Cost of Capital

Course

: Commerce

Paper

: Fundamentals of Financial Management

Lesson

: Cost of Capital

Lesson Developer

: Dr. Vinay Kumar

Department/College : Commerce Department, Aryabhatta College, University of Delhi Reviewer’s Name

: Dr. Gurmeet Kaur Fellow in Commerce, ILLL Associate Professor, Daulat Ram College, University of Delhi

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Cost of Capital

Lesson: Cost of Capital Table of Contents: 1. Learning Outcomes 2. Concept and Meaning 3. Importance of Cost of Capital 4. Types of Cost of Capital 4.1: Implicit and Explicit Cost of Capital 4.2: Specific and Overall Cost of Capital 5. Measurement of Cost of Various Sources of Finance 5.1: Cost of Debentures  Cost of Redeemable Debentures  Cost of Irredeemable Debenture 5.2: Cost of Preference Shares  Cost of Redeemable Preference Shares  Cost of Irredeemable Preference Shares 5.3: Cost of Equity Shares  Divided Model  Dividend plus Growth Model  P/E Method  CAPM Model 5.4: Cost of Retained Earnings 6. Weighted Average Cost of Capital 7. Risk Return Analysis of Various Sources of Finance 8. Factors Affecting Cost of Capital Summary Glossary Exercises References

1. Learning Outcomes: After studying this chapter the students should be able to: 

Understand the concept of cost of capital;



Know different types of cost;



Calculate cost of different sources of finance;



Explain the factors affecting cost of capital;



Calculate weighted average cost of capital of the company;



Understand requirement of cost of capital. Institute of Lifelong Learning University of Delhi

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Cost of Capital

2. Concept and Meaning: Cost of capital is the most important concept in financing decisions. In order to evaluate the projects a firm need cost of capital of that project. If the cost of capital of the project is higher than expected return from the project then project is rejected. Therefore cost of capital serves as the yardstick for accepting or rejecting the project. A company needs fund to finance (buy) long term assets of the firm. These funds can be raised either through debt e.g. debenture, loan etc and equity shares. These sources of funds always have cost. The cost of these sources is minimum payment that a firm must pay to lender/shareholder to fulfil their expectation. This minimum payment on debt/equity is nothing but cost of capital of debt or cost of capital of equity. Therefore the cost of capital is the minimum payment a firm has to pay to its investor on the money advanced by them. Alternatively cost of capital can also be defined as the minimum rate of return that a firm must earn so as to keep the market price of its equity shares unchanged. It is also called discount rate, minimum rate of return, hurdle rate. The term cost of capital means the cost of the funds being raised by the firm. It should not be confused with cost in raising the fund. For instance flotation costs like brokerage and commission are cost incurred in raising the fund and it cannot be termed as cost of capital. A firm has to pay interest on long term debt funds and dividend on its equity and preference shares. The payment of interest and dividend is cost of capital of debt and equity respectively.

Value Addition 1: Know More Cost of Capital Click on the link given below to gain an insight into the concept of cost of capital. Source: https://hbr.org/2015/04/a-refresher-on-cost-of-capital

3. Importance of Cost of Capital: Cost of capital is the concept of vital importance in the field of financing decision making. Long term capital decisions are based on the cost of capital concept. A project cannot be evaluated without the help of cost of capital as it serves as the yardstick for accepting or rejecting a project. Cost of capital is useful in the following decisions: Evaluating Investment and Capital Budgeting Decisions: The main purpose of measuring the cost of capital is to use it as a standard for evaluating the investment projects. All long term projects or capital budgeting decisions are taken on the basis of cost of capital. As earlier stated cost of capital is the minimum rate of return that a project must earn to keep the market value of the shares unchanged. If the rate of return of the project is higher than cost of capital, project will be accepted otherwise it will be rejected. For example in NPV method a project with positive NPV is accepted while project with negative NPV is rejected. The NPV of the project is calculated by discounting the cash inflow/outflow of the project with the cost of capital. Therefore cost of capital serves as the standard for not only evaluating the capital budgeting decisions but also help in the case of capital rationing decisions. Deciding Debt Component in Capital Structure: Cost of capital plays an important role in deciding the debt component in overall capital structure of the firm. Debt is cheap source of fund as interest payment on debt is tax deductible. But debt also increases the financial risk of the firm as it a fixed charge on the earning of the firm. Therefore the objective of the finance manager is to use only that amount of debt in capital structure that will enhance the shareholders wealth.

