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COST OF CAPITAL

INDEX

Sr. No. Particulars Page No.

1. Introduction and Meaning 2

2. Definition 3

3. Significance 3-4

4. Concept of Capital Budgeting 5-6

5. Capital Structure: Meaning and Concept 7-14

6. Cost of Equity 15-20

7. Cost of Retained Earnings 21-22

8. Weighted Average Cost of Capital 23-26

9. Marginal Cost of Capital 27-28

10. Cost of Debt 29

11. Cost of Preference Share Capital 30-31

12. Problems in determination of Cost of Capital 32-33

13 Cost of Capital in India 34-35

14. Bibliography 36

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Introduction and Meaning:

Investment decision is major decision for an organization. Under investment decision

process, the cost and benefit of prospective projects is analysed and the best alternative is

selected on the basis of the result of analysis. The benchmark of computing present value

and comparing the profitability of different investment alternatives is cost of capital. Cost of

capital is also known as minimum required rate of return, weighted average cost of capital,

cut off rate, hurdle rate, standard return etc. Cost of capital is determined on the basis of

component cost of financing and proportion of these sources in capital structure.

Business firms raise the needed fund from internal sources and external sources.

Undistributed and retained profit is the main source of internal fund. External fund is raised

either by the issue of shares or by issue of debenture (debt) or by both means. The fund

collected by any means is not cost free. Interest is to be paid on the fund obtained as debt

and dividend is to be paid on the fund collected through the issue of shares. The average

cost rate of different sources of fund is known as cost of capital.

From the view point of return, cost of capital is the minimum required rate of return to be

earned on investment. In other words, the earning rate of a firm which is just sufficient to

satisfy the expectation of the contributors of capital is called cost of capital. Shareholders

and debenture holders are the contributors of the capital. For example, a firm needs Rs.

5,00,000 for investing in a new project. The firm can collect Rs.3,00,000 from shares on

which it must pay 12% dividend and Rs. 2,00,000 from debentures on which it must pay 7%

interest. If the fund is raised and invested in the project, the firm must earn at least Rs.

50,000 which becomes sufficient to pay Rs.36,000 dividend (12% of Rs.3,00,000) and

Rs.14000 interest (7% of Rs.2,00,000). The required earning Rs. 50,000 is 12% of the total

fund raised. This 12% rate of return is called cost of capital.

In this way, cost of capital is only minimum required rate of return to earn on investment

and it is not the actual earning rate of the firm. As per above example, if the firm is able to

earn only 10%. All the earnings will go in the hands of contributors of capital and nothing

will be left in the business. Therefore, any business firm should try to maximize the earning

rate by investing in the projects that can provide the rate of return which is more than the

cost of capital.

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Definition

In economics and accounting, the cost of capital is the cost of a company's funds

(both debt and equity), or, from an investor's point of view "the required rate of return on a

portfolio company's existing securities". It is used to evaluate new projects of a company. It

is the minimum return that investors expect for providing capital to the company, thus

setting a benchmark that a new project has to meet.

The cost of funds used for financing a business. Cost of capital depends on the mode of

financing used – it refers to the cost of equity if the business is financed solely through

equity, or to the cost of debt if it is financed solely through debt. Many companies use a

combination of debt and equity to finance their businesses, and for such companies, their

overall cost of capital is derived from a weighted average of all capital sources, widely known

as the weighted average cost of capital (WACC). Since the cost of capital represents

a hurdle rate that a company must overcome before it can generate value, it is extensively

used in the capital budgeting process to determine whether the company should proceed

with a project.

Significance

Capital budgeting, or investment appraisal, is the planning process used to determine

whether an organization's long term investments such as new machinery, replacement of

machinery, new plants, new products, and research development projects are worth the

funding of cash through the firm's capitalization structure (debt, equity or retained

earnings). It is the process of allocating resources for major capital, or investment,

expenditures. One of the primary goals of capital budgeting investments is to increase the

value of the firm to the shareholders.

An organization undertakes multiple projects with different capital requirements, rates of

return, and time duration. For example, some projects may need investment over a longer

period of time, whereas others need investments only in the initial years.

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“Capital Budgeting is a kind of thinking that is necessary to design and carry through the

systematic programme for investing stockholders’ money”-Joel Dean.

Since every project requires investment; therefore, an organization should take project

selection decisions very prudently to ensure the optimum utilization of funds invested. Any

wrong selection of a project may incur heavy losses for the organization. In addition, the

reputation and goodwill of the organization may also get affected.

An organization needs to evaluate the capital requirements of a project and the returns

generated from it, before selecting a project. This can be done with the help of capital

budgeting, which is a process of determining the actual profitability of a project. In other

words, capital budgeting is a process that helps in planning the investment projects of an

organization in the long run. The long- term investments of an organization can be purchase

and replacement of fixed assets, new product launching or expansion of existing products,

and research and development.

The capital budgeting process can be effective if an organization determines the total capital

expenditure for a project that is expected to generate returns over a particular period of

time. An organization uses various techniques to determine the total expenditure for a

project and rate of return yielded from it. Some of the popular techniques are net present

value, internal rate of return, payback period, sensitivity analysis, and decision tree analysis.

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Concept of Capital Budgeting:

Capital budgeting is a planning process that is used to determine the worth of long-term

investments of an organization. The long- term investments of the organization can be

made in purchasing a new machinery, plant, and technology.

