Cost of Capital

COC
• The financing decision
• Cost of capital
• Leverage
• Capital Structure
• The Dividend Decision
• Working Capital

COC
The financing decision

Liabilities & Equity Assets

Current Liabilities Current assets

Long-term debt Fixed Assets

Preferred Stock
Common Equity

COC
The financing decision

Liabilities & Equity Assets

Current Liabilities Current assets

Long-term debt Fixed Assets

Preferred Stock Capital Structure
Common Equity

COC
What is cost of Capital?

COC
 Cost of Capital

Co’s cost of capital = Av. Cost of Various components

employed by it

Co’s cost of Capital =Average rate of return required by

by the investors who provide capital
to the company

COC
 Cost Of Capital

• For Investors

• the rate of return on a security

COC
 Cost Of Capital

• For Financial Managers

• The rate of return is a cost of raising

funds that are needed to
operate the firm.

COC
 Cost Of Capital

• In other words,

• the cost of raising funds

is the firm’s
cost of capital.

COC
Cost of Capital

used for evaluating

Investment projects
Determining Capital structure
Assessing leasing proposals

COC
 How can the firm raise capital?
• Bonds
• Preferred Stock
• Common Stock
• Each of these offers a rate of return
to investors.
• This return is a cost to the firm.
• “Cost of capital” actually refers to
the weighted cost of capital –
a weighted average cost of financing
sources. COC
 The Weighted Cost of Capital

A company’s cost of Capital is the weighted average cost of

Various sources of finance used by it

Equity
Preference and
Debt

COC
 The Weighted Cost of Capital
Company uses

Equity 50%
Preference 10%
Debt 40%

Components cost
Equity 16%
Preference 12%
Debt 8%

WACC = (Proportion of Equity)(Cost of Equity)+

(Proportion of Preference )(Cost of Pref )+
(Proportion of Debt)(Cost of Debt)

= (0.5)(16)+(0.10)(12)+(0.4)(8)
= 12.4% COC
 The Weighted Cost of Capital

 Only three types of capital are used

 Debt includes short term and long term debt

 Non interest bearing liabilities,trade creditors

are not included in WACC

COC
 Rationale behind WACC

if ROR> COC than share holders benefit

A firm employs equity and Debt in equal proportions
And whose cost of equity and Debt are 14% and 6%

WACC=(0.5X14 +0.5X6)
= 10%

If the firm invest Rs 100 million on a project @12%

Total Return on Project -Interest on Debt

Equity Funds
100x.12 -50x.6 =18%
50

18% IS MORE THAN COST ON EQUITY 14%

SHARE HOLDERS WILL BENEFIT COC
 Company COC AND Project COC

CCOC is the rate of return expected by existing

Capital Providers

PCOC is the rate of return expected by existing

capital providers or investment the company
Proposes to undertake

COC
Cost of Debt

COC
 Cost of Debt

For the issuing firm, the cost of debt is:

Debenture
Loans DEBT
Commercial Papers

Yield to maturity of that instrument

COC
Cost of Debt is Value of RD in the Equation

P0 = ∑ I + F
T=1 (1+rd)t ( 1+rd)n

Where PO = Current Market Price of Debenture

I = Annual interest payment
n = Number of years left to maturity
F = Maturity value of debenture
rd = Yield to Maturity

COC
 Yield To Maturity

I+(F-P)/n
Rd =
0.6Po + .4F

Face Value=Rs 1000 120+(1000-1040)/4

Coupon Rate=12% Rd =
Remaining Period of Mat=4 Yr
0.6x1040 + .4x1000
Current Market Price=Rs1040
=10.7%

COC
 Firm Using different instruments of Debt
Debt Instrument Face Value Mkt Value Coupon Rate Current Rate

Non Convertible Rs 100 mil Rs 104 mil 12% 10.7%

Debentures
Bank Loan Rs 200mil Rs 200 mil 13% 12%
C Papers Rs 50 mil Rs 48.25 NA 7.39

ACD=10.7(104/352.25) +12%(200/352.25+7.39(48.25/352)
=10.98%

Post tax cost of Debt =Pre tax cost of Debt(1-taxrate)

= 10.98%(1-tax rate)
= 10.98%(1-.30)
= 7.69%
COC
 Example: Tax effects of financing with debt

with stock with debt

EBIT 4,00,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 2,64,000 231,000

Now, suppose the firm pays Rs50,000

in dividends to the stockholders. COC
 Example: Tax effects of financing with debt

with stock with debt

EBIT 4,00,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 2,64,000 231,000
Dividend 50.000 -
Retained earnings 214,000 231,000

COC
 Post-tax Before-tax
Cost of = Cost of _ Tax
Debt Debt

33,000 = 50,000 - 17,000

OR
33,000 = 50,000 ( 1 - .34)
Or,
if we want to look at percentage costs:

COC
After-tax Before-tax
%Cost of = %Cost of _ 1- marginal
Tax Rate
Debt Debt

Rd = Rd (1 - T)

.066 = .10 (1 - .34)

COC
 Example: Cost of Debt
• A Company issues a Rs1,000 par,
20 year bond paying the market rate
of 10%. Coupons are annual. The
bond will sell for par since it pays
the market rate, but flotation costs
amount to Rs50 per bond.