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Cost of Capital Performance Appraisal: Cost of capital can be used as a tool to measure the performance of top management. Performance of the management can be judged by comparing the actual profitability of the project undertaken by the management with cost of capital of the firm.

Value Addition 2: Know More Importance of Cost of Capital Click on the link given below to gain an insight into the significance of cost of capital. Source:

http://accountlearning.blogspot.in/2011/07/significance-andcomponents-of-cost-of.html

4. Types of Cost of Capital: Cost of capital can be classified into various categories. The following are a few types of costs of capital:

4.1: Implicit and Explicit Cost of Capital: Explicit Cost of Capital: Explicit cost of capital is the actual payment made by the firm to procure the fund. For instance interest paid by the firm on debenture is the actual cost of debenture or alternatively called explicit or real cost of capital. As per Porterfield ”explicit cost of any source of capital is the discount rate that equates the present value of cash inflows that are incremental to the taking of financial opportunities with the present value of its incremental cash outflow.” So explicit cost of capital is the real cost incurred by the firm. Explicit cost is also called out of pocket cost as these are actually paid. Explicit cost of an interest free loan is zero since there is no actual payment in the form of interest although principal is repayable. Implicit Cost of Capital: Implicit cost of capital is the notional cost of capital. It is also called opportunity cost of capital. Implicit cost of capital does not involve any outflow of fund. The best example of implicit cost is the cost of retained earnings. Implicit cost of retained earnings is the opportunity cost foregone by the shareholder, had these earnings been distributed to them as dividend. Therefore explicit cost arises when funds are raised while implicit cost arises when funds are used. Implicit cost cannot easily be measured and therefore not recorded in the books.

4.2 Specific Cost and Combined Cost: Specific Cost of Capital: Specific cost is the cost of each source of fund used. For example if firm is using three sources viz. equity shares, debentures and long term loan then respective cost of these three will be termed as specific cost. Specific cost is used when a project is financed through a specific source of fund. Combined Cost of Capital: When the specific cost of each source of finance is combined together it becomes combined cost or overall cost of capital. It is also known as composite cost or weighted average cost of capital (WACC). Combined cost is used to evaluate those projects which are financed through more than one source of finance. The combined cost of capital can be shown as follows:

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Cost of Capital Ko= ke*we+kd*wd+kp*wp+ke*we Where w is the weight assigned to each source of finance.

5. Measurement of Cost of Capital: Every firm needs to measure its cost of capital accurately and carefully because all long term investment decisions are taken on the basis of the cost of capital. If it is not calculated properly than some projects which are not profitable may be accepted thereby leading to loss of wealth of shareholders. Generally cost of capital is calculated on after tax basis. As we know that interest payment on debt component is tax deductible therefore cost of debt capital will always be after tax basis. For other sources of capitals like equity share and preference share there is no need to make adjustment for tax benefits as dividend paid on these shares does not enjoy tax deductions. Measurement of cost can be divided into two parts: 

Measurement of specific cost



Measurement of combined cost or overall cost

5.1: Cost of Bonds and Debenture/Long Term Loans: Debt is one of important component of the overall cost of the firm. It plays an important role. The debt component can significantly increase or decrease the overall cost of capital (ko) of the firm thereby deciding the fortune of the firm. There are various ways to raise debt capital. Firm can borrow it from the financial institutions (banks) or it may approach the public and raise fund through issue of debentures. The decision is taken by the management keeping various factors in mind viz easily availability, formalities required, tenure of the loan requirement and more. A debenture may be issued at par, discount or even at premium. The coupon rate (stated interest rate) on the debenture forms the basis for calculation of cost of debenture. A debenture certificate hold by debenture holder indicates coupon rate, date of payment of interest, period of holding and date of repayment of principal i.e. maturity date. Debenture can mature at par or at premium at the time of maturity. The cost of debenture and bond can be calculated for redeemable or irredeemable (perpetual) bonds. 