In other words, capital budgeting is a method of identifying, evaluating, and selecting long-

term investments. The concept of capital budgeting has a great importance in project

selection as it helps in planning capital required for completing long-term projects. Selection

of a project is a major investment decision for an organization. Therefore, capital budgeting

decisions are included in the selection of a project. In addition, capital budgeting helps in

estimating costs and benefits involved in a particular project. A project is not worth

investing, if it does not yield adequate return on invested capital.

Some of the management experts have defined capital budgeting in the following ways:

According to Charles T. Holmgren, “Capital Budgeting is long-term planning for making and

financing proposed capital outlays.”

As per Richards and Green law, “The capital budgeting generally refers to acquiring inputs

and long-run returns.”

In the words of G. C. Philipattos, “Capital budgeting is concerned with the allocation of the

firm’s scarce financial resources among the available market opportunities. The

consideration of investment opportunities involves the comparison of the expected future

streams of earnings from a project; with the immediate and subsequent stream of

expenditures for it.”

According to Joel Dean, “Capital Budgeting is a kind of thinking that is necessary to design

and carry through the systematic programme for investing stockholders’ money.” From the

aforementioned definitions, it can be concluded that capital budgeting is an important

process for any organization.

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The significance of capital budgeting is explained in the following points:

(a) Long-term Applications:

Implies that capital budgeting decisions are helpful for an organization in the long run as

these decisions have a direct impact on the cost structure and future prospects of the

organization. In addition, these decisions affect the organization’s growth rate. Therefore,

an organization needs to be careful while making capital decisions as any wrong decision

can prove to be fatal for the organization. For example, over-investment in various assets

can cause shortage of capital to the organization, whereas insufficient investments may

hamper the growth of the organization.

(b) Competitive Position of an Organization

Refers to the fact that an organization can plan its investment in various fixed assets

through capital budgeting. In addition, capital investment decisions help the organization to

determine its profits in future. All these decisions of the organization have a major impact

on the competitive position of an organization.

(c) Cash Forecasting:

Implies that an organization needs a large amount of funds for its investment decisions.

With the help of capital budgeting, an organization is aware of the required amount of cash,

thus, ensures the availability of cash at the right time. This further helps the organization to

achieve its long-term goals without any difficulty.

(d) Maximization of Wealth:

Refers to the fact that the long-term investment decisions of an organization help in

safeguarding the interest of shareholders in the organization. If an organization has invested

in a planned manner, shareholders would also be keen to invest in the organization. This

helps in maximizing the wealth of the organization. Capital budgeting helps an organization

in many ways. Thus, an organization needs to take into consideration various aspects.

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Capital Structure: Meaning & Concept

Let us make an in-depth study of the meaning, concept, importance and factors of capital

structure.

The term ‘structure’ means the arrangement of the various parts. So, capital structure

means the arrangement of capital from different sources so that the long-term funds

needed for the business are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital,

preference share capital, debentures, long-term loans, retained earnings and other long-

term sources of funds in the total amount of capital which a firm should raise to run its

business.

Few definitions of capital structure given by some financial experts:

“Capital structure of a company refers to the make-up of its capitalisation and it includes all

long-term capital resources viz., loans, reserves, shares and bonds.”—Gerstenberg.

“Capital structure is the combination of debt and equity securities that comprise a firm’s

financing of its assets.”—John J. Hampton.

“Capital structure refers to the mix of long-term sources of funds, such as, debentures, long-

term debts, preference share capital and equity share capital including reserves and

surplus.”—I. M. Pandey.

Capital Structure, Financial Structure and Assets Structure:

The term capital structure should not be confused with Financial structure and Assets

structure. While financial structure consists of short-term debt, long-term debt and share

holders’ fund i.e., the entire left hand side of the company’s Balance Sheet. But capital

structure consists of long-term debt and shareholders’ fund.

So, it may be concluded that the capital structure of a firm is a part of its financial structure.

Some experts of financial management include short-term debt in the composition of

capital structure. In that case, there is no difference between the two terms—capital

structure and financial structure.

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So, capital structure is different from financial structure. It is a part of financial structure.

Capital structure refers to the proportion of long-term debt and equity in the total capital of

a company. On the other hand, financial structure refers to the net worth or owners’ equity

and all liabilities (long-term as well as short-term). Capital structure does not include short-

term liabilities but financial structure includes short-term liabilities or current liabilities.

Assets structure implies the composition of total assets used by a firm i.e., make-up of the

assets side of Balance Sheet of a company. It indicates the application of fund in the

different types of assets fixed and current.

Assets structure = Fixed Assets + Current Assets.

Example:

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Note:

The term capitalisation means the total amount of long-term funds at the disposal of the

company, whether raised from equity shares, preference shares, retained earnings, deben-

tures, or institutional loans.

Importance of Capital Structure:

The importance or significance of Capital Structure:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and

securities which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully. A

properly designed capital structure ensures the determination of the financial requirements

of the firm and raise the funds in such proportions from various sources for their best

possible utilisation. A sound capital structure protects the business enterprise from over-

capitalisation and under-capitalisation.

3. Maximisation of return:

A sound capital structure enables management to increase the profits of a company in the

form of higher return to the equity shareholders i.e., increase in earnings per share. This can

be done by the mechanism of trading on equity i.e., it refers to increase in the proportion of

debt capital in the capital structure which is the cheapest source of capital. If the rate of

return on capital employed (i.e., shareholders’ fund + long- term borrowings) exceeds the

fixed rate of interest paid to debt-holders, the company is said to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth

through minimisation of the overall cost of capital. This can also be done by incorporating

long-term debt capital in the capital structure as the cost of debt capital is lower than the

cost of equity or preference share capital since the interest on debt is tax deductible.

