Cost of Capital

Outline
• Introduction & meaning
• Cost of debt & preference
• Cost of equity
• Weighted average cost of capital
 Definition
The Cost of Capital (k) of a project is
the minimum acceptable rate of return
on funds committed to the project
(meeting the financial objectives of the firm)
– Opportunity Cost of Capital
– Discount Rate
 Important Considerations
• Investment projects may differ in risk
– each of them will have its own unique cost of
capital
• Firm represents the aggregate of investment
projects undertaken by it
– Firm’s k will be the average of all the investment
projects
• Firm’s k can be used as a standard for
establishing the required rate of return of the
individual investment projects
 Components of Cost of Capital
• Risk Free Return or zero risk
• Premium for Business Risk
– Variability in operating profit due to change in
sales
• Premium for Financial Risk
– Risk from fixed income securities viz. debt &
preference capital
 SINGNIFICANCE
1. Evaluating investment decisions
2. Designing a firm’s Debt policy
3. Appraising the financial performance
4. Dividend Decision
5. Leasing/ Hire-Purchase
6. Working Capital Management
 Components of Cost of Capital
• Cost of Debt (Debenture/ Bond)
– Issued at par
– Issued at a discount/ premium
• Cost of Preference Capital
• Cost of Equity Capital
• Cost of Retained Earnings
 Cost of Debt
• Issued at Premium/ Discount
n Intt Bn
B0 = Σ +
t=1 (1+ kb)t (1+ kb)n

• Perpetual debt
Int
kb =
B0
After-tax cost of debt = Pre-tax cost (1 – tax rate)
 Illustration
DEBT EMPLOYED BY ABC LTD
Instrument BondA BondB TL CP
Maturity value 200mn 300mn 300mn 100m
Market value 185mn 280mn NA 95mn
Coupon rate 11% 12% 14% -
YTM 13% 14% 15% 10.5%

Avg. rate of debt = 13%(185/860) + 14%(280/860) +

15%(300/860) + 10.5%(95/860) = 13.75%
 Cost of Debt for a firm
• A company has raised debt capital in the
following ways:
• Rs. 200 crore by issuing Bonds which have a
maturity life of five years. Carry a coupon rate
of 10.5% and are selling for Rs. 982.5.
• Rs. 300 crore Term-loan maturing in 7 years.
Interest rate is 11.25%,
• Tax Rate applicable is 35%.
 Cost of Preference Share
• Irredeemable preference share
PDiv
kp =
P0
• Issued at Premium/ Discount

PDivt Pn
Σn
P0 = +
t=1 (1+ kp)t (1+ kp)n
 Cost of Equity Capital

• Sources:
– Internal in the form of RE
– External by issuing new shares

WHAT IS THE COST?

 Cost of Retained Earnings
• Normal growth
Div1 Div1
E0 = ke = +g
ke – g E0
• Supernormal Growth
Div0(1+gs)t En
E0 = Σ n
+
t=1 (1+ ke)t (1+ ke)n
 Cost of External Equity
• Normal growth
Div1
ke = +g
I0 = Issue price of new equity
I0
• Earnings-Price Ratio Model
EPS1
ke =
E0
 Cost of Equity Capital
CAPM relationship
– Cost of equity is a function of
• Risk Free Rate (Rf)
• Expected market return (Rm)
• Beta of a security (βi)

ke = Rf + (Rm – Rf) βi
 Estimation of Inputs in SML
Approach
• Risk-free rate may be estimated as the yield on a LT
Govt. bond with a maturity of 10 years or more
• The market risk premium (Rm – Rf) may be
estimated over the past 10 to 30 years
• Beta may be calculated by regressing the monthly
returns on the stock over the monthly returns on the
market index over the past 60 months or more
 Weighted Avg. Cost of Capital

• Composite or Overall Cost of Capital

• Steps involved:
– Calculate the cost of the specific sources of funds
(i.e., debt, equity, preference shares, etc.)
– Establish a set of weights (proportions)
– Add the weighted component costs to get the
firm’s WACC

WACC = Σ pi ki
 Condition for using WACC
• The risk of new investments is the same as
the average risk of existing investments
• New investment will not change the risk
composition of the firm
• The capital structure of the firm will not be
affected by new investments
 Determining Proportions in
WACC
• Proportion may be based on the following:
– Book values
– Capital structure
– Market value

WACC = E k + P k + D kd (1 – T)
e P
V V V
 Illustration
Source of Finance Amount (Rs ‘000) Cost (%)
Share capital 450,000 18.0
Reserves & Surplus 150,000 18.0
Preference share capital 100,000 11.0
Debt capital 300,000 10.0

Tax rate applicable is 30%

Selection of Appropriate Weights
• Historical vs Marginal weights
• Marginal weights are computed as
proportions the firm intends to raise
• Book value vs Market value weights
 Illustration
Existing Sources Amount (Rs ‘000) Cost (%)
Share capital 450,000 18.0
Reserves & Surplus 150,000 18.0
Preference share capital 100,000 11.0
Debt capital 300,000 10.0

Tax rate applicable is 30%

Now, the firm wishes to raise Rs. 500 mn for expansion of its plant.
If 100 million will be taken from free reserves, Rs. 300, million
will be raised from new debt and Rs. 100 mn issuing preference
capital, what is firm’s Wt. marginal cost of Capital
 Weighted Marginal Cost of Capital
• Rate of return required tend to increase as the
supplier of funds are required to lend more
WMCC

13

12

11

11 20 40 60 80 Financing
 Divisional/ Project
Cost of Capital
• When return from one project is sensitive to
firm’s return, the project cost of capital
should be considered separately
• Applying WACC can potentially lead to
poor decisions
• Approaches:
– Pure play approach
– Subjective approach
 Pure Play Approach
• Identify comparable firms (proxy)
• Estimate equity beta of comparable firms
• Estimate asset betas for comparable firms
– Levered equity betas of proxy firms are changed to
unlevered (all-equity) beta
• Calculate division’s beta
• Calculate division’s all-equity cost of capital
• Calculate division’s equity cost of capital
• Calculate division’s cost of capital
 Judgmental Approach
• If it is difficult to find comparable firms
• WACC is adjusted with a adjustment factor
R

Adjusted WACC = WACC ± R