Cost of capital, its significance and its Cost of capital, its significance and its computationcomputation

Under guidance of Prepared byUnder guidance of Prepared byDr Abhijeet singh Prashant KiranDr Abhijeet singh Prashant Kiran

Roll No. 20Roll No. 20 MBAMBA

Cost of CapitalCost of Capital

The cost of capital of a firm is the minimum rate of return The cost of capital of a firm is the minimum rate of return expected by its investors.expected by its investors.Cost of capital for a firm may be defined as the cost of Cost of capital for a firm may be defined as the cost of obtaining funds i.e. the average rate of return that the investors obtaining funds i.e. the average rate of return that the investors in a firm would expect for supplying funds to the firm.in a firm would expect for supplying funds to the firm.According to Solomon Ezra, ”cost of capital is the minimum According to Solomon Ezra, ”cost of capital is the minimum required rate of earnings or the cut-off rate of capital required rate of earnings or the cut-off rate of capital

expendituresexpenditures.”.”

Symbolically, cost of capital may be Symbolically, cost of capital may be represented as:represented as:K=rK=r00+b+f+b+f

Where,Where,

K=Cost of capitalK=Cost of capital

rroo=Normal rate of return at zero risk level=Normal rate of return at zero risk level

b=premium for business riskb=premium for business risk

f=premium for financial risk f=premium for financial risk

Significance of the cost of capitalSignificance of the cost of capital

1.1. As an Acceptance Criterion in capital As an Acceptance Criterion in capital budgetingbudgeting

2.2. As a Determinant of capital mix in capital As a Determinant of capital mix in capital structure Decisionsstructure Decisions

3.3. As a Basis for Evaluating the financial As a Basis for Evaluating the financial performanceperformance

Determination of cost of capitalDetermination of cost of capital

The cost of capital can be computed asThe cost of capital can be computed as

1.1. Computation of cost of specific source of Computation of cost of specific source of financefinance

2.2. Computation of weighted average cost of Computation of weighted average cost of capital capital

1.1. Computation of specific source of financeComputation of specific source of finance

Computation of each specific source of finance, viz, debt, Computation of each specific source of finance, viz, debt, preference share capital, equity share capital and retained earnings preference share capital, equity share capital and retained earnings are as followsare as follows

(a) (a) Cost of DebtCost of Debt

The cost of debt is the rate of interest payable on debt. It is The cost of debt is the rate of interest payable on debt. It is given asgiven as

(i) The cost of debt before tax is (i) The cost of debt before tax is

KKdbdb=I/p=I/p

Where, KWhere, Kdbdb=Before tax cost of debt=Before tax cost of debt

I =interestI =interest

p =principalp =principal

• In the case when the debt is raised in premium or In the case when the debt is raised in premium or discount,P is consider as the amount of net proceeds discount,P is consider as the amount of net proceeds received from the issue and not the face value of received from the issue and not the face value of securities. The formula may be changed tosecurities. The formula may be changed to

(ii) K(ii) Kdbdb=I/NP=I/NP

where, NP=Net proceedswhere, NP=Net proceeds

• Further when the debt is used as a source of finance, Further when the debt is used as a source of finance, the firm saves a considerable amount in payment oif the firm saves a considerable amount in payment oif tax as interest is allowed as a deductable expences in tax as interest is allowed as a deductable expences in computation of tax which reduces the effective cost of computation of tax which reduces the effective cost of debt. The after tax cost of debtdebt. The after tax cost of debt

(iii) K(iii) Kdada=K=Kdbdb(1-t)(1-t)

where, Kwhere, Kdada=After tax cost of debt=After tax cost of debt

t = Rate of taxt = Rate of tax

Cost of redeemable debtCost of redeemable debt

When the debt is issued as a redeemable i.e. it is When the debt is issued as a redeemable i.e. it is redeemed after a certain period of time thenredeemed after a certain period of time then

(iv) Before tax cost of redeemable debt,(iv) Before tax cost of redeemable debt,

KKdbdb==

I +(RV-NP)

n

RV+NP

2Where,Where,

I =Annual interest I =Annual interest n=Number of years in which debt is to be reedemed n=Number of years in which debt is to be reedemed

RV=Redeemable value of debtRV=Redeemable value of debtNP=Net proceeds of debenturesNP=Net proceeds of debentures

(v) After tax cost of redeemable debt(v) After tax cost of redeemable debt

KKdada==

I(1-t)+(RV-NP)

n

(RV+NP)

2

problemproblem

(a)(a) Y itd. Issues Rs 50000,8% debentures at a premium of Y itd. Issues Rs 50000,8% debentures at a premium of 10%.The tax rate applicable to the company is 10%.The tax rate applicable to the company is 60%.Compute cost of debt capital.60%.Compute cost of debt capital.