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5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of

debt capital because, at the time of poor earning, the solvency is disturbed for compulsory

payment of interest to. the debt-supplier.

6. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so that,

according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:

A good capital structure does not allow the equity shareholders control on business to be

diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e.,

payment of fixed interest charges and repayment of principal amount of debt in time) will

also increase. A sound capital structure protects a business enterprise from such financial

risk through a judicious mix of debt and equity in the capital structure.

Factors Determining Capital Structure:

The following factors influence the capital structure decisions:

1. Risk of cash insolvency:

Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally, the

higher proportion of debt in capital structure compels the company to pay higher rate of

interest on debt irrespective of the fact that the fund is available or not. The non-payment

of interest charges and principal amount in time call for liquidation of the company.The

sudden withdrawal of debt funds from the company can cause cash insolvency. This risk

factor has an important bearing in determining the capital structure of a company and it can

be avoided if the project is financed by issues equity share capital.

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2. Risk in variation of earnings:

The higher the debt content in the capital structure of a company, the higher will be the risk

of variation in the expected earnings available to equity shareholders. If return on

investment on total capital employed (i.e., shareholders’ fund plus long-term debt) exceeds

the interest rate, the shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the shareholders may not

get any return at all.

3. Cost of capital:

Cost of capital means cost of raising the capital from different sources of funds. It is the

price paid for using the capital. A business enterprise should generate enough revenue to

meet its cost of capital and finance its future growth. The finance manager should consider

the cost of each source of fund while designing the capital structure of a company.

4. Control:

The consideration of retaining control of the business is an important factor in capital

structure decisions. If the existing equity shareholders do not like to dilute the control, they

may prefer debt capital to equity capital, as former has no voting rights.

5. Trading on equity:

The use of fixed interest bearing securities along with owner’s equity as sources of finance is

known as trading on equity. It is an arrangement by which the company aims at increasing

the return on equity shares by the use of fixed interest bearing securities (i.e., debenture,

preference shares etc.).

If the existing capital structure of the company consists mainly of the equity shares, the

return on equity shares can be increased by using borrowed capital. This is so because the

interest paid on debentures is a deductible expenditure for income tax assessment and the

after-tax cost of debenture becomes very low.

Any excess earnings over cost of debt will be added up to the equity shareholders. If the

rate of return on total capital employed exceeds the rate of interest on debt capital or rate

of dividend on preference share capital, the company is said to be trading on equity.

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6. Government policies:

Capital structure is influenced by Government policies, rules and regulations of SEBI and

lending policies of financial institutions which change the financial pattern of the company

totally. Monetary and fiscal policies of the Government will also affect the capital structure

decisions.

7. Size of the company:

Availability of funds is greatly influenced by the size of company. A small company finds it

difficult to raise debt capital. The terms of debentures and long-term loans are less

favourable to such enterprises. Small companies have to depend more on the equity shares

and retained earnings. On the other hand, large companies issue various types of securities

despite the fact that they pay less interest because investors consider large companies less

risky.

8. Needs of the investors:

While deciding, capital structure the financial conditions and psychology of different types

of investors will have to be kept in mind. For example, a poor or middle class investor may

only be able to invest in equity or preference shares which are usually of small

denominations, only a financially sound investor can afford to invest in debentures of higher

denominations. A cautious investor who wants his capital to grow will prefer equity shares.

9. Flexibility:

The capital structures of a company should be such that it can raise funds as and when

required. Flexibility provides room for expansion, both in terms of lower impact on cost and

with no significant rise in risk profile.

10. Period of finance:

The period for which finance is needed also influences the capital structure. When funds are

needed for long-term (say 10 years), it should be raised by issuing debentures or preference

shares. Funds should be raised by the issue of equity shares when it is needed permanently.

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11. Nature of business:

It has great influence in the capital structure of the business, companies having stable and

certain earnings prefer debentures or preference shares and companies having no assured

income depends on internal resources.

12. Legal requirements:

The finance manager should comply with the legal provisions while designing the capital

structure of a company.

13. Purpose of financing:

Capital structure of a company is also affected by the purpose of financing. If the funds are

required for manufacturing purposes, the company may procure it from the issue of long-

term sources. When the funds are required for non-manufacturing purposes i.e., welfare

facilities to workers, like school, hospital etc. The company may procure it from internal

sources.

14. Corporate taxation:

When corporate income is subject to taxes, debt financing is favourable. This is so because

the dividend payable on equity share capital and preference share capital are not deductible

for tax purposes, whereas interest paid on debt is deductible from income and reduces a

firm’s tax liabilities. The tax saving on interest charges reduces the cost of debt funds.

Moreover, a company has to pay tax on the amount distributed as dividend to the equity

shareholders. Due to this, total earnings available for both debt holders and stockholders is

more when debt capital is used in capital structure. Therefore, if the corporate tax rate is

high enough, it is prudent to raise capital by issuing debentures or taking long-term loans

from financial institutions.

15. Cash inflows:

The selection of capital structure is also affected by the capacity of the business to generate

cash inflows. It analyses solvency position and the ability of the company to meet its

charges.

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16. Provision for future:

The provision for future requirement of capital is also to be considered while planning the

capital structure of a company.

