“COST OF CAPITAL”
GUIDANCE OF:
Priyanka Mam
Apptunix
Submitted By:
Rajat Salaria
B.Com (Prof.
Roll No-1518319
INDEX
S. NO. PARTICULARS
1. Acknowledgement
2. Preface
22. Bibliography
23. Questionnaire
ACKNOWLEDGEMENT
A large number of individual has contributed to this report. I am thankful to all of them
for their help and enlargement. Like other reports, this report is also drawn from the
work of large number of researchers and author in the field of finance.
I would like to express my gratitude to Mr. Gaurav Sharma {finance} for giving me the
opportunity and enough of support to undergo training in their organization.
I shall like to thanks finance department for their able guidance, support, supervision
and care during the whole training programme and to whom words can never express
my feeling of gratitude and reverence.
The successful completion of my project has been carried out under the able guidance
of Mr. Gaurav Sharma {finance}. I take upon this opportunity to thank them for
encouragement and guidance in completion of project. Their knowledge and expertise
was great help for the project study.
We would like to thank our project guide, Mr. Gaurav Sharma, for consultative help and
constructive suggestion on the matter in this project.
I have tried to give credit to all sources from where i have drawn material in this project
still I feel obliged if they are brought to my notice.
Last but not least, I would like to express my deep sense of gratitude to my parents and
friends for their unflinching moral support. Their towering presence instilled in me the
carving to the work harder and completes this daunting task timely with a sufficient
degree of in depth study.
Rajat Salaria
PREFACE
About three decade ago, the scope of financial management was confined to the raising
of funds, whenever needed and little significance used to be attached to financial
decision-making and problem solving.
As a consequence, the traditional finance texts were structured around this theme and
contained description of the instruments and institution of raising funds and of the major
events, such as promotion, reorganization, readjustment, merger,consolidation etc.
When funds were raised. In the mid fifties, the emphasis shifted to the judicious
utilization of funds. The modern thinking financial management acord a far greater
importance to management decision-making and policy.
They are now responsible for the fortune of the enterprises and are involved in most
vital management decision of allocation of capital.It is their duty to ensure the funds are
raised most economically and used in the most efficient effective manner.
Because of this change in emphasis, the descriptive treatment of the subject of financial
management is being replaced by growing analytical content and sound theoretical
underpinnings.
Rajat Salaria
COST OF CAPITAL
FORMULA:
Risks Associated with the Cost of Capital
The cost of capital is comprised of three key risk components: (1) risk free rate of return,
(2) business risk premium, and (3) financial risk premium.
Risk Free Rate of Return:
The risk free rate of return is an investment completely free of risk (i.e. Treasury Note)
Business Risk Premium:
A business risk premium is a reason to increase the rate of return due to the uncertainty
of the future. For example, potential investors would heavily factor in the business risk
premium with the major U.S. automakers since the auto industry as a whole is influx.
Financial Risk Premium:
The financial risk premium is another factor into the cost of capital since a company's
current debt levels and interest payment to debt holders will play a role in their attempts
at profitability.
Importance of cost of capital
The importance of cost of capital is that it is used to evaluate new project of company
and allows the calculations to be easy so that it has minimum return that investor expect
for providing investment to the company. It has such an importance in financial decision
making. It actually used in managerial decision making in certain field such as-
Cost of capital is measured in terms of weighted average cost of capital. In this the total
capital value of a firm without any outstanding warrants and the cost of its debt are
included together to calculate the cost of capital.
To calculate the company's weighted cost of capital, first the calculation of the costs of
the individual financing sources:
Cost of Debt Cost of Preference Capital, Cost of Equity Capital, and cost of stock capital
take place and the formula is given as:-
WACC= Wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. Stock)
Cost of the capital is the rate of return which is minimum which has to be earned on
investments in order to satisfy the investors of various types who are making
investments in the company in the form of shares, debentures and loans. It is used in
financial investment which refers to the cost of a company's funds or the shareholders
return on the company's existing deals.
Basic concept of cost of capital
The following are the various relevant costs associated with the problem of
measurement of firm’s cost of capital.
1. Marginal Cost of Capital. It is the current interest on long term debt. In other words,
the marginal cost of capital is the weighted average cost of new or additional funds
raised by the company.
2. Specific Cost. Specific cost is the cost which is associated with the particular
component of a capital structure.
For example. Equity shares, debentures etc. It is also known as component cost.
3. Combined Cost. It is the cost of capital of all the sources taken together i.e., debt,
equity and preference share capital. The combined cost of capital can be otherwise
called as average cost or weighted cost of capital.
4. Spot Cost. Spot cost represents costs prevailing in the market at certain point of
time.
5. Future Cost. It is the cost which is related to the cost of funds intended to finance the
expected project.
6. Historical Cost. Historical costs are the costs which are calculated on the basis of
existing capital structure of the firm.
7. Explicit Cost. Explicit cost of any source of fund may be expressed as the discount
rate that equates the present value of cash inflows that are incremental to the taking of
the financial opportunity with the present value of its incremental cash outflows.