Cost of Irredeemable Debt: The concept of irredeemable debt is theoretical in nature as loan amount has to be repaid at the time of maturity. The cost of debt can be calculated with the help of following formula

Kd= I/NP or I/ MP0 Where I= Interest Payment made Annually NP= Net Proceeds at the time of Issue of Debenture/Bond MP0= Current Market Price of the Debenture Kd= Cost of Debenture The above calculation can be said to be cost of debt capital before tax basis as tax deduction has not been incorporated. Since interest paid on debt capital is tax deductible therefore above cost can be adjusted for tax benefit. As a result of interest tax shield the after tax cost of the debt to the firm will be substantially low than the investor expected required rate of return. That is why though debt is a risky capital but it’s a cheap source of finance. Every firm should use it with due diligence. After tax cost of debt can be calculated as follow:

Kd= I(1-t)/NP or I(1-t)/MP0 Institute of Lifelong Learning University of Delhi

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Cost of Capital or alternatively it can be

Kd=Kd (1-t) Where t= Rate of Tax

Numerical 1: A company issue 10% perpetual debt of Rs. 2,00,000. The applicable tax rate is 50%. Calculate the cost of debt assuming that debt is issued at:

a. Par; b. 10% discount; c. 20% premium Solution: Calculation of cost of debt a. Issued at Par

Kd(before tax) = I/NP =20,000/2,00,000 = 10% Kd(after tax)

= Kd(1-t)

Or I(1-t)/NP

= 10%(1-.5)= 5% b. Issued at discount

Kd(before tax) = I/NP = 20,000/ 2,00,000-20,000 x 100 = 11.11% Kd (after tax)

= I(1-t)/NP = 20,000(1-.5)/2,00,000-20,000 x100 =5.55%

c. Issued at Premium Kd(before tax) = I/NP = 20,000/ 2,00,000+40,000 x 100 = 8.33% Kd (after tax)

= I(1-t)/NP Or Kd(1-t)

= 8.33%(1-.5) =4.16%  Cost of Redeemable Debt: While calculating cost of redeemable debt one should remember to account for interest payment and principal repayment on the debt capital. There are two methods for repayment of the principal (i) principal can be repaid in one lump-sum amount at the maturity or (ii) part of principal can be repaid annually along with interest. If principal is repaid in one lump-sum amount, the cost of debt can be measured by two methods (a) Trial and Error Method (b) Short Cut Method

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Cost of Capital (a)Trial and Error Method: Trial and error method is the cumbersome technique of calculation of cost of capital. This method can be applied all cases whether principal is repaid in instalments or at maturity in lump-sum amount. Cost of debt capital can be obtained with the help of following formula:

Numerical 2: XYZ Ltd. Issues 15% Debentures of face value of Rs. 100 each at floatation cost of Rs. 5 per Debenture. Find out the cost of capital if the debenture is to be redeemed in 5 annual instalments of Rs.20 each starting from the end of year 1. The tax rate may be taken at 30%.

Solution: In the given situation, the net proceeds i.e., Bo is Rs. 100- 5 = Rs.95. As the debenture is to be amortised in 5 instalments of Rs. 20 per year, the interest at 15% will be payable only on the reduced balances as follows: Year-end 1 2 3 4 5

Interest 15 12 9 6 3

Repayment 20 20 20 20 20

After-tax Cash Flow 20 + 10.5 = 30.5 20 + 8.40 = 28.40 20 + 6.30 = 26.30 20 + 4.20 = 24.20 20 + 2.10 = 22.1

These after-tax cash flows may be discounted at an appropriate rate , say, 12 % and 13%, to be made equal to Rs.95 i.e., 95= 30.5/(1+ Kd)1 + 28.4/(1+ Kd)2 + 26.3/(1+ Kd)3+ 24.3/(1+ Kd)4 + 30.5/(1+ Kd)5 At kd = 12%, the right hand side of the equation gives a value of Rs.96.518 At kd = 13%, the right hand side of the equation gives a value of Rs.94.391 By interpolation between 12% and 13%, value of kd comes to 12.71%. Conclusion: The cost of capital of debt kd increases as the net proceeds from the debt issue decreases because the investors have paid less to get the fixed interest payment and the principal repayment. By paying Rs.95 only and getting Rs.100, the investors have a capital gain which accrues to them proportionately every year. The rate of interest on the debenture is 15% and therefore the after-tax cost of debt should be 10.5% only. However, due to net proceeds of Rs.95 only, the cost of debt (after-tax) comes to 12.71%.