17. EBIT-EPS analysis:

If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT is

high from EPS point of view, debt financing is preferable to equity. If ROI is less than the

interest on debt, debt financing decreases ROE. When the ROI is more than the interest on

debt, debt financing increases ROE.

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Cost of Equity

In finance, the cost of equity is the return (often expressed as a rate of return) a firm

theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they

undertake by investing their capital. Firms need to acquire capital from others to operate

and grow. Individuals and organizations who are willing to provide their funds to others

naturally desire to be rewarded. Just as landlords seek rents on their property, capital

providers seek returns on their funds, which must be commensurate with the risk

undertaken.

Firms obtain capital from two kinds of sources: lenders and equity investors. From the

perspective of capital providers, lenders seek to be rewarded with interest and equity

investors seek dividends and/or appreciation in the value of their investment (capital gain).

From a firm's perspective, they must pay for the capital it obtains from others, which is

called its cost of capital. Such costs are separated into a firm's cost of debt and cost of

equity and attributed to these two kinds of capital sources.

While a firm's present cost of debt is relatively easy to determine from observation of

interest rates in the capital markets, its current cost of equity is unobservable and must be

estimated. Finance theory and practice offers various models for estimating a particular

firm's cost of equity such as the capital asset pricing model, or CAPM. Another method is

derived from the Gordon Model, which is a discounted cash flow model based on dividend

returns and eventual capital return from the sale of the investment. Another simple method

is the Bond Yield Plus Risk Premium (BYPRP), where a subjective risk premium is added to

the firm's long-term debt interest rate. Moreover, a firm's overall cost of capital, which

consists of the two types of capital costs, can be estimated using the weighted average cost

of capital model.

According to finance theory, as a firm's risk increases/decreases, its cost of capital

increases/decreases. This theory is linked to observation of human behavior and logic:

capital providers expect reward for offering their funds to others. Such providers are usually

rational and prudent preferring safety over risk. They naturally require an extra reward as

an incentive to place their capital in a riskier investment instead of a safer one. If an

investment's risk increases, capital providers demand higher returns or they will place their

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capital elsewhere. Knowing a firm's cost of capital is needed in order to make better

decisions. Managers make capital budgeting decisions while capital providers make

decisions about lending and investment. Such decisions can be made after quantitative

analysis that typically uses a firm's cost of capital as a model input.

The cost of equity is the return a company requires to decide if an investment meets capital

return requirements; it is often used as a capital budgeting threshold for required rate of

return. A firm's cost of equity represents the compensation the market demands in

exchange for owning the asset and bearing the risk of ownership. The traditional formulas

for cost of equity (COE) are the dividend capitalization model and the capital asset pricing

model.

The cost of equity refers to two separate concepts depending on the party involved. If you

are the investor, the cost of equity is the rate of return required on an investment in equity.

If you are the company, the cost of equity is used to determine the required rate of return

on a particular project or investment.

There are two ways in which a company can raise capital: debt or equity. Debt is cheap, but

it must be paid back. Equity does not need to be paid back, but it generally costs more than

debt due to the tax advantages of interest payments. Even though the cost of equity is

higher than debt, equity generally provides a higher rate of return than debt. Analysts

calculate the cost of equity with the dividend growth model and the capital asset pricing

model (CAPM).

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Dividend Growth Model:

Equity valuation is a subject of great depth and complexity. Valuation entails understanding

a business; forecasting its performance, selecting the appropriate valuation model;

converting such forecasting to a valuation and making a recommendation whether or not to

purchase. Valuation models are as nuanced as the companies to which their application

would appear to be best suited. For the purpose of the CFP® examination, candidates are

expected to demonstrate proficiency in the basic mechanics and application of the dividend

discount model which utilizes a firm's cost of capital to discount dividends to arrive at an

approximate intrinsic value of the company.

Constant (Gordon) Dividend Growth Model:

P=D/k-g

Where: P=security's price;

D=dividend pay-out ratio;

k=required rate of return (derived from the capital asset pricing model;

g=dividends' expected growth rate.

The model's assumptions are that: (i) the dividend growth rate is constant; the growth rate

cannot equal or exceed the required rate of return; the investor's required rate of return is

both known and constant. In practice, a company's earnings and growth rates are not

known and not constant

Multi-stage Dividend Discount Models:

P=D(1+g)/(1+k) + D(1+g)(1+g)/(1+r)(k-g)

Where: P=security's price;

D=dividend pay-out ratio;

g=dividends' expected growth rate;

k=required rate of return.

Multistage models can accommodate any number of patterns of future streams of expected

dividends. Spreadsheets enable the analyst to build and analyze many permutations on such

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models. However, care must be taken when choosing the model's inputs, lest the results

become meaningless. Spreadsheets are susceptible to data errors which can result in

erroneous valuations.

Ratio Analysis - The ratios to be discussed below, analysts use as alternative valuation

measures to the dividend discount models and fall under the rubric of market-based

valuation tools.

a. Price/Earnings: price per share/earnings per share. This is a relative valuation

model.

b. Price/Free Cash Flow (FCF): cash flow is less susceptible to manipulation than

earnings, when the appeal of this metric.

c. Price/Sales: how much an investor is paying for sales revenue. A drawback to

this ratio is that this considers price as a multiple of top line growth, whereas

net income (bottom line growth) may be negative.

d. Price/Earnings/Growth (PEG): used to compare firms with different growth

rates. PEG ratios can be used to determine possible value opportunities for

analysts.

