54732cost of capital-final

8/7/2019 54732Cost of Capital-Final

1/28

Amity School Of Business

1


BBA Semister four

Financial Management-II

Ashish Samarpit Noel


2/28


Cost Of Capital Cost of Capital is the cost of raising

capital and using it. In other words it is

evaluation of the required rate of return tofirms investors.

Signifiance:-

Evaluating Investment decision

Designing a firms debt policy

Appraising the financial performance of topmanagement

2


3/28


3

Factors determining the cost of capital General economic conditions

Demand for and supply of capital within the economy

and the level of expected inflation

Market conditions

A firms operating and financing decisions

Business Risk-Companys investment decisions

Financial Risk-Use of Debt


4/28


4

Project cost of capital & Companys cost ofcapital

The project cost of capital is the minimum

required on funds committed to a project, which

depends on the riskiness of its cash flows.

The company cost of capital is the overall or

average, required rate of return on theaggregate of investment projects.


5/28


5

Explicit and Implicit Costs Explicit Cost

Discount rate that equates the PV of

incremental cash inflows to the PV ofincremental cash outflows

Implicit Cost/Opportunity Cost Rate of return of the foregone opportunity,

E.g. Retained Earnings


6/28


6

Weighted Average Cost of Capital (WACC)vs. Specific Costs of Capital

The cost of capital for each source of capital is known as

specific or component cost of capital

The component costs are combined according to the

weights of each component capital to obtain weighted

average cost of capital or overall cost of capital


7/28


7

Tax Adjustment

The interest paid on debt is tax deductible

The higher the interest charges, lower would be the

amount of tax payable by the firm

As a result, the after-tax cost of debt to the firm will besubstantially lower than the investors required rate of

return

After-tax-cost of debt = kd(1-T)

Where T is the corporate tax rate

Loss making firms will not have after tax cost of debt

In Calculation of WACC after-tax-cost of debt is to be

used


8/28


8

In case of preference capital, payment of dividends is notlegally binding

The cost of preference capital is a function of thedividend expected by the investors

Irredeemable Preference Shares If Preference shares are perpetual,

where, kp is the cost of preference shares

PDIV is the expected preference dividend

P0 is the issue price of preference shares

Cost of Preference

Capital

0P

PDIVkp !


9/28


9

Redeemable Preference Share

Cost of Redeemable Preference Shares can be

computed as:

The cost of preference share is not adjusted for taxes because

preference dividend is paid after the corporate taxes have been

paid

Since interest is tax deductible & Preference dividend is

not, the cost of preference is substantially higher than

the after tax cost of debt

n

p

n

n

t

t

p

t

k

P

k

PDIVP

)1()1(10

!

!


10/28


10

Cost of Equity Capital Equity capital can be raised internally by retained

earnings or the firm can distribute dividends & raise

capital by new issue of equity shares

In both the cases the shareholders are providing funds to

the firms to finance their capital expenditures

Equity shareholders required rate of return would be

same

Difference between cost of retained earnings & cost of

external equity would be floatation costs


11/28


11

Is equity CapitalF

ree of Cost? Equity capital involves opportunity cost; ordinary

shareholders provide funds to the firm in

expectation of dividends and capital gains

The shareholders required rate of return

equates the PV of the expected dividends with

the market value of shares

Two difficulties in measurement:

Difficult to estimate expected dividends

Future earnings & Dividends are expected to grow


12/28


12

Cost of Internal Equity: Dividend Growth Model

The opportunity cost of retained earnings is therate of return foregone by equity shareholders

1. Normal Growth: The cost of Equity is equal to

the expected dividend plus capital gain rate

gP

DIke !

0

1

Where,

ke = cost of equity

DIV1 = DIV0(1+g)

g= expected growth in dividends


13/28


13

Cost of Internal Equity: Dividend Growth Model

Can be written as follows:

These equations are based on the following assumptions:

Market price of shares is a function of expected dividends

The Dividend is positive

The dividends grow at a constant rate & g = ROE X Retention

Ratio

The dividend payout ratio is constant

Also called as GORDONs model

Implies the opportunity cost for the shareholders, if these

earnings were to be distributed as dividends

gk

DIVP

e

o

! 1


14/28


14

2. Supernormal Growth When dividends grow at different rates, thedividend valuation model is used as follows:

Where, gs = super-normal growth rate for n years

& gn is the growth rate beginning in the year n+1,

perpetually

3. Zero growth:

nenen

tn

t

t

e

s

kX

gkDIV

kgDIVP

)1(1

1)1( 1

1

00

!

!

0

1

P

DIVke !


