Cost of Capital

Meaning

• The cost of capital is defined as the minimum rate of return a firm must earn on its investments in order to satisfy investors and to maintain its market value i.e it is the investor’s required rate of return.

• It refers to the discount rate which is used determining the present value

• The cost of capital constitutes an integral part of investment decisions. It provides a yardstick to measure the worth of investment proposal and thus performs the role of accept- reject criterion.

• Cost of Capital is also referred to as cut- off rate, target rate, hurdle rate, minimum required rate of return, standard return and so on.

• The Cost of Capital can be explicit or implicit.

• The explicit cost of capital is associated with the raising of funds.

• When funds are internally used, the cost is known as implicit cost in terms of the opportunity cost of the foregone alternatives.

Relevance of Cost of Capital in Capital Budgeting Decisions

• In the present value method of discounted cash flow technique, the cost of capital is used as the discount rate to calculate the NPV.

• In profitability index or benefit- cost ratio, cost of capital is used to determine the present value of future cash inflows.

• In Internal Rate of Return method, the computed IRR is compared with the cost of capital.

Factors Affecting Cost of Capital

• Nature of Business• Requirements of the Firm• Attitude of Management• Risk Free Rate of Interest• Decision of Financing Mix• Business Risk and Financial Risk

Significance of Cost of Capital

• Designing the Capital Structure• Capital Budgeting Decisions• Comparative Study of Sources of Financing• Evaluation of Financial Performance of Top

Management• Knowledge of Firm’s Expected Income and Inherent Risk• Financing and Dividend Decisions

The long- term funds requirement of the firm is generally met from the following sources:

• Equity Share Capital• Preference Share Capital• Retained Earnings• Debentures and Bonds• Term Loans from Financial Institutions and Banks

The Cost of Capital consists of the following elements:

• Cost of Debt, includes both Debentures, Bonds and Term Loans (kd)

• Cost of Preference Capital (kp)• Cost of Equity Capital (ke)• Cost of Retained Earnings (kr)

Cost of Debt (kd)

• Debt may be in the form of debentures, bonds, term- loans from financial institutions and banks etc.

• It carries a fixed rate of interest payable to debenture holders, irrespective of the profitability of the company.

• Dividend payable to equity shareholders and preference shareholders is an appropriation of profit, whereas the interest payable on debt is a charge against profit.

• Any payment towards interest will reduce the profit and ultimately the company’s tax liability would decrease. This phenomenon is called tax shield.

• Net Proceeds- from debentures and other long- term loans are equal to the issue price of the debenture or amount of loan minus flotation costs.

• Flotation Costs- are the cost of issuing debentures or obtaining the loans. It includes the expenses such as printing and selling of prospectus, advertisement, stamp duty, underwriting commission and brokerage, postage etc. Its generally expressed as percentage of face value.

Debentures can be issued at:

• At par

• At discount

• At premium

Net Proceeds

At Par = Par Value – Flotation Cost

At Premium = Par Value + Premium – Flotation Cost

At Discount = Par Value – Discount – Flotation Cost

Kd (before tax) = R + (MV – NP)

n

(MV + NP)

2

Here, Kd = Cost of Debt

MV = Maturity Value of Debt

NP = Net Proceeds

n = Number of Years to Maturity

R = Annual Interest Payment

* 100

Kd (after tax) = Kd (before tax) (1 – t)

• When debentures are redeemable at par, the MV will be the face value or par value and when redeemable at premium the MV will be face value plus premium to be paid on redemption.

• Cost of Perpetual Debentures- Debentures which are not redeemable during the life time of the company shall be ascertained by dividing the amount of interest by the net proceeds.

kd = R

NP

Here, kd = Cost of Debt

R = Annual Interest Payments

NP = Net Proceeds

• Tax Adjustment

Cost of Preference Shares

• Preference Shareholders have a preferential right as regards payment of dividend as well as return of principal, as compared to the ordinary shareholders. A fixed dividend rate is stipulated on preference shares.

There are two types of preference shares

(i) Irredeemable- In this kind of perpetual security the principal is not to be returned for a long time or is likely to be available till the life of the company.

(ii) Redeemable- These shares are issued with a maturity date so that the principal will be repaid at some future date.

Cost of Irredeemable Preference Shares

Kp (after tax) = DPS

NP

Kp (before tax) = Kp (after tax) * 1

(1 – t)

* 100

Cost of Redeemable Preference Shares

Kp (after tax) = DPS + (MV – NP)

n

(MV + NP)

2

Kp (before tax) = Kp (after tax) * 1

(1 – t)

* 100

Cost of Equity

• The return to the equity holders solely depends upon the discretion of the company management.

• The equity shareholders rank at the bottom as claimants on the assets of the company at the time of liquidation.

• Equity capital like other sources of funds certainly involve a cost to the firm.

• The objective of financial management is to maximize shareholders wealth and the maximization of market price of shares is the operational substitute for wealth maximization.

• When equity holders invest their funds they also expect returns in the form of dividends. The market value of shares is a function of the return that the shareholders expect and get. If the company does not meet the requirements of its shareholders and pays dividends, it will have an adverse effect on the market price of shares.

• The equity shares involves the highest degree of financial risk since they are entitled to receive dividend and return of principal after all other obligations of the firm are met. High Risk High Return.