Book Value - The company's equity after subtracting liabilities. Book value is an

inaccurate measure of a company's value as assets are recorded at historical cost on the

company's balance sheet and generally accepted accounting principles may produce

different company valuations, depending on the pronouncements that the company

follows.

Liquidation Value - The value of the business once discontinued when assets are sold off.

The actual value may be a distressed one or one in which the sum of the parts is greater

than the whole. The process can be quite subjective.

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Capital Asset Pricing Model - CAPM

The capital asset pricing model (CAPM) is a model that describes the relationship between

systematic risk and expected return for assets, particularly stocks. CAPM is widely used

throughout finance for the pricing of risky securities, generating expected returns for assets

given the risk of those assets and calculating costs of capital.

Formula:

The formula for calculating the expected return of an asset given its risk is as follows:

The general idea behind CAPM is that investors need to be compensated in two ways: time

value of money and risk. The time value of money is represented by the risk-free (rf) rate in

the formula and compensates the investors for placing money in any investment over a

period of time. The risk-free rate is customarily the yield on government bonds like U.S.

Treasuries.

The other half of the CAPM formula represents risk and calculates the amount of

compensation the investor needs for taking on additional risk. This is calculated by taking a

risk measure (beta) that compares the returns of the asset to the market over a period of

time and to the market premium (Rm-rf): the return of the market in excess of the risk-free

rate. Beta reflects how risky an asset is compared to overall market risk and is a function of

the volatility of the asset and the market as well as the correlation between the two. For

stocks, the market is usually represented as the S&P 500 but can be represented by more

robust indexes as well.

The CAPM model says that the expected return of a security or a portfolio equals the rate

on a risk-free security plus a risk premium. If this expected return does not meet or beat the

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required return, then the investment should not be undertaken. The line plots the results of

the CAPM for all different risks (betas).

Example of CAPM

Using the CAPM model and the following assumptions, we can compute the expected return

for a stock:

The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected market

return over the period is 10%, so that means that the market risk premium is 8% (10% - 2%)

after subtracting the risk-free rate from the expected market return. Plugging in the

preceding values into the CAPM formula above, we get an expected return of 18% for the

stock:

18% = 2% + 2 x (10%-2%)

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Cost of Retained Earnings:

The portion of net profit distributed to shareholders is called dividend and the remaining

portion of the profit is called retained earnings. In other word, the amount of undistributed

profit which is available for investment is called retained earnings. Retained earnings is

considered as internal source of long-term financing and it is a part of shareholder’s equity.

Generally, retained earnings is considered as cost free source of financing. It is because

neither dividend nor interest is payable on retained profit. However, this statement is not

true. Shareholders of the company that retains more profit expect more income in future

than the shareholders of the company that pay more dividend and retains less profit.

Therefore, there is an opportunity cost of retained earnings. In other words, retained

earnings is not a cost-free source of financing. The cost of retained earning must be at least

equal to shareholder’s rate of return on re-investment of dividend paid by the company.

Retained earnings is one of the sources of finance for investment proposal; it is different

From other sources like debt, equity and preference shares. Cost of retained earnings is the

Same as the cost of an equivalent fully subscripted issue of additional shares, which is

Measured by the cost of equity capital. Cost of retained earnings can be calculated with the

Help of the following formula:

Kr = Ke (1 – t) (1 – b)

Where,

Kr=Cost of retained earnings

Ke=Cost of equity

T=Tax rate

B=Brokerage cost

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Illustration:

A firm’s Ke (return available to shareholders) is 10%, the average tax rate of shareholders

Is 30% and it is expected that 2% is brokerage cost that shareholders will have to pay while

Investing their dividends in alternative securities. What is the cost of retained earnings?

Solution

Cost of Retained Earnings, Kr = Ke (1 – t) (1 – b)

Where,

Ke = rate of return available to shareholders

T = tax rate

B = brokerage cost

So, Kr = 10% (1–0.5) (1–0.02)

= 10%×0.5×0.98

= 4.9%

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Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the rate that a company is expected to pay

on average to all its security holders to finance its assets. The WACC is commonly referred

to as the firm’s cost of capital. Importantly, it is dictated by the external market and not by

management. The WACC represents the minimum return that a company must earn on an

existing asset base to satisfy its creditors, owners, and other providers of capital, or they will

invest elsewhere.

Companies raise money from a number of sources: common stock, preferred stock,

straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive

stock options, governmental subsidies, and so on. Different securities, which represent

different sources of finance, are expected to generate different returns. The WACC is

calculated taking into account the relative weights of each component of the capital

structure. The more complex the company’s capital structure, the more laborious it is to

calculate the WACC.

Companies can use WACC to see if the investment projects available to them are

worthwhile to undertake. Weighted average cost of capital (WACC) is a calculation of

a firm's cost of capital in which each category of capital is proportionately weighted. All sources

of capital, including common stock, preferred stock, bonds and any other long-term debt, are

included in a WACC calculation. A firm’s WACC increases as the beta and rate of

return on equity increase, as an increase in WACC denotes a decrease in valuation and an

increase in risk.

To calculate WACC, multiply the cost of each capital component by its proportional weight

and take the sum of the results. The method for calculating WACC can be expressed in the

following formula:

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

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D = market value of the firm's debt

V = E + D = total market value of the firm’s financing (equity and debt)

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

Cost of equity (Re) can be a bit tricky to calculate, since share capital does not technically

have an explicit value. When companies pay debt, the amount they pay has a

predetermined associated interest rate that debt depends on size and duration of the debt,

though the value is relatively fixed. On the other hand, unlike debt, equity has no concrete

price that the company must pay. Yet, that doesn't mean there is no cost of equity.

