF method.
Solution:
Ks = D1 + G
P0
= D0 (1+G) + G
P0
= Rs. 4.19 (1.05) + 0.05
Rs. 50
= 0.088 + 0.05
= 0.138 OR 13.8%
Illustration 11: C Ltd provides the following details:
Rf = 7% b = 1.20 Rm =13%
Calculate the cost of retained earnings based on CAPM method
Solution:
Ks = Rf + b (Rm – Rf)
= 7% + 1.20(6%)
= 7% + 7.20
Ks = 14.2%
WACC (Weighted Average Cost of Capital) represents the investors’ opportunity cost of taking on the risk of putting money into a company.
Since every company has a capital structure i.e. what percentage of funds comes from retained earnings, equity shares, preference shares, debt and bonds, so by taking a weighted average, it can be seen how much cost/interest the company has to pay for every rupee it borrows/invest. This is the weighted average cost of capital.
The weighted average cost of capital for a firm is of use in two major areas: -
1. In consideration of the firm’s position;
2. Evaluation of proposed changes necessitating a change in the firm’s capital. Thus, a weighted average technique may be used in a quasi-marginal way to evaluate a proposed investment project, such as the construction of a new building.
Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.
KO = (we x Ke) + (wP x KP) + (wd x Kd) + (wS x KS)
Where, we = % of Equity share capital in capital structure
wP = % of Preference share capital in capital structure
wd = % of Debt in capital structure
wS = % of Retained Earnings in capital structure
The cost of weighted average method is preferred because the proportions of various sources of funds in the capital structure are different. Therefore, cost of capital should take into account the relative proportions of different sources of finance.
Illustration 12: Calculate the WACC using the following data
(a) Book value weights Basis
(b) Market value weights Basis
The capital structure of the company is as under:
| Rs. |
Debentures (Rs 100 per debenture) | 5,00,000 |
Preference shares (Rs 100 per share) | 5,00,000 |
Equity shares (Rs 10 per share) | 10,00,000 |
The market prices of these securities are:
Debenture Rs. 105 per debenture, Preference Rs. 110 per preference share, Equity Rs. 24 each.
Additional information:
(1) Rs 100 per debenture redeemable at par, 10% coupon rate, 4% flotation costs, 10-year maturity.
(2) Rs 100 per preference share redeemable at par, 5% coupon rate, 2% flotation cost and 10-year maturity.
(3) Equity shares have Rs 4 flotation cost.
The expected dividend is Rs 10 with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividend. Corporate tax rate is 30%.
Solution:
Cost of Equity (Ke) = 10 + 0.05
20
= 0.05 + 0.05
= 0.10 OR 10%
Cost of Debt (Kd) = 10 (1-0.30) + [(100-96)/10]
(100+96)/2
= 7+ 0.40
98
= 0.0755 OR 7.55%
Cost of Preference Shares (KP) = 5 + (2/10)
(198/2)
= 5.2/98
= 0.0535 OR 5.35%
Calculation of WACC using book value weights
Source of Capital | Book value | Weights (w) | Specific cost (K %) | Total cost (w x k) |
10% Debentures | 5,00,000 | 0.25 | 7.55 | 1.8875 |
5 % Preference shares | 5,00,000 | 0.25 | 5.35 | 1.3375 |
Equity shares | 10,00,000 | 0.50 | 10.00 | 5.00 |
| 20,00,000 | 1.00 |
| 8.225 OR 8.23% |
Calculation of WACC using Market value weights
Source of Capital | Book value | Weights (w) | Specific cost (K %) | Total cost (w x k) |
10% Debentures | 5,25,000 | 0.15 | 7.55 | 1.1325 |
5 % Preference shares | 5,50,000 | 0.16 | 5.35 | 0.856 |
Equity shares | 24,00,000 | 0.69 | 10.00 | 6.9 |
| 34,75,000 | 1.00 |
| 8.889 OR 8.89% |
