cost of capital - lecture 3

8/10/2019 Cost of Capital - Lecture 3

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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL

TIME VALUE OF MONEY

Growing Annuity

when the cash flow grows at a constant rate

for a specified period

e.g. office rent @ 20000 per year and increase

per year 3% and rate of discount is 10%

The PV for one year will be will be

(20000 x 1.03)/1.10PV for next five years will be PV of a growing

annuity=An(1+g){ [1-(1+g)t/(1+r)t] /r-g}




TIME VALUE OF MONEY

Growing Annuity

PV of growing An= 20000(1.03)

{ [1-(1.03)5

/(1.10)5

] / 0.10-0.03 } =20600{[1-(1.159/1.610)] / 0.07

= 20600 (1-0.72)/0.07 = 20600(0.28 /

0.07)= 20600x4 = 82400




TIME VALUE OF MONEY

PERPETUITY

A Perpetuity is an annuity of infinite period

– PV of Perpetuity= An/r

– e.g. you will make an income of 60 per year inperpetuity with an interest rate of 9%

– PV of Perpetuity will be 60/0.09 = 667

– Growing Perpetuity PV will be=An/(r-g) assume

growth rate is 3%

– 60/(0.09-0.03)=60/(0.06)

– 60/0.06 = 1000




THE COST OF CAPITAL

A PRESENTATION

BYCA. R.C.AGARWAL



THE COST OF CAPITAL -

SIGNIFICANCE Provides very basis for financial appraisal of new

capital Exp. Proposals. It serves as acceptance

criterion for the new project

Helps in determining the optimal capital structureHelps in evaluating the financial performance of top

management

Helps in formulating Dividend policy and Working

capital policy

It is the firm’s required rate of return which will just

satisfy all capital providers




THE COST OF CAPITAL

Important business decisions require capital

Rate of return should exceed the cost of capital

Compensations plans of companies use the concept of

Economic Value Added (EVA). EVA is the differencebetween operating profits after taxes and charge of

capital.Charge of capital is multiplying the capital amount by

cost of capital. Therefore, cost of capital is an importantcomponent of compensation schemes also.

Cost of capital is an important factor in choosing the

mixture of debt and equity





THE COST OF CAPITAL

Basic conditions

– New investment has similar risk as

the typical or average investmentundertaken by the firm

– Proposed investment does not

change financing policy of the firm




THE COST OF CAPITAL

Characteristics

– It is really a rate of return and not the cost

– Rate of return calculated on the basis of actual

cost of different components of capital – Usually related to long-term capital funds

– It is used as discount rate to arrive at PV

– It has two components

Return at Zero risk level

Risk premium




Classification of cost of capital

Explicit and Implicit cost

– Explicit cost relates to raising of

funds i.e. rate of return of the cashflows of financing opportunity

– Implicit cost relates to usage of

funds i.e. rate of return associatedto best investment opportunity





Average cost and Marginal cost

– Average cost is weighted average

cost of each component of funds – Marginal cost is weighted average

cost of new funds raised by the

firm





Future cost of capital

– Historical cost means the cost of

capital incurred in procuring fundsin past

– Future cost refers to expected

cost to be incurred in raising newfunds





Specific cost and Combined cost

– Specific cost means cost of

individual components – Combined cost means average

cost of capital of all sources of

capital




THE COST OF CAPITAL

Discount rate / opportunity cost is called costof capital

Major capital components are equity,preference and debt

Cost of capital = weighted average cost ofvarious capital components used (WACC) or

Average rate of return required by investorswho provide capital

Cost of capital (WACC) is used for – evaluating investment projects

– determining capital structure etc




THE COST OF CAPITAL

Company cost of capital V/s

Project cost of capital

– Company Cost of capital=returnexpected by existing investors

– Project cost of capital = return

expected by investors in newproject




THE COST OF CAPITAL

Rational – If rate of return on investment is more than cost of capital

shareholders benefit

– ABC used equity and debt in equal proportion and cost is 14%

and 6% respectively. Cost of capital = 0.5x14+0.5x6= 10% – Firm invests total 100 and rate of return is 12% the benefit willbe = (total return on project – intt. on debt) / equity funds =[(100x0.12) – (50x0.06)] / 50 = 18%

– Therefore return on equity comes to 18% which is more than14% cost of equity, equity shareholders benefit

Return an investor expects to receive is cost tocompany



Concept of WACC

ABC uses equity 50%, preference 10%

and debt 40% and the respective cost is

16%, 12% and 8% respectively

WACC= (Proportion of equity)(cost of

equity) + (proportion of preference) (cost

of preference) + (proportion of debt)(cost

of debt)

WACC will be?