15/28


15

Cost of External Equity: Dividend GrowthModel

The firms external equity consists of funds raised

externally through public or rights issue

The minimum rate of return required by equity

shareholders to keep the market price of share

same is the cost of equity

Cost of retained earnings is lesser than the cost ofexternal equity


16/28


COST OF EXTERNAL EQUITY (No Flotation Cost)

DIVIDEND GROWTH MODEL

Consists of funds raised externally through public or rights issue

The minimum rate of return required by equity shareholders to keep

the market price of share same is the cost of equity

Firm can induce existing or potential shareholders to purchase new

shares when it promises rate of return which is equal to

ke = Div1 + g

PoWhere

Div1 = Expected dividend = Div0 (1+g)

P0 = Current market price

g = Expected growth rate in dividend = RoE x Retention Ratio


17/28


COST OF EXTERNAL EQUITY (With Flotation Cost)

DIVIDEND GROWTH MODEL(2)

New issues of ordinary shares are generally sold at a price less than

the prevailing market price

Hence cost of equity can be calculated as

ke = Div1 + g

Pn

Where

Div1 = Expected dividend = Div0 (1+g)

Pn = Issue price of new equity = Issue Price Floatation cost

g = Expected growth rate in dividend = RoE x Retention Ratio


18/28


18

Cost of Debt

Cost of Debt Based on the interest/coupon rate

Before tax cost of debt is the rate of return required by

the lenders

1. Debt Issued At Par

where,

kd is the cost of debt

I is the coupon rate of interest

B0 is the issue price of the bond

INT is the amount of interest

0B

INTikd !!


19/28


19

The before tax cost of debt can be calculated using the

following equation:

where,

Bn is the repayment of debt on maturity

B0 is the issue price of the bond

This equation can be solved for kd by trial & error &

interpolation

01

I T(1 ) (1 )

n

t n

t nt

d d

BBk k!

!

2

. Debt Issued at Discount/Premium`


20/28


20

Tax Adjustment

The interest paid on debt is tax deductible

The higher the interest charges, lower would be the

amount of tax payable by the firm

As a result, the after-tax cost of debt to the firm will besubstantially lower than the investors required rate of

return

After-tax-cost of debt = kd(1-T)

Where T is the corporate tax rate

Loss making firms will not have after tax cost of debt

In Calculation of WACC after-tax-cost of debt is to be

used


21/28


21

Earnings Price Ratio & Cost of Equity The firms external equity consists of funds

raised externally through public or rights

issue

The minimum rate of return required by

equity shareholders to keep the market

price of share same is the cost of equity


22/28


22

Cost of Equity & Capital Asset Pricing Model

The CAPM is a model that provides a framework to determine the

required rate of return on an asset and indicates the relationship

between return and risk of the asset

Assumptions:

Market Efficiency

Risk Aversion

Homogeneous expectations

Single time period

Risk-free rate Risk has two parts:

Unsystematic Risk (Diversifiable)

Systematic Risk (Cannot be reduced)


23/28


24/28


24

Cost of Equity: CAPM Vs. Dividend-Growth

Model

The dividend-growth approach has limited

application in practice

The expected dividend growth rate, g, shouldbe less than the cost of equity, ke, to arrive at

the simple growth formula

Cant be used if a company is not payingdividends

Fails to deal with risk directly


25/28


25

Cost of Equity: CAPM Vs. Dividend-Growth Model

CAPM has a wider application although it is based on

restrictive assumptions:

The only condition for its use is that the companys

share is quoted on the stock exchange All variables in the CAPM are market determined and

except the company specific share price data, they are

common to all companies

The value of beta is determined in an objective mannerby using sound statistical methods. One problem with

the use of beta is that it does not remain stable over

time


26/28


26

Weighted Average Cost of Capital (WACC)

The following steps are involved for calculating the firms

WACC:

Calculate the cost of specific sources of funds

Multiply the cost of each source by its proportion in the capitalstructure.

Add the weighted component costs to get the WACC.

Weighted Marginal Cost of Capital (WMCC):

Marginal cost is the new or incremental cost of new capital(equity & debt) issued by the firm

New funds are raised at new costs according to the firms

target capital structure

WMCC is the WACC of new capital given the firms target

capital structure


27/28


27

Book Value Versus Market Value Weights Managers prefer the book value weights for calculating

WACC:

Firms in practice set their target capital structure in terms ofbook values.

The book value information can be easily derived from the

published sources. The book value debtequity ratios are analysed by investors to

evaluate the risk of the firms in practice.

The use of the book-value weights can be seriously

questioned on theoretical grounds: First, the component costs are opportunity rates and are

determined in the capital markets. The weights should also bemarket-determined.

Second, the book-value weights are based on arbitraryaccounting policies that are used to calculate retained earningsand value of assets. Thus, they do not reflect economic values.


28/28


28

Book Value Versus Market Value Weights

Market-value weights are theoretically superior tobook-value weights: They reflect economic values and are not influenced by

accounting policies

They are also consistent with the market-determined

component costs.

The difficulty in using market-value weights: The market prices of securities fluctuate widely and frequently. A market value based target capital structure means that the

amounts of debt and equity are continuously adjusted as the

value of the firm changes.

54732cost of capital-final

Documents