cost of capital
TRANSCRIPT
COST OF CAPITAL
SEEMA CHAKRABARTI
MEANING
COST OF CAPITAL: It is the return paid to an investor or the lender of
funds on the money borrowed from him by the company.It may be in the form of dividends or interest or the opportunity cost of funds in case of retained earnings.
SIGNIFICANCE OF THE COST OF CAPITAL
Evaluating investment decisions,
Designing a firm’s debt policy, and
Appraising the financial performance of top management
SOURCES OF CAPITAL
The capital required for a firm can be funded through any one or more of the following sources:
EQUITY SHARES forming equity capital.
PREFERENCE SHARES forming preference capital.
DEBT INSTRUMENTS forming debt capital.
Cost Of Equity
MEANING:It is the minimum rate of return that a firm must offer to its shareholders to compensate for waiting for their returns and bearing some risk.
There are two sources of equity finance:
Retained Earnings or Internal Equity
Issue of New Shares to public or Right Shares Known as External Equity.
Cost Of Equity
In case of retained earnings, the cost comes in the form of opportunity cost and is delivered in the form of capital appreciation (i.e. increase in share prices) whereas in case of new issue of shares to public or right shares issued to existing shareholders ,it is paid in form of dividends.
In case of issue of additional shares, the company has to incur additional cost in the form of floatation costs. The floatation cost generally ranges between 2-10%.
Cost Of Equity
The returns to be considered are expected future returns, not the historical returns, hence it should be expressed as the anticipated dividends on the shares every year in perpetuity.
It involves a certain degree of risk as the RETURNS ARE NOT FIXED.
The risks associated with equity can be broadly divided into two categories:
Unsystematic Risk or Unique risk Systematic Risk or Market Risk
UNSYSTEMATIC RISK
The unsystematic risk is specific to a security.
It generally stems from firm specific factors.
It is measured in terms of STANDARD DEVIATION, which is a measure of the dispersion of a set of data from its mean.The higher the value, the riskier the stock. A volatile stock will always have a high standard deviation.
It may be considerably eliminated by an efficient portfolio diversification.
SYSTEMATIC RISK
The systematic risk affects the market as a whole.
Also known as "un -diversifiable risk" as it cannot be eliminated.
It is measured in terms of BETA, which reflects the sensitivity of a stock to the movements of the market as a whole.
Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification.
Cost Of Equity ( Dividend Growth Model)
I ) Internal Equity or Retained Earnings;A) Normal Growth:
B) Supernormal Growth:
1
0
DIVek g
P
100
= 1
DIVDIV (1 ) 1
(1 ) (1 )ns
t e e
tn
t nn e
gP
k k g k
P0 denotes price of new shares or market price in case of existing shares
Cost Of Equity ( Dividend Growth Model)
c) Zero Growth: In case of zero growth( i.e g=0), a firm will not retain any earnings & hence distribute all profits as dividends. Therefore,
1 1
0 0
DIV EPS (since 0)ek g
P P
Cost Of Equity ( Dividend Growth Model)
II ) External Equity:
Where, P0 = Issue Price of Shares
g = Growth rate of DividendsDIV1 = Dividend paid in next year
1
0
DIVek g
P P0 denotes price
of new shares or market price in case of existing shares
Cost Of Equity ( Dividend Growth Model)
LIMITATIONS:It cannot be applied to companies which do not pay dividends or which are not listed on stock exchange.
The assumption that dividends will grow at a constant rate is not valid.
There is no explicit consideration of risk.Only an implicit consideration in the form of stock prices is done.
Cost of Equity & Earnings Price Ratio
1
0
1
0
EPS (1 ) ( )
EPS ( 0)
e
bk br g br
P
bP
Cost Of Equity ( Capital Asset Pricing Model )
CAPM : It refers to a model that helps in calculating the returns
that are required by an investor by investing in a particular security, given a particular level of risk.
The returns required by an investor are for compensating
two things:
Time value of money
Market risk associated with a security
Cost Of Equity ( Capital Asset Pricing Model )
TIME VALUE OF MONEY : It represented by the risk-free rate, which is generally taken to be equal to the yield given by a long term government bond of maturity period of more than 10 years.It compensates the investors for placing money in any risk-free investment avenue over a period of time.
