Cost of Capital

Minimum rate of return which a company is

expected to earn from a proposed project so as to
make no reduction in the earning per share to equity
shareholders and its market price.
In economic terms there are two approaches to
define CoC:
1. It is the borrowing rate of the firm, at which it can
acquire funds to finance the proposed project
2. It is the lending rate which the firm could have
earned if the firm would have invested elsewhere
CoC is a combined cost of each type of
source by which a firm raises funds.
CoC
Also referred to as cut-off rate, target rate,
hurdle rate, minimum required rate of return,
standard return, etc.
Assumption: that the firms business and
financial risks are unaffected by the
acceptance and financing of projects.
Business risk is the risk to the firm of being
unable to cover fixed operating costs.
Financial risk is the risk of being unable to
cover required financial obligations such as
interest, preference dividends.
Importance of CoC
Capital Budgeting Decisions
Designing the Corporate Financial
Structure
Deciding about the method of financing
in lieu with capital market fluctuations
Performance of top management
Other areas eg., dividend policy,
working capital
Measuring CoC
A realistic measure of CoC should have the following
qualities of capital expenditure decisions:
1. It must account for the general uncertainty of
expected future returns from investment proposals.
2. It must allow for the various degrees of uncertainty
of expected future returns associated with different
uses of funds.
3. It must allow for the effects of uncertainty
associated with an incremental investment and the
uncertainty of returns from the entire asset portfolio
of the firm.
4. It must account for a variety of financing means
available to a firm.
5. It must allow for the differential effects of financing
combination on the amount and quality of residual
net benefits accruing to shareholders.
6. It must reflect the changes in the capital market.
Basic costs of capital
1. Cost of equity capital: the cost of
obtaining funds through the sale of
common stock.
2. Cost of preference shares
3. Cost of debt
4. Cost of retained earnings
Cost of equity capital
Ke is defined as the minimum rate of
return that a firm must earn on the
equity-financed portion of an investment
project in order to leave unchanged the
market price of the shares.
It is the rate at which investors discount
the expected dividends of the firm to
determine its share value
2 approaches to
measure Ke
1. Dividend approach dividend valuation
model: assumes that the value of a share
equals the present value of all future
dividends that it is expected to provide over
an indefinite period.
Ke accordingly is defined as the discount rate
that equates the present value of all expected
future dividends per share with the net
proceeds of the sale (or the current market
price) of a share.
formula
Po = D1 / (Ke g)
Ke = (D1/Po) + g; where
D1 = expected dividend per share
Po = net proceeds per share/current
market price
g = growth in expected dividends
Assumptions of the
dividend approach
The market value of shares depends upon
the expected dividends.
Investors can formulate subjective probability
distribution of dividends per share expected
to be paid in various future periods. The initial
dividend is greater than 0.
Dividend payout ratio is constant.
Investors can accurately measure the
riskiness of the firm so as to agree on the rate
at which to discount the dividends.
2. Capital asset pricing
model approach
The CAPM explains the behavior of security
prices and provides a mechanism whereby
investors could assess the impact of
proposed security investment on their overall
portfolio risk and return. In other words, it
formally describes the risk-return trade-off for
securities.
The basic assumption of CAPM are related to
A. the efficiency of the market, and
B. investor preferences.
Efficient market implies
All investors have common (homogeneous)
expectations regarding the expected returns,
variances and correlation of returns among all
securities;
All investors have the same information about
securities;
There are no restrictions on investments;
There are no taxes;
There are no transaction costs; and
No single investor can affect the market price
significantly.
Risk to which security investment
is exposed to are of 2 types:
Diversifiable/unsystematic risk: is the
portion of the securitys risk that is
attributable to firm-specific random
causes; can be eliminated through
diversification. Eg., management
capabilities and decisions, strikes,
unique government regulations,
availability of raw materials,
competition.
Non-diversifiable risk: is the relevant
portion of a securitys risk that is
attributable to market factors that affect
all firms; cannot be eliminated through
diversification. Eg., interest rate
changes, inflation or purchasing power
change, changes in investor
expectations about the overall
performance of the economy and
political changes.
Market portfolio
Systematic risk can be measured in relation
to the risk of a diversified portfolio which is
commonly referred to as the market portfolio
of the market. According to CAPM, the non-
diversifiable risk of an
investment/security/asset is assessed in
terms of the beta coefficient.
Beta is the measure of the volatility of a
securitys return relative to the returns of a
broad-based market portfolio. Beta coefficient
of 1 would imply that the risk of the specified
security is equal to the market.
formula
Ke = Rf + b (Km Rf);
Where,
Ke = cost of equity capital;
Rf = the rate of return required on a risk free
asset/security/investment
Km = required rate of return on the market
portfolio of assets that can be viewed as the
average rate of return on all assets
B = the beta coefficient.