(b)(b) X ltd issues Rs. 50,000 ,8% debentures at par. The tax rate X ltd issues Rs. 50,000 ,8% debentures at par. The tax rate applicable to the company is 50%.Compute the cost of debt applicable to the company is 50%.Compute the cost of debt capital.capital.

(c)(c) A ltd issues Rs 50000,8% debentures at a discount of A ltd issues Rs 50000,8% debentures at a discount of 5%.The tax rate is 50%.Compute the cost of debt capital.5%.The tax rate is 50%.Compute the cost of debt capital.

(d)(d) B ltd issues Rs 100000,9% debenture at a premium of B ltd issues Rs 100000,9% debenture at a premium of 10%.The cost of flotation are 2%.The tax rate applicable is 10%.The cost of flotation are 2%.The tax rate applicable is 60%.Compute cost of debt capital. 60%.Compute cost of debt capital.

Cost of debt Redeemable in InstallmentsCost of debt Redeemable in InstallmentsA company may also issue a bond or debentures to be reedemed A company may also issue a bond or debentures to be reedemed periodically. In such case principal amount is repaid each period instead periodically. In such case principal amount is repaid each period instead of lump sum amount at maturity and hence cash outflow each period of lump sum amount at maturity and hence cash outflow each period include interest and principal. It is given asinclude interest and principal. It is given as

VVdd==

Vd=present value of bond or debtVd=present value of bond or debt

I=Annual interest in period 1,2,…and so onI=Annual interest in period 1,2,…and so on

P=periodic payment of principalP=periodic payment of principal

Kd=cost of debt or required rate of returnKd=cost of debt or required rate of return

I1+P1

1+Kd + I2 + P2

(I+Kd)2

+ ………

Cost of existing DebtCost of existing Debt

If a firm wants to compute the current cost of existing If a firm wants to compute the current cost of existing debt, the current market yield of the debt is take into debt, the current market yield of the debt is take into considerationconsideration

ProblemProblem

Suppose a firm has 10% debentures of Rs 100 each Suppose a firm has 10% debentures of Rs 100 each outstanding on Jan1,1999 to be redeemed on December outstanding on Jan1,1999 to be redeemed on December 31,2005 and the new debentures could be issued at a net 31,2005 and the new debentures could be issued at a net realisable price of Rs 90 in the beginning of 2001,the realisable price of Rs 90 in the beginning of 2001,the

current cost of existingcurrent cost of existing debt will bedebt will be

KKdbdb==10 + (100-90)

5100+90

2

=12.63%

Cost of preference capitalCost of preference capitalThe cost of preference capital which is perpetual can be The cost of preference capital which is perpetual can be calculated ascalculated as

KKpp==

where,where,

KKpp=cost of preference capital=cost of preference capital

D=Annual preference dividendD=Annual preference dividend P=Preference share capitalP=Preference share capital

D

P

If preference share are issued at premium or Discount or when If preference share are issued at premium or Discount or when costs of floatation are incurred to issue preference shares, then the costs of floatation are incurred to issue preference shares, then the cost of preference capital can be computed with the following cost of preference capital can be computed with the following formula:formula:

KKpp==

It has to be noted that as dividends are not allowed to be deducted in It has to be noted that as dividends are not allowed to be deducted in computation of tax, no adjustments are required for taxes.computation of tax, no adjustments are required for taxes.

For reedeemable preference shares, the cost can be calculated as: For reedeemable preference shares, the cost can be calculated as:

KKprpr= =

D

NP

D+MV-NP

nMV+NP

2

A company issues 10000, 10% preference A company issues 10000, 10% preference shares of Rs 100 each. Cost of issue is Rs 2 shares of Rs 100 each. Cost of issue is Rs 2 per share.Calculate cost of preference capital per share.Calculate cost of preference capital if these shares are issued if these shares are issued

(a)(a) At parAt par

(b)(b) At a premium of 10%At a premium of 10%

(c)(c) At a discount of 5% At a discount of 5%

Cost of equity share capitalCost of equity share capital

1.1. The cost of equity is the maximum rate of return The cost of equity is the maximum rate of return that the company must earn on equity financed portion of that the company must earn on equity financed portion of its investments in order to leave unchanged the market its investments in order to leave unchanged the market price of its stock.price of its stock.

2.2. Payment of dividend is not legal binding. It may or may Payment of dividend is not legal binding. It may or may not be paid.not be paid.