Concept of WACC

WACC will be

WACC=(0.5)(16)+(o.10)(12)+

(0.40)(8) = 12.4%

Assumed non-convertible, non-

callable preference; and non-convertible, non-callable debt




Concept of WACC

Cost of short term debt like Commercial

paper has to be taken in consideration as

the investors of short term debt also have

claim on the operating earning of thecompany

Non intt. bearing liabilities e.g. trade

creditors are not taken in A/c as the cost ofsuch debt is already taken in account in

purchase price




Basic conditions for using WACC for

evaluating new investments

Risk of new investment is same as that of

average risk of existing investments

Capital structure of the firm will not be effected

due to new investmentWACC is the discount rate of the project which is

a carbon copy of the existing business

WACC can be used as the base hurdle rate tobe adjusted for variations in risk and financing

pattern




Cost of Debt and Preference

Debt and preference require fixed payments hence

estimating cost is almost similar

Debt is raised through debentures, bank loans,

commercial paper etc. Cost of debt is weighted average

rate of different type of debt used

Weighted average rate of debt is calculated using market

values and yield to maturity (YTM) or current rate at

which the firm can raise new debt

As the interest on debt is tax deductible exp. pre-tax cost

of debt to be adjusted for tax factor to arrive at post tax

cost of debt





Cost of Debt and Preference-

cont…

Cost of debenture= Po=sum of (I)/(1+r d)t +

(F)/(1+r d )n

Po= current market price of deb.

I = annual intt. payment

F = maturity value of deb.

r d = cost of deb.

n = no. of years left to maturity





cont…

As computation of rd requires trial and error

method following formula can be used

r d = {I + [(F-Po)/n]}/0.6xPo+0.4xF

e.g. Face value 1000coupon rate 12%

remaining period of maturity

4 years current market price 1040rd i.e. YTM = {120+[(1000-1040)/4]} /

0.6x1040+0.4x1000=10.7%





cont…

Cost of bank loan= current market rate

of intt. as Bank loan is not traded in

secondary market.

If the company has taken loan earlier @

13% but now the loan can be obtained @

12%

If rate on which fresh loan can be raised

is 12%, that will be treated as cost





cont…

Cost of commercial paper i.e. short termdebt instrument issued on a discount andredeemed at par. The cost is implicit intt. rate

e.g. ABC ltd. commercial paper face value is10,00,000, remaining period to maturity is 6months and traded in market at 9,65,000

The cost = (10,00,000/9,65,000) – 1

= or (10,00,000-9,65,0000)/9,65,000 =0.0363 Annualized rate will be (1.0363)2 -1= .0739 or7.39%





cont…

Weighted average cost of debt

Debt Face market coupon curr.rate

Value Value Rate

NCD 100 104 12% 10.7%

Bank loan 200 200 13% 12%

Com.Paper 50 48.25 NA 7.39%total 352.25

Tax rate is 35% Calculate WACC





cont…

Weighted average cost of debt

Average cost of debt

=10.7%(104/352.25)+12%(200/352.25)+7.39%(48.25/352.25)=10.98

Current rate = rate at which new debt canbe raised

Post-tax cost of debt= pre-tax cost(1-taxrate)=10.98(1-0.35)=7.14%



Cost of Long term Debt

Debt at premium or discount

r d = (I/Np)(1-tc)

I = Annual interest payment

Np = Net proceeds of loansXYZ issues 10% irredeemable Deb. Of Rs. 1,00,000

and tax rate is 60%

At par = (10,000/1,00,000)(1-0.60)= 4%

At 10% discount = (10,000/90,000)(1-0.60) = 4.44%

At 10% premium =(10,000/1,10,000)(1-0.60)=3.63%






cont…

Cost of preference

– Preference capital carries fixed Div. and is

redeemable.