Difference b/w CAPM and
dividend valuation method
Valuation model does not consider the
risk as reflected in beta.
CAPM model suffers from the problem
of collection of data
Beta measures only systematic risk.
Cost of preference shares
The preference shareholders carry a prior right to
receive dividends over the equity shareholders.
Moreover, preference shares are usually cumulative
which means that preference dividend will keep
getting accumulated unless it is paid.
Further, non-payment of preference dividend may
entitle their holders to participate in the management
of the firm as voting rights are conferred on them in
such cases.
Above all, the firm may encounter difficulty in raising
further equity capital mainly because the non-
payment of preference dividend adversely affects the
prospects of ordinary shareholders.
Cost of retained
earnings
May be defined as the opportunity cost in
terms of dividends foregone by/withheld from
the equity shareholders.
Cost of retained earnings is the same as the
cost of an equivalent fully subscribed issue of
additional shares, which is measured by the
cost of equity capital.
Cost of debt capital
It is the interest rate which equates the
present value of the expected future
receipts with the cost of the project. The
present value of tax-adjusted interest
costs plus repayments of the principal is
equated with the amount received at the
time the loan is consummated.
Cost of debt
Cost of debt is the after-tax cost of long-term
funds through borrowing.
Net cash proceeds are the funds actually
received from the sale of security.
Flotation cost is the total cost of issuing and
selling securities.
Cost of perpetual debt
Cost of redeemable debt
Cost of debt
Debt is the cheapest form of long-term debt
from the companys point of view as:
Its the safest form of investment from the point
of view of creditors because they are the first
claimants on the companys assets at the
time of its liquidation. Likewise they are the
first to be paid their interest. Another, more
important reason for debt having the lowest
cost if the tax-deductibility of interest
payments.
Cost of preference
capital
Cost of preference share capital is the
annual preference share dividend
divided by the net proceeds from the
sale of preference shares.
Perpetual security (irredeemable)
Cost of redeemable preference share
Weighted average cost
of capital (WACC)
This gives us the overall cost of capital.
Weight age is given to the cost of each
source of funds by assessing the relative
proportion of each source of fund to the total,
and is ascertained by using the book value or
the market value of each type of capital. The
cost of capital of the market value is usually
higher than it would be if the book value is
used.
Steps in calculation
WACC (Ko)
Assigning weights to specific costs.
Multiplying the cost of each sources by
the appropriate weights.
Dividing the total weighted cost by the
total weights.
Market value vs. book
value weights
MV sometimes preferred to BV for the MV
represents the true expectations of the
investors. However, it suffers from the
following limitations:
1. MV undergoes frequent fluctuations and
have to be normalized;
2. The use of MV tends to cause a shift
towards larger amounts of equity funds,
particularly when additional financing is
undertaken.
MV more appealing than
BV
Market values of securities closely
approximate the actual amount to be
received from their sale.
Costs of specific sources of finance
which constitute the capital structure of
the firm are calculated using prevalent
market prices.
Advantages of BV
weights
1. The capital structure targets are usually
fixed in terms of book value.
2. It is easy to know the book value.
3. Investors are interested in knowing the debt-
equity ratio on the basis of book values.
4. It is easier to evaluate the performance of a
management in procuring funds by
comparing on the basis of book values.
Relevant costs closely
related to CoC
1. Marginal cost of capital: average cost of new
or incremental funds raised by the firm. MC
tens to increase proportionately as the
amount of debt increases.
2. Explicit cost and implicit cost:
a. Explicit cost: of any source of finance is the
discount rate that equates the present value
of the cash inflows that are incremental to the
taking of the financial opportunity with the
present value of the incremental cash
outflows. The explicit cost of a debt would be
0 if it is interest free. The explicit cost of a gift
would be 100%.
b. Implicit cost: is the opportunity cost. It is the
rate of return associated with the best
investment opportunity for the firm and its
shareholders that will be foregone if the
project presently under consideration by the
firm were accepted. It is not concerned with
any particular source of finance.
The explicit cost include only the CoC to be
paid and ignores the other factors such as
risk involved, flexibility and leverage
characteristics which are adversely affected
with an increase in debt contents in its capital
structure and these changes imply additional
but hidden costs.
3. Future cost and
Historical cost
We always consider the projects
expected internal rate of return and
compare it with the expected (future)
cost of capital while making capital
expenditure decision. Historical costs
(past costs) help in predicting the future
costs and provide an evaluation of the
past performance.
4. Specific cost and
inclusive/combined/composite
CoC
a. Specific CoC is associated with a
specific component of capital structure.
b. Inclusive CoC is an aggregate of the
CoC from all sources. In other words, it
is WACC.
5. Spot costs and
normalized costs
a. Spot costs represent those costs
prevailing in the market at a certain
time.
b. Normalized cost indicate an estimate of
cost by some averaging process from
which cyclical element is removed.