Cost Of Equity ( Capital Asset Pricing Model )
MARKET RISK ASSOCIATED WITH A SECURITY:
It refers to additional compensation in the form of risk premium that an investor would ask for taking additional risk.
Market risk or the risk premium is given by the difference
between the average returns given a market portfolio and the average risk free rate over the past 10 years or more multiplied by the beta of a security i.e ßs ( E (RM) – Rf ).
Cost Of Equity ( Capital Asset Pricing Model )
Thus, According to CAPM,the returns required from a security or a
portfolio of securities equals the risk-free rate plus a risk premium.
Or
Mathematically speaking:
Cost Of Equity ( Capital Asset Pricing Model )
REQUIRED RETURNS ON A SECURITY S:
E(R)S= Rf + ßs ( E (RM) – Rf )
where,E(R)S = Required returns on a security S
Rf = Risk free return
ßs = Beta of Security S
E(RM)= Expected return on market portfolio
Cost Of Equity ( Capital Asset Pricing Model )
If the expected return does not meet or beat the required return, then the investment should not be undertaken.
Cost Of Equity ( Capital Asset Pricing Model )
ASSUMPTIONS OF CAPM: Only systematic risk is taken into account assuming that investors are able to eliminate unsystematic risk themselves by portfolio diversification.
Investors are risk averse.
Investors can borrow and lend freely at the risk free rate of interest.
The market is perfect – there are no taxes, no transaction costs, securities are perfectly divisible and the market is competitive.
Cost Of Equity ( Capital Asset Pricing Model )
LIMITATION OF CAPM:Beta of a securities keep changing,thus using a historical beta value for cost calculation becomes questionable.
Debt As A Source Of FinanceDebt instruments are contracts in which one party lends money to another on predetermined terms with regard to rate of interest to be paid by the borrower to the lender, the periodicity of such interest payments, and the repayment of the principal amount borrowed (either in installments or in bullet).
In the Indian securities markets, we generally use the term ‘bond’ for debt instruments issued by the central and state governments and public sector organizations, and the term ‘debentures’ for the debt instruments issued by the private corporate sector.
Debt As A Source Of Finance
The three principal features of bonds are: Principal – refers to the amount that has been borrowed and
is also called the par value or the face value of the bond. Coupon – refers to the rate at which the interest is paid, and
is usually paid as a percentage of the par value or the face value of the bond.
Maturity – refers to the date on which the bond matures or the date on which the borrower has agreed to repay (redeem) the principal amount to the lender.
Cost Of Debt
It refers to the the effective rate that a company pays on its current debt.It can be measured in terms of either before or after-tax returns.
Debt can be in the form of debentures or bonds, bank loans,commercial papers etc.
In case of a bank loan or a commercial paper, the cost will be the rate of interest that is to be paid back to the bank or the corporate issuing such commercial paper.
Cost Of Debt
In case of any other debt instrument it is calculated as it’s “yield to maturity” .
Since interest expense is deductible, the after-tax cost is used most.
Cost Of Debt V/S Cost Of Equity
Cost of debt is always less than equity because: The rate of interest required to be paid on debt is
always less as compared to equity because the risk involved with debt is always less than equity.
The interest paid on debt can be setoff against pre-tax profits, thus reducing the tax liability of a company.Hence, a profitable company effectively pays all the more less for debt capital than equity.
Cost Of Debt V/S Cost Of Equity
Floatation costs associated with raising debt is generally less as compared to equity shares.