– Due to preference Div., principal repaymentcommitment and absence of tax. The cost =

its yield = r p = YTM

– Dividend is not tax deductible exp.





cont…

Cost of preference

– E.g. preference face value 100

Dividend rate 11%

Maturity period 5 years

Market price 95

r p = {I + [(F-Po)/n]}/0.6xPo+0.4xF

r p={11+[(100-95)/5]}/0.6x95+0.4x100 = 12.37



Cost of Preference

It can also be calculated as:

Dividend / Face value – Issue cost

ABC issues 9% preference shares atRs.85 par value. Cost of issue is Rs.3 per

share

Preference dividend will be 85X9 = 7.65

7.65 / 82 i.e. (85-3) = 9.33%





Cost of equity

Equity finance can be obtained by – Retention of earnings involves cost, as opportunity

cost is lost by shareholders. Only flotation cost is notinvolved

– Issue of additional equity

Cost of equity or the return required by equity holders issame in both cases

Hence in both cases cost of capital is same

Cost of equity means cost of retained earnings and cost

of external equityThere is no definite commitment to dividend

Equity to provide higher expected rate of return than

debt of the company




Cost of equity

The required rate of return=expected rate ofreturn

r e=Rf + Rp= (D1/Po)+g

r e=cost of equityRf =risk free rate

Rp=risk premium

D1=dividend expected to be paid

Po=current price of the stock

g=expected growth rate of dividend



Cost of equity

E/P (earning price ratio) Ratio method: (Eo/Po)X100

Eo = current earning per share

Po = current market price per share

A has 5 EPS Current market price is Rs. 50

The r e = (5/50)100 = 10%

Limitations:

– Earning do not represent expectations of shareholders

– Earnings are not constant

– There should not be debt capital

– All earnings should be paid to shareholders

– There is no growth in earnings




Cost of equity

E/P Ratio + Growth rate method:

[Eo (1+b)3]/Po

(1+b)3 = Growth factor i.e. b is growth rate as a

% and estimated for 3 years

A has 5 EPS with 10% growth rate earning for a

period of 3 years. Current market price is Rs. 50

r e = {[5(1+.10)3

]/50}100{[5(1.331)/50}100 = (6.665/50)100 = 13.31%





Cost of equity

Risk premium approach

–Cost of equity=Yield on long term

bonds + Risk premium –Firm having high risk have high cost

of debt will have high cost of equity

–Difficult to determine risk premium



Cost of equity

D/P (Dividend price ratio) Ratio method:

(Do/ Po)100

Do = Dividend per share

Po = Market price per shareMarket price Rs. 15 and dividend rate is 15% (par value

Rs. 10 per share)

(1.5/15)100 = 10%

Assumptions: – Risk remains unchanged

– Investors desire to have dividend

– Shares are purchased at par





Cost of equity-cont…

Dividend growth approach

If dividend is expected to grow at constant rate

Po=D1/(r e-g) or r e=(D1/Po)+g

Po=current price of stock

D1=dividend expected to be paid at the end of yearr e=required rate of return on equity

ABC ltd. market price of share is Rs. 50.

Expected dividend Rs. 4 at the end of year. Approximate

growth rate 5% p.a. The share price should be:50 = 4/(r e – 0.05) = 4/(0.13-0.05) = 4/0.08

r e = (4/50)+0.05 = 0.08 + 0.05 = 13%

Required return = dividend yield + expected growth rate




Cost of equity-cont…

Dividend growth approach

Expected growth to be determined by averaging

the growth of dividend declared in last few years

Or multiply retention rate(1-dividend payout rate)x expected future return on equity (ROE)

e.g. retention rate is 0.60 and return on equity is

15%Expected growth i.e. g= (0.6)(15%)=9%




Determining proportion

Proportions=target capital structureweights stated in market value terms

Purpose of using target capital structure is

that present capital structure may notreflect capital structure expected to remainin future

For calculating weights use market valueand if not available than use book value.Investors expect return on market value




Weighted average cost of capital

Multiply specific cost of each source of financingby its proportion in capital structure and addweighted values

WACC=wEr E+w

pr p+w

Dr D(1-t

c)

WACC=weighted average cost of capital

wE=proportion of equity

r E=cost of equity

wp=proportion of preference

r p=cost of preferencewD=proportion of debtr D=cost of debt

tc=corporate tax rate




Weighted average cost of

capital-cont…

Source of capital Proportion Cost Weighted cost

(1x2)

Equity 0.60 16% 9.60%

Preference 0.05 14% 0.70%

Debt 0.35 8.4% 2.94%

WACC= 13.24%

Cost of debt= 12x(1-0.30)=12x0.70=8.4%




Weighted marginal cost of

capital

In market suppliers expect more return toprovide more capital

Estimate cost of each source of financing forvarious levels of its use through expectation of

investors and lendersIdentify breaking points i.e. where cost of newcomponent would change

Calculate WACC for various range of total

financing between breaking pointsPrepare weighted marginal cost of capitalschedule which reflects WACC for each level oftotal new financing



W i ht d i l t f




Weighted marginal cost of

capital-cont… WACC for various range of total finance Range of total source of proportion cost weighted

New finance capital % cost%

Rs.inlakhs

0-75 Equity 0.4 0.18 .072Debt 0.6 0.10 .060

WACC .132

Above75-83.3 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




Floatation cost and WACC

The cost incurred for raising funds

It should not affect WACC instead it should be

adjusted in project cost

e.g. project cost is 200 and floatation cost is 8%it means company will receive 184.