Since shareholders will expect to receive a certain return on their investment in a company,

the equity holders' required rate of return is a cost from the company's perspective, since if

the company fails to deliver this expected return, shareholders will simply sell off their

shares, which leads to a decrease in share price and in the company’s value. The cost of

equity, then, is essentially the amount that a company must spend in order to maintain a

share price that will satisfy its investors.

Calculating cost of debt (Rd), on the other hand, is a relatively straightforward process. To

determine the cost of debt, use the market rate that a company is currently paying on its

debt. If the company is paying a rate other than the market rate, you can estimate an

appropriate market rate and substitute it in your calculations instead.

There are tax deductions available on interest paid, which is often to companies’ benefit.

Because of this, the net cost of companies’ debt is the amount of interest they are paying,

minus the amount they have saved in taxes as a result of their tax-deductible interest

payments. This is why the after-tax cost of debt is Rd (1 - corporate tax rate).

In a broad sense, a company finances its assets either through debt or with equity. WACC is

the average of the costs of these types of financing, each of which is weighted by its

proportionate use in a given situation. By taking a weighted average in this way, we can

determine how much interest a company owes for each Rupee it finances.

Debt and equity are the two components that constitute a company’s capital funding.

Lenders and equity holders will expect to receive certain returns on the funds or capital they

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have provided. Since cost of capital is the return that equity owners (or shareholders) and

debt holders will expect, so WACC indicates the return that both kinds

of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC is

an investor’s opportunity cost of taking on the risk of investing money in a company.

A firm's WACC is the overall required return for a firm. Because of this,

company directors will often use WACC internally in order to make decisions, like

determining the economic feasibility of mergers and other expansionary opportunities.

WACC is the discount rate that should be used for cash flows with risk that is similar to that of

the overall firm.

To help understand WACC, try to think of a company as a pool of money. Money enters the

pool from two separate sources: debt and equity. Proceeds earned through business

operations are not considered a third source because, after a company pays off debt, the

company retains any leftover money that is not returned to shareholders (in the form

of dividends) on behalf of those shareholders.

Suppose that lenders requires a 10% return on the money they have lent to a firm, and

suppose that shareholders require a minimum of a 20% return on their investments in order

to retain their holdings in the firm. On average, then, projects funded from the company’s

pool of money will have to return 15% to satisfy debt and equity holders. The 15% is the

WACC. If the only money in the pool was Rs.50 in debt holders’ contributions and Rs.50 in

shareholders’ investments, and the company invested Rs.100 in a project, to meet the

lenders’ and shareholders’ return expectations, the project would need to generate returns

of Rs.5 each year for the lenders and Rs.10 a year for the company’s shareholders. This

would require a total return of Rs.15 a year, or a 15% WACC.

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Uses of Weighted Average Cost of Capital (WACC)

Securities analysts frequently use WACC when assessing the value of investments and when

determining which ones to pursue. For example, in discounted cash flow analysis, one may

apply WACC as the discount rate for future cash flows in order to derive a business's net

present value. WACC may also be used as a hurdle rate against which to

gauge ROIC performance. WACC is also essential in order to perform economic value added

(EVA) calculations.

Investors may often use WACC as an indicator of whether or not an investment is worth

pursuing. Put simply, WACC is the minimum acceptable rate of return at which a

company yields returns for its investors.

To determine an investor’s personal returns on an investment in a company, simply subtract

the WACC from the company’s returns percentage. For example, suppose that a company

yields returns of 20% and has a WACC of 11%. This means the company is yielding 9%

returns on every Rupee the company invests. In other words, for each Rupee spent, the

company is creating nine cents of value. On the other hand, if the company's return is less

than WACC, the company is losing value. If a company has returns of 11% and a WACC of

17%, the company is losing six cents for every Rupee spent, indicating that potential

investors would be best off putting their money elsewhere. WACC can serve as a useful

reality check for investors; however, the average investor would rarely go to the trouble of

calculating WACC because it is a complicated measure that requires a lot of detailed

company information. Nonetheless, being able to calculate WACC can help investors

understand WACC and its significance when they see it in brokerage analysts' reports.

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Marginal Cost of Capital

The marginal cost of capital (MCC) is the cost of the last dollar of capital raised, essentially

the cost of another unit of capital raised. As more capital is raised, the marginal cost of

capital rises.

With the weights and costs given in our previous example, we computed Newco's weighted

average cost of capital as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)

WACC = 0.084, or 8.4%

We originally determined the WACC for Newco to be 8.4%. Newco's cost of capital will

remain unchanged as new debt, preferred stock and retained earnings are issued until the

company's retained earnings are depleted.

Example: Marginal Cost of Capital

Once retained earnings are depleted, Newco decides to access the capital markets to raise

new equity. As in our previous example for Newco, assume the company's stock is selling for

$40, its expected ROE is 10%, next year's dividend is $2.00 and the company expects to pay

out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%.

Newco's cost of new equity (kc) is thus 12.3%, as calculated below:

kc = 2 + 0.07 = 0.123, or 12.3%

40(1-0.05)

Answer:

Using this new cost of equity, we can determine the WACC as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)

WACC = 0.086, or 8.6%

The WACC has been stepped up from 8.4% to 8.6% given Newco's need to raise new equity.