Cost Of Debt
Debt Issued at Par
Debt Issued at Discount or PremiumBn – Repayment of debt on maturity
Tax adjustment
0
INTdk i
B
01
INT
(1 ) (1 )
nt nt n
td d
BB
k k
After-tax cost of debt (1 )dk T
Kd- cost of debt before taxINT – facevalue * intrest rateB0 – Issue priceof bond
Cost Of Debt ( Approximate Method)
The “BEFORE TAX” cost of debt is equal to it’s Yield to Maturity and is given by:
kDBT = I + ( F – PO ) / n 1 / 2 (PO + F)
Where, kDBT = Cost of debt
I = Annual Interest Payment PO = Current market price or issue price n = numbers of years left to maturity F = Maturity value or redemption price
Cost Of Debt ( Approximate Method)
The “AFTER TAX” cost of debt is given by: kDAT = kDBT (1 – T)
where,kDAT = After tax cost of debt
kDBT = Before tax cost of debt
T = Marginal tax rate of a firm
Cost Of Preference Capital The preference capital carries a fixed rate of dividend.
They are redeemable in nature.
It does not produce any tax savings as it is not a tax deductible expenditure.
The formula for calculating cost of preference capital is same as the formula for cost of debt before tax.
Cost Of Preference Capital
Irredeemable Preference Share
Redeemable Preference Share
0
PDIVpk P
01
PDIV = +
(1 ) (1 )
nt nt n
tp p
PP
k k
COST OF CAPITAL OF A FIRM
AVERAGE COST OF CAPITAL (WACC)OF A FIRM IS GIVEN BY:
The weighted average cost of various sources of
finances used by the company in the form of equity, preference or debt capital.
WEIGHTED AVERAGE COST OF CAPITAL
WACC = wEkE + wPkP + wDkD (1- tc)
Where,wE = Proportion of equity
kE = cost of equity
wP = proportion of preference
kP = cost of preference
wD = proportion of debt
kD = cost of debt
tc = corporate tax rate
WEIGHTED AVERAGE COST OF CAPITAL
Ex:The cost of specific sources of capital for BHEL is: rE = 16%, wE =0.60
rP = 14%, wP =0.05
rD = 12%, wD =0.35
The tax rate is 30%WACC :- 16* 0.60 + 14*0.05 + 12*0.35(1-0.3) =9.60 + 0.70 + 2.94 =13.24%
WEIGHTED MARGINAL COST OF CAPITAL
CONCEPT: Given the capital structure of the firm,the weighted
average cost of capital tend to increase as firms seek more and more capital.
This is because as suppliers provide more funds they start expecting higher returns.
WEIGHTED MARGINAL COST OF CAPITAL
BREAKING POINT: The level at which the cost of new components would change given the capital structure of the company is known as Breaking Point.It is calculated as:
BPs = TFs / Ws
where, BPs = Breaking Point of source (s) TFs = Total new financing from source (s) at the breaking
point Ws = Proportion of source (s) in the capital structure
WEIGHTED MARGINAL COST OF CAPITAL
PROBLEM: The following is the set of data relating to the capital structure &
the cost associated with the various sources of finance for different ranges (Rs in million):
SOURCE/RATIO
RANGE (Rs) COST(%)
EQUITY (40%)
0 – 30 18
More than 30 20
DEBT (60%)
0 - 50 10
More than 50 11
CALCULATE: The Breaking point at which the cost of new
components would increase?
WACC for various ranges of total financing between breaking points?
Prepare the marginal cost of capital schedule which reflects the WACC for each level of total new financing?
SOURCE COST (%) RANGE BPNEW
RANGE
Equity
18 0-30 30/0.4=75 0-75
20Above
30-- Above 75
Debt
10 0-5050/0.6=83.
30-83.3
11Above
50--
Above 83.3
CALCULATION FOR BREAKING POINT AND NEW RANGE OF FINANCE
RANGE OF NEW
FINANCE
SOURCE OF CAPITAL
(1)
PROP. IN TOTAL
CAPITAL (2)
COST (%) (3)
WEIGHTED COST (%) [(2)*(3)]
0-75
Equity 0.4 0.18 .072
Debt 0.6 0.10 .060
WACC .132
75-83.3
Equity 0.4 0.20 .080
Debt 0.6 0.10 .060
WACC .140
Above 83.3
Equity 0.4 0.20 .080
Debt 0.6 0.11 .066
WACC .146
RANGE OF TOTAL FINANCING
WEIGHTED MARGINAL COST OF CAPITAL (%)
0-75 13.2
75-83.3 14.0
Above 83.3 14.6