Cost of Capital

Concept of Value
2

Book Value
Replacement Value
Liquidation Value
Going Concern Value
Market Value

Features of a Bond
3

Face Value
Interest Ratefixed or floating
Maturity
Redemption value
Market Value

Bonds Value
4

Bonds with maturity

Pure discount bonds
Perpetual bonds

Value of Bonds with

Maturity
Bond value = Present value of interest
+ Present value of maturity value:
n

B0
t 1

INTt
Bn

(1 kd )t (1 kd ) n

Yield to Maturity
6

The yield-to-maturity (YTM) is

bonds internal rate of return.
A perpetual bonds yield-tomaturity:
n

B0
t 1

INT
INT

(1 kd )t
kd

Yield to Call
7

Call period would be different from the

maturity period and the call (or
redemption) value could be different
from the maturity value.
Example: Suppose the 10% 10-year
Rs 1,000 bond is redeemable (callable)
in 5 years at a call price of Rs 1,050.
The bond is currently selling for Rs
950.The bonds yield to call is 12.7%.
5

950
t 1

100

1 YTC

1,050

1 YTC

Bond Value and Amortisation of

Principal
8

A bond (debenture) may be amortised

every year, i.e., repayment of principal
every year rather at maturity.
The formula for determining the value of
a bond or debenture that is amortised
every year, can be written as follows:
n

CFt
t
t 1 (1 k d )

B0

Note that cash flow, CF, includes both the

interest and repayment of the principal.

Pure Discount Bonds

9

Difference between face value of the

bond and its purchase price gives the
return or YTM to the investor.

Pure Discount Bonds

Example: A company may issue a

pure discount bond of Rs 1,000 face
value for Rs 520 today for a period
of five years. The rate of interest
can be calculated as follows:
520

1, 000

1 YTM

1, 000
1.9231
1 YTM
520
i 1.92311/ 5 1 0.14 or 14%
5

10

Pure Discount Bonds

11

Pure discount bonds are called deepdiscount bonds or zero-interest

bonds or zero-coupon bonds.
The market interest rate, also called
the market yield, is used as the
discount rate.
Value of a pure discount bond = PV of
the amount on maturity:
B0

Mn

1 kd

Perpetual Bonds
12

Perpetual bonds, also called

consols, has an indefinite life and
thereforeno maturity value - rarely
found in practice.

Valuation of Preference
Shares

13

The value of the preference share is

sum of present values of dividends
and redemption value.
A formula similar to the valuation of
bond can be used to value
preference shares with a maturity
period:
n

P0
t 1

Pn
PDIV1

(1 k p )t (1 k p ) n

14

Value of a Preference ShareExample

Suppose an investor is considering the purchase of a 12-year, 10% Rs 100 par value preference share. The
redemption value of the preference share on maturity is Rs 120. The investors required rate of return is
10.5 percent. What should she be willing to pay for the share now? The investor would expect to receive
Rs 10 as preference dividend each year for 12 years and Rs 110 on maturity (i.e., at the end of 12 years).
We can use the present value annuity factor to value the constant stream of preference dividends and the
present value factor to value the redemption payment.

1
1
120

12
12
0.105 0.105 (1.105) (1.105)
10 6.506 120 0.302 65.06 36.24 Rs101.30

P0 10

Note that the present value of Rs 101.30 is a composite of the present value of dividends, Rs 65.06 and
the present value of the redemption value, Rs 36.24.The Rs 100 preference share is worth Rs 101.3 today
at 10.5 percent required rate of return. The investor would be better off by purchasing the share for Rs 100
today.

Value of Shares
Dividend Capitalisation
15

The value of an ordinary share is

determined by capitalising the future
dividend stream at the opportunity
DIV1 P1
cost of capital
P0
1 ke
Single Period Valuation:

If the share price is expected to grow at g

per cent, then P1:
P1 aP0simple
(1 g ) formula for the share
We obtain
valuation as follows:
DIV1
P0
ke g

Multi-period Valuation
16

If the final period is n, we can write the

general formula for share value as follows:
n

Growth in

DIVt
Pn
P0

t
n
(1

k
)
(1

k
)
t

1
e
e
Dividends

Growth = Retention ratio Return on equity

g b ROE
Normal Growth

DIV1
ke g
Super-normal Growth
P0

Share value PV of dividends during finite super-normal growth period

PV of dividends during indefinite normal growth period

Equity Capitalisation Rate

For firms for which dividends are

expected to grow at a constant rate
indefinitely and the current market
price is given
ke

DIV1
g
P0

17

COST OF CAPITAL
The cost of capital of any investment (project,
business, or company) is the rate of return the
suppliers of capital would expect to receive if the
capital were invested elsewhere in an investment
(project, business, or company) of comparable
risk

The cost of capital reflects expected return

The cost of capital represents an opportunity

cost

COMPANY COST OF CAPITAL AND

PROJECT COST OF CAPITAL
The company cost of capital is the rate of return
expected by the existing capital providers.
The project cost of capital is the rate of return
expected
by capital providers for a new project the
company
proposes to undertake
The company cost of capital (WACC) is the right
discount rate for an investment which is a
carbon copy
of the existing firm.

COST OF DEBT
P0 =

t=1

+
(1 + rD)t

F
(1 + rD)n

P0 = current price of the debenture

I = annual interest payment
n = number of years left to maturity
F = maturity value
rD is computed through trial-and-error. A very close
approximation is:
I + (F P0)/n
rD =

0.6P0 + 0.4F

ILLUSTRATION
Face value = 1,000
Coupon rate = 12 percent
Period to maturity = 4 years
Current market price = Rs.1040
The approximate yield to maturity of this
debenture is :
rD =

120 + (1000 1040) / 4

= 10.7 percent
0.6 x 1040 + 0.4 x 1000

COST OF PREFERENCE
Given the fixed nature of preference
dividend

and

principal

repayment

commitment and the absence of tax

deductibility, the cost of preference is
simply equal to its yield.