8. Implicit Cost . 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 forgone
if the project presently under consideration by the firm were accepted.
COST OF EQUITY CAPITAL
1 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.
2 It is the rate at which investors discount the expected dividends of the firm to determine
its share value.
APPROCHES TO MEASURES TO KE
Financial experts express conflicting option as to the correct way in which the cost of
capital can be measured.it is a concept of vital important in the financial decision
making. It is useful as a standard for:
Evaluating investment decisions.
Designing a firm’s debt policy.
Appraising the financial performance of top management.
Investment evaluation
The primary purpose of measuring the cost of capital is its use as a financial standard
for evaluating the investment projects. In the net present value (NPV) method, an
investment project is accepted if it has a positive NPV. The project’s NPV is calculated
by discounting its cash flows by the cost of capital.
Designing debt policy
The debt policy of a firm is significantly influenced by the cost consideration. In
designing the financing policy, that is, the proportion of debt and equity in the capital
structure, the firm aims at maximizing the overall cost of capital.
Performance appraisal
The cost of capital framework can be used to evaluate the financial performance of top
management. Such an evaluation will involve a comparison of actual profitability of the
investment projects undertaken by the firm with the projected overall cost of capital, and
the appraisal of the actual costs incurred by management in raising the required funds.
Cost of capital is based on assumptions which are closely associated calculating and
measuring the cost of capital. It is to be considered that there are three basic concepts:
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consists of three important risks i-e: zero risk level, business risk and financial risk.
K = rj + b + f.
Where, K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
ASSUMPTIONS OF THE DIVIDEND APPROACH
Cost of capital may be classified into the following types on the basis of nature and
usage:
• Explicit and Implicit Cost.
• Average and Marginal Cost.
• Historical and Future Cost.
• Specific and Combined Cost.
In corporate finance
: In corporate finance, the cost of
capital plays a central role in investment analysis,
capital structure and dividend policy, helping to
determine whether and where a business should
invest, how much it should borrow and how much it
should return to stockholders.
In valuation
: In valuation, the cost of capital operates
as the primary mechanism for measuring and
adjusting for risk in the expected cash flows
Cost of capital is the minimum rate of investment which a company has to earn
for getting fund .
When any company investor invests his money , he sees the rate of return . So ,
company has to mention , what will company pay , if investors provide their money to
company . That average cost on the investment is called cost of capital . We calculate it
with following way :-
Cost of capital = interest rate at zero level risk + premium for business risk +
premium for financial risk
The cost of equity is the return that stockholders require for their investment in a
company. The traditional formula for cost of equity (COE) is the dividend capitalization
model:
A firm's cost of equity represents the compensation that the market demands in
exchange for owning the asset and bearing the risk of ownership.
Mechanics of Computing the Cost of Capital
Cost of Capital
What are the two ways that companies can raise common equity?
„
Directly, by issuing new shares of
common stock.
„
Indirectly, by reinvesting earnings that
are not paid out as
dividends (i.e.,
retaining earnings)
• The cost of capital is the rate of return that the suppliers of capital
require as compensation for their contribution of capital.
• Alternatively it can be defined as the opportunity cost of funds for the
suppliers of capital who will not voluntarily invest in a company unless
its return meets or exceeds what the supplier could earn elsewhere in an
investment of comparable risk.
• WACC of capital is a weighted average of the
marginal cost of various components of capital.
• MCC or WACC is the cost of next dollar to be raised.
WACC =wdrd(1-t) + wprp + were
– wd proportion of debt that the company uses when it raises
new funds
– rd before - tax marginal cost of debt
– t company’s marginal tax rate
– wp proportion of preferred stock the company uses when it raises new funds
– r p marginal cost of preferred stock
– we proportion of equity that the company uses when it raises new funds
The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summed:
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Dps = preferred
dividends
Pnet = net
issuing price
Estimating the Cost of Common Stock
The cost of common equity is represented as re, and it is the rate of return
required by the common shareholders.
The cost of common equity can be measured using the following methods:
Where:
E(Ri) is the expected return on the security
Rf is the risk-free rate of return
Β is the beta of the stock
Rm is the expected return from the market
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Summary of Formulae
S.No Purpose Formula
7
Cost of irredeemable preference K = p
share capital
8
Cost of redeemable preference share
capital
9
Cost of equity –dividend yield
approach
10
K =
e
13
K =
w
Ke = R + b (R - R )
f I m f
Issues in estimating the cost of debt
• The cost of floating-rate debt is difficult because the cost depends not only on current
rates but also on future rates.
- Possible approach: Use current term structure to estimate future rates.
• Option-like features affect the cost of debt.
- If the company already has debt with embedded options similar to what it may
issue, then we can use the yield on current debt.
- If the company is expected to alter the embedded options, then we would need to
estimate the yield on the debt with embedded options.
• Nonrated debt makes it difficult to determine the yield on similarly yielding debt if the
company’s debt is not traded.
- Possible remedy: Estimate rating by using financial ratios.
• Leases are a form of debt, but there is no yield to maturity.
- Estimate by using the yield on other debt of the company.