• What is the pre-tax and after-tax

cost of debt for the Corporation?
COC
• Pre-tax cost of debt:
950 = 100(PVIFA 20, kd) +
1000(PVIF 20, kd) So 10 % cost of
using the calculator, Bond Costs the
Firm only 7%
Rd = 10.61%. (With floatation
Costs) since
• After-tax cost of debt: The interest is
Tax deductible
rd = Rd (1 - T)
Rd = .1061 (1 - .34)
Rd = .07 = 7% COC
Cost of Preference Stock

COC
 Cost of Preference

1 carries a fixed rate of dividend

2 it is redeemable in nature

3 preference dividend at regular interval

3 not tax- deductible expense

4 does not produce any tax saving

5 COP is = to its yield

COC
 Cost of Capital of Preference Shares

Kp =
PD +(P n- P o)/n
(Pn + p o)/2
Where
Kp is Cost of capital of preference capital
Pd is annual preference dividend at fixed rate
Pn is amount payable at the time of redemption
Po is net proceed on issue of preference shares
n is number of years

COC
 Cost of Preference

EXP yield

Face Value :Rs 100

Dividend Rate :11%
11+(100-95)/n
Maturity Period :5 Yr 0.4x100+.6x95
Market Price Rs 95 =12.37%

If more than one issue of preference stock outstanding than

We apply average yield of preference like debt
COC
Cost of Equity

COC
 Cost of Equity
• There are 2 sources of Equity:

3) Internal equity
(retained earnings),
&
2) External equity
(new issues)

Do these 2 sources have the same cost?

COC
 Cost of Internal Equity

• Since the stockholders own the firm’s retained

earnings, the cost is simply the stockholders’
required rate of return.

Why?
• If managers are investing stockholders’
funds, stockholders will expect to earn an
acceptable rate of return.

COC
Cost of External Equity

• Far more difficult to measure than other sources

• No Coupon rate in equity capital

• Value comprises
Earnings
Dividend
Market Value

• Dividend decisions Depends upon Board

• Market value depends upon lot of factors

COC
 Cost Of External Equity

D1 + D2 ----------+ Dn + Pn
PO = ( 1+ke)1 ( 1+ke)2 ( 1+ke)n ( 1+ke)n

Where

Po is Current Market Price of Equity Shares

Pn is share Market Price after n year
D1 is dividend receivable over different years
Ke Req rate of return of share holders

COC
WACC

COC
 Weighted Cost of Capital

• The weighted cost of capital is

just the weighted average cost
of all of the financing sources.

COC
Weighted Cost of Capital

WACC = re.w1 + rp.w2+ rd.w3(1-tc)

Where
WACC is cost of Weighted Av. Cost of Capital
re is cost of equity capital
rd is after tax cost of debt
W1 Proportion of Equity capital in capital Structure
W3 Proportion of Debt Capital
W2 Proportion of Pref.Capital
tc is corporate tax rate

COC
Cost of specific sources of capital in a company are

Re =16%

Rp =14%

Rd =12%

Market Value proportion of Equity,Preference and Debt

We =0.60
Wp =0.05
Wd =0.35

Tax rate is 30%

Sources Proportions Cost W
Cost
Debt 1.60 216.0% 3
9.60
Preference .05 14.0% 0.70
Equity .35 8.4% 2.94
WACC= 13.24% COC
 Weighted Cost of Capital

Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16% 70%

COC
 Weighted Cost of Capital

• Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16)

= 13.4%

COC
 The Concept of COC is too Academic

The cost of Equity is Equal to dividend rate or ROE

Retained Earnings are either Cost free or cheaper

than External Equity
Some
Share Premium has no Cost
Misconceptions
Depreciation has no cost

The COC can be defined in terms of Accounting Based

Measures

Co. can apply same COC to all Projects

Project heavily financed by debt has low WACC

COC
Few Responses about Cost of Capital

We look at the profitability of Investment

Proposals from point of view of equity
Capital.Our dividend rate is 10percent—
So our cost of Capital is 10%

* Electrical

COC
Few Responses about Cost of Capital

We don’t calculate COC- it is too

Academic and impractical

*Chemical

COC
Few Responses about Cost of Capital

Our rate of return is too high and

Thus it is not necessary
*Chemical

COC