ILLUSTRATION
Face value : Rs.100
Dividend rate : 11 percent
Maturity period : 5 years
Market price : Rs.95
Approximate yield :
11 + (100 95) / 5
= 12.37 percent
0.6 x 95 + 0.4 x 100

COST OF EQUITY
Equity finance comes by way of (a) retention of
earnings
and (b) issue of additional equity capital.
Irrespective of whether a firm raises equity
finance by
retaining earnings or issuing additional equity
shares,
the cost of equity is the same. The only
difference is in
floatation cost.
Floatation costs will be discussed separately.

APPROACHES TO ESTIMATE
COST OF EQUITY
Security Market Line Approach
Bond Yield Plus Risk Premium Approach
Dividend Growth Model Approach
Earnings-Price Ratio Approach

SECURITY MARKET LINE

APPROACH
rE = Rf + E [E(RM) Rf ]
rE = required return on the equity of the
company
Rf = risk-free rate

E = beta of the equity of the company

E(RM) = expected return on the market
portfolio
Illustration
Rf = 7%,

E = 1.2,

E(RM) = 15%

rE = 7 + 1.2 [15 7] = 16.6%

BOND YIELD PLUS RISK

PREMIUM APPROACH
Yield on the
long-term +
bonds
Cost of =
Risk
of the firm premium
equity
Should the risk premium be 2 percent, 4 percent,
or n percent ? There seems to be no objective
way of determining it.

DIVIDEND GROWTH MODEL APPROACH

If the dividend per share grows at a constant rate
of g percent.
D1
P0 =
rE g
So, rE =

D1

+g

P0

Thus, the expected return of equity shareholders,

which in equilibrium is also the required return, is
equal to the dividend yield plus the expected
growth rate

GETTING A HANDLE OVER g

Analysts forecasts of growth rate.

Average annual growth rate in the last 5

10 years.
(Retention rate) (Return on equity)

EARNINGS-PRICE RATIO APPROACH

Cost of equity = E1 / PO

where

E1 = the expected EPS for the

next year
PO = the current market price
This approach provides an accurate
measure in the following two cases:
When the EPS is constant and the
dividend payout
ratio is 100 percent.
When retained earnings earn a rate
of return equal to the cost of equity.

DETERMINING THE
PROPORTIONS OR WEIGHTS
The appropriate weights are the target capital
structure
weights stated in market value terms.
The primary reason for using the target capital
structure
is that the current capital structure may not
reflect the
capital structure expected in future.
Market values are superior to book values
because in
order to justify its valuation the firm must earn
competitive returns for shareholders and
debtholders on

WEIGHTED AVERAGE
COST OF CAPITAL (WACC)
WACC = wErE + wprp + wDrD (1 tc)
wE = proportion of equity
rE = cost of equity
wp = proportion of preference
rp = cost of preference
wD = proportion of debt
rD = pre-tax cost of debt
tc = corporate tax rate

WACC

Source of Capital
Weighted Cost
(1)

Debt

Preference
0.70%
Equity
2.94%

0.60

Proportion
(2)

Cost
[(1) x (2)]

16.0%
0.05
0.35

9.60%
14.0%
8.4%

WACC = 13.24%

WEIGHTED MARGINAL COST OF CAPITAL

SCHEDULE
The procedure for determining the weighted
marginal cost of capital involves the
following steps:
1. Estimate the cost of each source of financing
for various levels of its use through an
analysis of current market conditions and an
assessment of the expectations of investors
and lenders.
2. Identify the levels of total new financing at
which the cost of the new components would
change, given the capital structure policy of

WEIGHTED MARGINAL COST OF CAPITAL

SCHEDULE
BPj =

TFj
wj

where BPj is the breaking point on account of

financing source j, TFj is the total new
financing from source j at the breaking point,
and wj is the proportion of financing source j
in the capital structure.
3. Calculate the WACC for various ranges of total
financing between the breaking points.
4. Prepare the weighted marginal cost of capital
schedule which reflects the WACC for each

DIVISIONAL AND PROJECT COST

OF CAPITAL
Using WACC for evaluating investments whose
risks are
different from those of the overall firm leads to
poor
In such cases, the expected return
mustdecisions.
be
as compared with the risk-adjusted required return,
calculated by the security market line.

Multidivisional firms that have divisions

characterised
by costs
differing risks may calculate separate
divisional
of capital.
Two approaches are commonly
employed
for
this purpose:
The pure play approach

FLOATATION COSTS
Floatation or issue costs consist of items like
underwriting costs, brokerage expenses,
fees of
merchant bankers, underpricing cost, and so
on.
One approach to deal with floatation costs is
to adjust
the WACC to reflect the floatation costs:
WACC

Revised WACC =
1 Floatation costs
A better approach is to leave the WACC
unchanged but
to consider floatation costs as part of the

SOME MISCONCEPTIONS
Several misconceptions characterise the
calculation and application of cost of
capital in practice.
The concept of cost of capital is too
academic or
impractical.

The cost of equity is equal to the

dividend rate or return
on equity.
Retained earnings are either cost free or
cost

SOME MISCONCEPTIONS
Depreciation has no cost
The cost of capital can be defined in
terms of an
accounting-based measure.
A company must apply the same cost of
capital to all
projects.
If a project is financed heavily by debt,
its WACC is low.