Figure 11.1

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MCC Vs. WACC

The marginal cost of capital is simply the weighted average cost of the last dollar of capital

raised. As mentioned previously, in making capital decisions, a company keeps with a target

capital structure. There comes a point, however, when retained earnings have been

depleted and new common stock has to be used. When this occurs, the company's cost of

capital increases. This is known as the "breakpoint" and can be calculated as follows:

Breakpoint for retained earnings = retained earnings

wce

Example:

For Newco, assume we expect it to earn $50 million next year. As mentioned in our previous

examples, Newco's payout ratio is 30%. What is Newco's breakpoint on the marginal cost

curve, if we assume Wce = 55%?

Answer:

Newco's breakpoint = $50 million (1-0.3) = $63.6 million

0.55

Thus, after Newco raises roughly $64 million of total capital, new common equity will need

to be issued and Newco's WACC will increase to 8.6%.

Factors that affect the cost of capital can be categorized as those that are controlled by the

company and those that are not.

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Cost of Debt:

Cost of debt refers to the effective rate a company pays on its current debt. In most cases,

this phrase refers to after-tax cost of debt, but it also refers to a company's cost of debt

before taking taxes into account. The difference in cost of debt before and after taxes lies in

the fact that interest expenses are deductible. Cost of debt is one part of a

company's capital structure, which also includes the cost of equity. A company may use

various bonds, loans and other forms of debt, so this measure is useful for giving an idea as

to the overall rate being paid by the company to use debt financing. The measure can also

give investors an idea of the riskiness of the company compared to others, because riskier

companies generally have a higher cost of debt.

To calculate its cost of debt, a company needs to figure out the total amount of interest it is

paying on each of its debts for the year. Then, it divides this number by the total of all of its

debt. The quotient is its cost of debt. For example, say a company has a Rs. 1 million loan

with a 5% interest rate and a Rs. 200,000 loan with a 6% rate. It has also issued bonds worth

Rs. 2 million at a 7% rate. The interest on the first two loans is Rs. 50,000 and Rs. 12,000,

respectively, and the interest on the bonds equates to Rs. 140,000. The total interest for the

year is Rs. 202,000. As the total debt is Rs. 3.2 million, the company's cost of debt is 6.03%.

To calculate after-tax cost of debt, subtract a company's effective tax rate from 1, and

multiply the difference by its cost of debt. Do not use the company's marginal tax rate;

rather, add together the company's state and federal tax rate to ascertain its effective tax

rate. For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax

cost of debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and

60% of 5% is 3%. The after-tax cost of debt is 3%. The rationale behind this calculation is

based on the tax savings the company receives from claiming its interest as a business

expense. To continue with the above example, imagine the company has issued Rs. 100,000

in bonds at a 5% rate. Its annual interest payments are Rs. 5,000. It claims this amount as an

expense, and this lowers the company's income on paper by Rs. 5,000. As the company pays

a 40% tax rate, it saves Rs. 2,000 in taxes by writing off its interest. As a result, the company

only pays Rs. 3,000 on its debt. This equates to a 3% interest rate on its debt.

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Cost of Preference Share Capital:

Preference shares represent a special type of ownership interest in the firm. They are

entitled to a fixed dividend, but subject to availability of profit for distribution. The

preference shareholders have to be paid their fixed dividends before any distribution of

dividends to the equity shareholders. Their dividends are not allowed as an expense for the

purpose of taxation. In fact, the preference dividend is a distribution of profits of the

business. Because dividends are paid out of profits after taxes, the question of after tax or

before tax cost of preference shares does not arise as in case of cost of debentures.

Preference shares can be divided into:

1. Irredeemable preference shares

2. Redeemable preference shares

The cost of preference share capital is apparently the dividend which is committed and paid

by the company. This cost is not relevant for project evaluation because this is not the cost at

which further capital can be obtained. To find out the cost of acquiring the marginal cost, we

will be finding the yield on the preference share based on the current market value of the

preference share.

The preference share is issued at a stated rate of dividend on the face value of the share.

Although the dividend is not mandatory and it does not create legal obligation like debt, it

has the preference of payment over equity for dividend payment and distribution of assets at

the time of liquidation. Therefore, without paying the dividend to preference shares, they

cannot pay anything to equity shares. In that scenario, management normally tries to pay a

regular dividend to the preference shareholders.

Broadly, preference shares can be of two types.

The cost of Redeemable Preference Shares: These shares are issued for a particular period

and at the expiry of that period, they are redeemed and principal is paid back to the

preference shareholders. The characteristics are very similar to debt and therefore the

calculations will be similar too. For finding cost of redeemable preference shares, following

formula can be used.

Here, preference share is traded at say P0 with dividend payments ‘D’ and principal

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repayment ‘P’. The cost of debt is designated by Kp. Kp can be determined by solving above

equation.

Explanation of cost of redeemable preference capital with example:

For example, a firm had on the balance sheet, a 9% preference stock which matures after 3

years. The face value is 1000. Putting the formula when current market price of the debenture

is 950, we get,

Solving the above equation, we will get 11.05%. This is the cost of preference share capital.

In the case of debt, it would have required further adjustment with respect to tax because

debt enjoys tax shield. Preference dividend is paid out of profits and not treated as an expense

for the company. Rather it is called profit distribution.

Cost of Irredeemable Preference Shares: These shares are issued for the life of the company

and are not redeemed. Cost of irredeemable preference shares can be calculated as follows:

Here, preference share is traded at say P0with dividend payments ‘D’. The cost of debt is

designated by Kp. Kp can be determined by solving above equation.

