Cost of capital

Mahendra M. Singhvi

10/23/2012

SINGHVI ASSOCIATES, PUNE

What is Cost of Capital?

Cost of capital (CoC) is the cost of funds used in the business. There are various sources of obtaining the funds to finance the business and each one of them has a cost attached to it. For example, the debt is raised at a certain interest rate while equity is serviced by giving dividends to the shareowners.

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Some definitions on Cost of Capital

It is the minimum required rate of return that the business must earn to justify the expectations of the providers of funds. It is the weighted average of the individual required rates of return associated with each source. Its an after-tax rate of return which the business must earn on its investments.

10/23/2012 SINGHVI ASSOCIATES, PUNE 3

Cost of Capital
Used as a benchmark (discount rate) for the investment decisions. Is affected by the changing expectations of return by the capital providers in the light of emerging developments in the market place. Higher the risk involved in a proposal, higher the return expectation and higher the cost of capital for the firm.

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Cost of Capital calculation

Funds from: Debt Preferred stock Common equity Total

2,000 3,000 5,000 10,000

@5% @10% @15% @?

10/23/2012

SINGHVI ASSOCIATES, PUNE

Cost of Capital calculation

Weighted average cost calculation Debt 20% of total at 5%. = 1% Preferred 30% of total at 10 %= 3% Common 50% of total at 15%= 7.5% Thus total weighted average = 11.5%

10/23/2012

SINGHVI ASSOCIATES, PUNE

Cost of Debt = Ki
Cost of debt is the required rate of return for the lenders on their investment in the company Cost of debt is on after tax basis since interest is tax deductible Ki= Kd (1-t) where Kd =y-t-m on the debt and t = companys applicable tax rate Assume Kd =8% and t=40%. Ki= 4.8%

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Cost of Preferred Stock = Kp

Cost of preferred stock is the required rate of return for the investment by the preferred stockholders of the firm Kp= Dividend per share (assume 5.60) / Current price of the preferred share( Rs. 70) Kp = 8%

10/23/2012

SINGHVI ASSOCIATES, PUNE

Cost of Equity
Historically, costlier than the cost of debt for the simple reason that the dividend is not tax-deductible. A rupee of dividend from after-tax profits is not equal to a rupee of interest paid from pre-tax profits.

10/23/2012

SINGHVI ASSOCIATES, PUNE

Cost of Equity
More difficult to determine since the return expectations of the equity owners are not fixed. They are also subject to the developments in the competing investment options, risk perceptions as well as growth expectations of the business.

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Cost of Equity = Ke

Cost of equity is the discount rate that equates the present value of all expected future dividends with the current market price of the stock Approaches: Discounted Dividend model and CAPM Gordons Discounted dividend model applicable in constant growth rate assumption. It reduces the model to Ke= (Div1/Po) +g
SINGHVI ASSOCIATES, PUNE 11

10/23/2012

Cost of equity =Ke

Assume Current Dividend per share Rs.3 Expected to grow @ 8% per year forever Current market price per share Rs. 64.80 Thus Div 1= (3*1.08) or 3.24 Ke= (3.24/64.80)+0.08 Ke= 0.05+0.08 or 13%

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Cost of Equity
Complex models developed by experts in the field to determine the cost of equity. One such model is known as capital asset pricing model (CAP-M) developed by Prof. Sharpe of Stanford. He was awarded the Nobel prize for this work. Takes into account the risk free rate, the risk premium, and the beta of individual stock.

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Cost of equity. CAPM Approach

Ke is equated to the required rate of return in market equilibrium. The Risk -Return relationship is described by the Security Market Line (SML) Ke= Rf + (Rm -Rf )I Where Rf is risk free return =assumed 4%; Expected Return on the market 11.2% and Beta of company Is share 1.25 Ke= 4%+(11.2%_4%)1.25 or 13%
SINGHVI ASSOCIATES, PUNE 14

10/23/2012

Cost of Capital Calculation: WACC

If the proportion of the funds from the three following sources are : Debt 35% Preferred Stock 15% Common Stock 50% Then WACC calculation would be: 0.35(.048)+.15(.08)+.50(.13) or 1.68%+1.2%+6.5% or 9.38%
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10/23/2012

Cost of Capital
If the business has to add value to the shareholders wealth, it has to earn more than the weighted average cost of capital. The market values of the funds should be taken into consideration rather than the book values to reflect an economic viewpoint which is more realistic.

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