Therefore to raise net 200

200=(1-0.08) x amount required to be raisedamount required to be raised=200/(1-0.08)=

217.39




CAPITAL STRUCTURE DECISION

Two principal sources of finance for a businessfirm are equity and debt.

What should be proportions of equity and debt incapital structure of a firm?

It is essentially concerned with how the firmdecides to divide its cash flows into two broadcomponents, a fixed component to meet thedebt obligations and residual component thatbelongs to equity shareholders.

No single method which can ensure optimalcapital structure




GUIDELINES

It is a difficult decision

which requires trade off

between income, risk,flexibility, control, timing,

etc.



CRITERIA FOR CAPITAL




STRUCTURECost principle

– Minimize cost of financing and maximize value per

share

– Debt capital more preferable as it is cheaper

Risk principle

– Avoid bankruptcy

– More dependence to be on equity financing

Control principle – Owners desirous to hold on the control will depend

more on bonds and preference capital






STRUCTUREFlexibility principle

– Maneuverability should be possible according to major

changes in needs of funds

– Combination of funds to be such that there is bargainability

in dealing with the suppliers of funds (bonds)

Timing principle

– Offer securities which are in great demand like in boom

equity issue is welcome

– Appropriate time to be chosen for raising the funds To take advantage of market opportunities

To minimize cost of funds

To obtain substantial savings


FACTORS INFLUENCING



FACTORS INFLUENCING

CAPITAL STRUCTURE Size of business

– Problems in raising funds by small firms

– Investors are not enthusiastic in putting funds in small

firms

Form of business organisation

– Control principle is important in Pvt. Ltd., proprietory and

partnership firms but not much in public ltd. companies

Stability of earnings

– Firms with stable earnings and public utility concerens faceless problems in raising funds as they have adequate

profits

– Manuf.and other firms have to mainly depend on equity


FACTORS INFLUENCING



FACTORS INFLUENCING

CAPITAL STRUCTURE Age of company

– Younger firms find it difficult to raise funds

– Established firms can raise funds from any source

Purpose of financing – If productive purpose the difficulty is less

– For welfare activities funds have to from equity

Market sentiments

– Times of boom and times of slacknessCredit standing

– High credit standing the problems are less


FACTORS INFLUENCING



FACTORS INFLUENCING

CAPITAL STRUCTUREPeriod of finance

– For temporary period or few years than raise through bonds

– Permanent requirement to be raised through equity

Legal requirements

– Companies Act, Banking companies Act, Income Tax Act etc.influence the capital structure

– Debenture/Preference shares are issued to increase the earning

of equity shares

– Equity shares are issued to absorb shocks of business cycles

and to afford flexibility

Tax consideration

– Debt is more advantageneous





Avail of Tax advantage of debt

Interest of debt is tax deductible

If the debt is perpetual the tax shield is

available on full loan i.e. present value of

tax shield will be = (tcr dD)/r d = tcD

Debt financing provides tax shelter which

increases firm value i.e.=tcD

where tc = corporate tax rate, r d=interest

rate on debt, D = debt financing

CONTROL IMPLICATIONS OF





ALTERNATIVE FINANCING PLAN

e.g. ABC Ltd. has equity capital of 10,00,000 totallyowned by promoters. Now additional Capital of10,00,000 can be in the form of total debt or right issueor public issue or a combination of two or more.Consider the following

Pros ConsRights issue No dilution of control limits on financing

ability of promoters

No financial risk High cost

Debt financing No dilution of control Financial risk

Lower cost

Public issue No financial risk Dilution of control

Higher cost






ALTERNATIVE FINANCING PLAN

Due to financing limits of right issue,

decision is to be taken between debt and

public issue and in this control is

important componentControl is related to equity holding below

100%, 50%, 26%. 50% for control over

the firm and 26% for stopping specialresolutions

NORMS OF LENDERS & CREDIT



NORMS OF LENDERS & CREDIT

RATING AGENCIES

Lenders normally want tangible assets like

plant & machinery as security hence if such

assets are available borrowing is possible

Rating agencies normally consider thefollowing

– Earning power, business and financial risk

– Asset protection, cash flow adequacy

– Financial flexibility, quality of accounting

Do not be obsessed about credit rating

cost of capital - lecture 3

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