3.3. The cost of equity share capital can be computed in the The cost of equity share capital can be computed in the following ways:following ways:

(a) Dividend yield method or Dividend/Price ratio method(a) Dividend yield method or Dividend/Price ratio method

(b) Dividend yield plus growth in dividend method(b) Dividend yield plus growth in dividend method

(c) Earning yield method (c) Earning yield method

(a) Dividend yield method(a) Dividend yield method In this method the cost of equity capital is the In this method the cost of equity capital is the

discount rate that equates the present value of expected discount rate that equates the present value of expected future dividends per share with the net proceeds (or future dividends per share with the net proceeds (or current market price) of a share. Symbolically,current market price) of a share. Symbolically,

where,where, KKee=cost of equity capital=cost of equity capital D=Expected dividend per shareD=Expected dividend per share NP=Net proceeds per shareNP=Net proceeds per share MP=Market price per shareMP=Market price per share

D

NPor

D

MP=Ke

A company issues 1000 equity shares of Rs 100 A company issues 1000 equity shares of Rs 100 each at a premium of 10%.The company has each at a premium of 10%.The company has been paying 20% dividend to equity share been paying 20% dividend to equity share holders for the past five years and expects to holders for the past five years and expects to maintain the same in the future also.Compute maintain the same in the future also.Compute the cost of equity capital.Will it make any the cost of equity capital.Will it make any difference if the market price of equity share is difference if the market price of equity share is Rs 160?Rs 160?

(b)Dividend yield plus growth in dividend method(b)Dividend yield plus growth in dividend method When the dividends of the firm are expected to grow at a When the dividends of the firm are expected to grow at a

constant rate and the dividend pay out ratio is constant this method constant rate and the dividend pay out ratio is constant this method is used. According to itis used. According to it

Where Ke=Cost of equity capitalWhere Ke=Cost of equity capital

D1=Expected dividend per share at the end of the yearD1=Expected dividend per share at the end of the year

NP=Net proceeds per shareNP=Net proceeds per share

G=Rate of growth in dividendG=Rate of growth in dividend

D0=Previous year’s dividendD0=Previous year’s dividend

KKee==D1

NP

+G =

Do (1+g)

NP

+G

(a) A company plans to issue 1000 new shares (a) A company plans to issue 1000 new shares of Rs 100 each at par.The flotation costs are of Rs 100 each at par.The flotation costs are expected to be at 5%. The company pays a expected to be at 5%. The company pays a dividend of Rs 10 per share initially and the dividend of Rs 10 per share initially and the growth in dividend is expected to be growth in dividend is expected to be 5%.Compute the cost of new issue of equity 5%.Compute the cost of new issue of equity shares.shares.

(b) If the current market price of an equity share (b) If the current market price of an equity share is Rs 150, calculate the cost of existing equity is Rs 150, calculate the cost of existing equity share capital.share capital.

(c) Earning yield Method(c) Earning yield Method According to this method ,the cost of equity According to this method ,the cost of equity

capital is the discount rate that equates the present value capital is the discount rate that equates the present value of expected earning per share with the net proceeds(or of expected earning per share with the net proceeds(or current market price) of a share. Symbollically,current market price) of a share. Symbollically,

KKe e ==

==

Where the cost of existing capital is calculatedWhere the cost of existing capital is calculated == = =

EPS

MP

Earnings per share

Market price per share

EPS

NP

Earning per share

Net proceeds

This method of computing cost of equity capital This method of computing cost of equity capital may be employed in the following cases:may be employed in the following cases:

1.1. When the earning per share is expected to When the earning per share is expected to remain constantremain constant

2.2. When the dividend pay out ratio is 1005 or When the dividend pay out ratio is 1005 or when the retention ratio is zerowhen the retention ratio is zero

3.3. When a firm is expected to earn an amount on When a firm is expected to earn an amount on new equity shares capital which is equal to the new equity shares capital which is equal to the current rate of earningscurrent rate of earnings

4.4. The market price of the share is influenced The market price of the share is influenced only by earning per share.only by earning per share.

Cost of retained earningCost of retained earning It can be computed with the help of following It can be computed with the help of following

formula formula

KKrr==

Where, Where,

KKrr=cost of retained earning=cost of retained earning

D =Expected earning at the end of the yearD =Expected earning at the end of the year NP=Net proceeds of share issueNP=Net proceeds of share issue G =Rate of growthG =Rate of growth MP=Market price per shareMP=Market price per share

D1

NP+ G Or

D1

MP

+ G

Computation of weighted Average cost of Computation of weighted Average cost of capitalcapital

Weighted average cost of capital is the average cost of Weighted average cost of capital is the average cost of the costs of various source of financing . Weighted the costs of various source of financing . Weighted average cost of capital is also known as composite cost average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of of capital, overall cost of capital or average cost of capital. It can be calculate4d as followscapital. It can be calculate4d as follows

KKww==Summation of XW

Summation of W

Where, Kw=Weighted average cost of capital

X=Cost of specific source of financeW=weight, proportion of specific source

of finance