• The cost of equity capital is relatively the highest among all the sources of funds.

Cost of Equity Shares (Existing Shares)

• Earning Yield Method

Ke (after tax) = EPS * 100

MPS• Dividend Yield Method

Ke (after tax) = DPS * 100

MPS• Dividend Yield + Growth Method

Ke (after tax) = DPS * 100 + G (Growth Rate)

MPS

Cost of Newly Issued Equity Shares

• Earning Yield Method

Ke (after tax) = EPS * 100

NP• Dividend Yield Method

Ke (after tax) = DPS * 100

NP• Dividend Yield + Growth Method

Ke (after tax) = DPS * 100 + G (Growth Rate)

NP

Cost of Retained Earnings

• There is no obligation, formal or implied, on a firm to pay a return on retained earnings. But retention of earnings does have implications for the shareholders of the firm.

• If earnings were not retained, they would have been paid out to the ordinary shareholders as dividends. Retention of earnings implies withholding of dividends from holders of ordinary shares. When earnings are, thus, retained, shareholders are forced to forgo dividends. The dividends foregone by the equity holders are, in fact, an opportunity cost. Thus, retained earnings involve opportunity cost.

• In other words, the firm is implicitly required to earn on the retained earnings at least equal to the rate that would have been earned by the shareholders if they were distributed to them. This is cost of retained earnings.

• The cost of retained earnings may be defined as opportunity cost in terms of dividends foregone by/ withheld from the equity shareholders.

• The alternative use of retained earnings is based on ‘external- yield criterion’.

• According to this approach, the alternative to retained earnings is external investment of the funds by the firm itself.

• The opportunity cost of retention of earnings is the rate of return that could be earned by investing the funds in another enterprise by the firm instead of what would be obtained by the shareholders on other investments.

• The firm should estimate the yield it can earn from external investment opportunities by investing its retained earnings there. While doing so, the firm should bear in mind that it selects such investment opportunities as have the same degree of risk as that of the firm itself.

• The kr under the assumption of external- yield criterion would be approximately ke.

Cost of Retained Earnings

Kr = DPS (1- Ti) (1- B) * 100

MPS (1- Tc)

Here,

Kr= Cost of Retained Earnings

DPS= Dividend Per Share

MPS= Market Price Per Share

B= Brokerage

Ti= Income Tax Rate of an Individual Shareholder

Tc= Capital Gain Tax Rate

Or

Kr= Ke (1- Ti) (1- B)

If capital gain tax rate is given then

Kr= Ke (1- Ti) (1- B)

(1- Tc)

• In absence of information regarding tax on dividend, brokerage and commission etc, the rate of capitalization of income on equity shares i.e cost of equity share capital would be the cost of retained earnings i.e Kr = Ke

Computation of Overall Cost of Capital

• The term cost of capital means the overall composite cost of capital defined as weighted average of the cost of each specific type of fund.

• The use of weighted average and not the simple average is warranted by the fact that the proportions of various sources of funds in the capital structure of a firm are different.

• Therefore for computing the overall cost of capital, the relative proportions of different sources should be taken into account and hence weighted average.

The computation of the overall cost of capital (represented

symbolically by ko) involves the following steps:

1. Assigning weights to specific costs.

2. Multiplying the cost of each of the sources by the appropriate weights.

3. Dividing the total weighted cost by the total weights.

Assignment of Weights

• Marginal Weights

• Historical Weights Book Value Weights

Market Value Weights

Marginal Weights

Historical Weights• In historical weights, the relative proportions of various

sources to the existing capital structure are used to assign weights. The basis of the weighting system is the funds already employed by the firm.

• The use of historical weights is based on the assumption that the firm’s existing capital structure is optimal and therefore, should be maintained in the future i.e the firm should raise additional funds for financing investments in the same proportion as they are in the existing capital structure.

• The existing proportion of various sources of long term funds will be followed whenever the firm raises additional long term funds to finance new investment projects.

• Suppose, if the present capital structure of firm has 30% debts, 20% Preference shares, 40% equity capital and 10% retained earnings, the company will be assumed to raise incremental funds in the same proportion as it has done in the past. Now if the firm requires additional funds amounting to Rs 1,00,000 to finance a new project. It should be expected, according to the historical weighting system, to raise this sum from different sources in the proportion of 30% debt (Rs. 30,000), 20% preference shares (Rs. 20,000), 40% equity shares (Rs. 40,000) and 10% retained earnings (Rs. 10,000).

• Historical weights appear to be superior to marginal weights as the former take into consideration the long term implications of the firms current financing. With historical weights a choice is to be made between book value and market value weights.

Book Value and Market Value Weights

Advantages of Market Value• Market value of securities closely approximate the actual

amount to be received from their sale.• The cost of the specific sources of finance which

constitute the capital structure of the firm are calculated using prevailing market prices.

Disadvantages of Market Value• Calculating the market value of securities may present

difficulties, particularly the market values of retained earnings.

• Weights based on market values are likely to fluctuate widely.

Advantages• Book value weights are operational in nature. Book

values are readily available from the published records of the firm.

• Firms set their capital structure targets in terms of book values rather than market values.

• The analysis of capital structure in terms of debt- equity ratio is based on book value.

Disadvantages• Book value is operationally convenient but the market

value basis is theoretically consistent and sound so a better indicator of firm’s true capital structure.