Explanation of cost of irredeemable preference capital with example:

For example, a firm issued a 10% preference stock of Rs. 1000 which has a current market

price of Rs. 900. Cost can be calculated as below:

Kp = 100/900

Solving the above equation, we will get 11.11%. This is the cost of redeemable preference

share capital.

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Problems in Determination of Cost of Capital

It has already been stated that the cost of capital is one of the most crucial factors in

most financial management decisions. However, the determination of the cost of capital of a

firm is not an easy task. The finance manager is confronted with a large number of problems,

both conceptual and practical, while determining the cost of capital of a firm. These problems

in determination of cost of capital can briefly be summarized as follows:

1. Controversy regarding the dependence of cost of capital upon the method and level of

financing:

There is a, major controversy whether or not the cost of capital dependent upon the method

and level of financing by the company. According to the traditional theorists, the cost of

capital of a firm depends upon the method and level of financing. In other words, according

to them, a firm can change its overall cost of capital by changing its debt-equity mix. On the

other hand, the modern theorists such as Miller the argue that is independent of the method

and level of financing. In other words, the change in the debt-equity ratio does not affect the

total cost of capital. An important assumption underlying MM approach is that there is

perfect capital market. Since perfect capital market does not exist in practice, hence the

approach is not of much practical utility.

2. Computation of cost of equity:

The determination of the cost of equity capital is another problem. In theory, the cost of

equity capital may be defined as the minimum rate of return that accompany must earn on

that portion of its capital employed, which is capitals that the market price of the shares of

the company remains unchanged. In other words, it is the rate of return which the equity

shareholders expect from the shares of the company which will maintain the present market

price of the shares of the company. This means that determination of the cost of equity

capital will require quantification of the expectations of the equity shareholders. This is a

difficult task because the equity shareholders value the equity shares on the basis of a large

number of factors, financial as well as psychological. Different authorities have tried in

different ways to quantify the expectations of the equity shareholders. Their methods and

calculations differ.

33

3. Computation of cost of retained earnings and depreciation funds:

The cost of capital raised through retained earnings and depreciation funds will depend upon

the approach adopted for computing. Since there are different views, therefore, a finance

manager has to face difficult task in subscribing and selecting an appropriate approach.

4. Future costs versus historical costs:

It is argued that for decision-making purposes, the historical cost is not relevant. The future

costs should be considered. It, therefore, creates another problem whether to

consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital,

i.e., the cost of total funds.

5. Problem of weights

The assignment of weights to each type of funds is a complex issue. The finance manager has

to make a choice between the risk value of each source of funds and the market value of each

source of funds. The results would be different in each case. It is clear from the above

discussion that it is difficult to calculate the cost of capital with precision. It can never be a

single given figure. At the most it can be estimated with a reasonable range of accuracy. Since

the cost of capital is an important factor affecting managerial decisions, it is imperative for

the finance manager to identify the range within which his cost of capital lies.

34

Cost of capital in India

The Indian industry has been consistently demanding lower interest rates to spur growth.

Finance ministry officials, without being aggressive, have been sending signals to the

Reserve Bank of India (RBI) to cut interest rates, pointing to the low consumer price inflation

and a likely deflation. The cost of capital in recent years is “one singular factor” that has led

to a slowdown in manufacturing growth.

“The credit offtake is slow, infrastructure creation becomes slower, the manufacturers find

it difficult to afford costly capital because it is going to add to each one of their costs. And,

therefore, this is one area where each one of us has to be concerned about.

Why the Cost of Capital is High in India?

The first requirement, is sustained low inflation which anchors inflationary expectation at a

low-enough level and is an important ingredient in making the cost of capital “apposite. It’s

not inflation last week or last month. It is medium to long-term inflation because we are

talking about long-term cost of capital.

The second requirement, is credible fiscal rectitude by the government both at the centre

and the state level. “The reason being, they are in direct competition with other long-term

borrowers. If government borrowing programme is reasonable, kept under control, and

markets perceive that to be credible, that creates fiscal space and helps mitigate the cost of

borrowing.

The third requirement, is faster restructuring of debt by banks. The higher the cost of

restructuring more is the cost of capital from the side of the lender, pointing to the high

level of bad loans with public sector banks.

There are three factors responsible for ensuring low cost of capital. First, a competitive,

vibrant banking system. With RBI granting licenses for payment banks, it should bring down

transaction costs, especially at the low-income level and for those who are unbanked.

The second factor is the vexed taxation issues. Corporate income tax at the highest level

works out to 33.99% for businesses. Above that there is the 2% spending of their net profit

35

on corporate social responsibility activities. That also internalizes the higher cost of capital

and we need to keep that in mind.

The third factor, he said, is the inherent lag in financial transmission which also keeps cost of

capital high. It is important to remember that only one-fifth to one-fourth of bank deposits

has to be priced over a 12-month period. So, that is an inherent lag in costing capital which

then creates its lag downstream.

Access to non-banking capital has become important even on the debt side. For April-

August, 2016 about 40% increase in provisional financial capital is on account of banks,

another 40% is domestic non-banks and 20% is foreign capital. It is important to keep that in

mind because the transmission non-banking pricing of capital finance has always been faster

than through the banks.

The Indian financial system works well for large business as risk is priced appropriately for

them and there is efficiency in capital allocation.

Financial inclusion programmes by the government such as Jan Dhan Yojana will help serve

the unbanked population, volatility in equity market also makes cost of capital high for

companies.

36

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