(b) Short Cut Method: Short cut method is an approximation of cost of debt. This is the simplest way to calculate cost of capital. But this method cannot be applied if repayment of principal amount is in instalment. It means this method is used only when entire principal is repaid at the maturity. Cost of debt through short cut method can be obtained as

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Cost of Capital follows:

Kd

I(1-t)+ (RV-NP)/N = ---------------------(RV-NP)/2

Where RV= Redeemable value of the debenture (debenture can be redeemed at premium. If debenture is redeemed at premium then its redeemable value will be higher than face value.) NP= Net Proceeds from Issue of Debentures (Face Value-Discount on issue- underwriting Commission or Flotation costs + Premium on Issue) I= Interest Payment t = Tax Rate N= Number of Years of Debt

Numerical 3: A company has issued 10% debenture of Rs. 100 each at 15% premium redeemable at par after 10 years. The flotation cost is estimated to be 2%. Calculate cost of debentures given the corporate tax rate is 40%.

Solution: Cost of Debenture Net Proceeds= Face Value +Premium on Issue- Flotation Costs NP

Kd

= (100+15)-(1-.02) =Rs. 112.7

I(1-t)+ (RV-NP)/N = ---------------------(RV-NP)/2

=

Rs. 10(1-.4) + (100-112.7)/10 ----------------------------------(100+112.7)/2

=

4.73/106.35 = 4.44%

5.2: Cost of Preference Shares: Preference shares enjoy the advantages of both debt and equity capital. As the name suggest these share holder are paid first while declaring the dividend. There is a fixed rate of preference dividend and the dividend gets accumulated in case company is not able to pay in a particular year. But Preference share holder cannot take any legal action against the company for non payment of dividend. Although there is no legal binding on firm to pay dividend to preference share, but nothing can be paid to equity shareholder until payment is made to preference shares and their dues are cleared. Moreover if dividend on preference shares remains in arrear than preference shareholder gets the right to participate in the management. Though the failure to pay dividend to preference shares does not result in bankruptcy it may result in damage to credit standing of the company in the market. Company will find it difficult to raise fresh fund through issue of shares. Also market value of the firm will be adversely affected. The dividend paid to preference share is not tax deductible as it is not an expense. Preference dividend is always paid out of profit. There are two types of preference share (a) Irredeemable Preference Shares (b) Redeemable Preference Shares

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Cost of Capital Cost of Irredeemable Preference Share: Kp=PD/NP or Kp= PD/MP0 Where Kp= Cost of Preference Shares PD= Annual Preference Dividend NP= Net Proceeds from Issue of Preference Share (Issue Price-Flotation Cost—Discount on Issue +Premium on Issue) MP0 =Current Market Price Numerical 4: XYZ Co. Ltd issues 10% irredeemable preference share of face value of Rs. 100 each. Flotation cost of the issue is 5% of the issue price. Calculate the cost of preference shares if shares are issued at: (i)

Par

(ii)

10% Premium

(iii)

15% Discount

Solution: Calculation of the cost of irredeemable preference shares when: (i)

(ii)

(iii)

Issued at Par Kp = PD/NP or MP = Rs. 10/100 x100 = 10% Issued at 10% Premium Kp = PD/NP = Rs. 10/110(1-0.5) = 9.56% Issued at 15% Discount Kp

= PD/NP = Rs.10/ 85(1-.5) = 18.03%

Cost of Redeemable Preference Shares: Cost of redeemable preference shares can be calculated with the help of two methods: (a)Trial and Error Method:

Numerical 5: Sanchit Ltd. issues 15% Preference Shares of the face value of Rs.1000 each at a flotation cost of 4%. Find the cost of capital of Preference Share if

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Cost of Capital a. the preference shares are irredeemable, and b. the preference shares are redeemable after 10 years at a premium of 10%. Solution: a. If the preference shares are irredeemable, then the cost of capital is kp = 150/960 = 15.63% b. If the preference shares are redeemable, then the cost of capital may be calculated by solving the following equation

where n is taken as 10 PD = 150 Pn = 1100 At kp = 16 %, the right hand side of the equation may be written as: = 150 (PVAF

(16%,10))

+ 1100 (PVAF

(16%,10))

= 150 (4.833) + 1100 (.227) = 974.60 As the value is more than Rs. 960, the rate of discount may be increased to 17% At kp = 17%, the right hand side of the equation may be written as: = 150 (PVAF

(17%,10))

+ 1100 (PVAF

(16%,10))

= 150 (4.659) + 1100 (.208) = 927.60 By interpolating between 16% and 17%, the value of kp comes to 16.31% as follows: Kp = 16% + (974.60-960) (974.60-927.6) = 16.31% Conclusion: The cost of preference share, kp, is higher i.e., 16.31%when it is redeemed after 10 years at 10% premium. The reason for this is premium payable at the time of redemption. In the same case, if the premium is not payable at the time of redemption and the preference share is redeemable, instead at Rs. 960 only, then the cost of capital will be as follows: At kp = 16%, the right hand side of the equation (1) may be written as = 150 (PVAF

(16%,10))

+ 960 (PVAF

(16%,10))

= 150 (4.833) + 960 (.227) = Rs. 942.7 At kp = 17%, the right hand side of the equation (1) may be written as: = 150 (PVAF

(15%,10))

+ 960 (PVAF

(15%,10))

= 150 (5.019) + 960 (.247) = Rs. 989.90 By interpolating between 15% and 16%, the value of kp comes to 15.63%.

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Cost of Capital Conclusion: The cost of capital is same at 15.63% as it was when the preference shares were treated as irredeemable. However, if the preference shares are redeemable at par i.e., Rs.1000, the kp comes to 15.83%. This increase in cost of capital from 15.63% to 15.83% arises because of premium of Rs. 40 payable at the time of redemption. This premium is a gain to shareholders but reflect a cost to the company as indicated by the increase in cost of capital. (b)Short Cut Method: Kp = PD+ (RV-NP)/N ----------------------(RV-NP)/2 Where RV= Redeemable value of the Preference (Preference can be redeemed at premium. If Preference is redeemed at premium then its redeemable value will be higher than face value.) NP= Net proceeds from issue of Preference shares (Face value-discount on issueunderwriting commission or flotation costs+ premium on issue) PD= Preference Dividend N=

Number of years of debt

Numerical 6: Y Ltd. Issue preference shares of face value of Rs.100 each carrying 15% dividend and company realized Rs. 95 per share. These shares are repayable after 5 year at 10% premium. Calculate cost of preference shares if the tax rate applicable to the company is 40%. Use short cut method. Solution: Cost of preference share using short cut method Kp = PD+ (RV-NP)/N ------------------(RV-NP)/2

=

Rs. 15+(110-95)/5 -----------------------(110+95)/2

= 18/102.5 =17.56%

5.3: Cost of Equity Shares: Generally it is argued whether equity share involve any cost or not as there is not legal binding to pay any dividend to the equity shareholders even for years. There is no specific rate of dividend like preference share. But it is wrong to believe that equity shares are free of any cost. Equity shares involve an opportunity cost. The equity shareholder supplies the fund in expectation of dividend and capital appreciation of their share price in the market. Therefore the cost of equity (ke) can be defined as minimum rate of return that a company must earn to leave the market price of shares unchanged. Thus it is the rate which equates the present value of expected stream of dividend and net sale proceed realised when share is sold with the current market value of share. In practice it is a difficult task to measure the cost of capital. The cost of equity can be calculated with the following equation:

MP0= D1/(1+ke)1+ D2/(1+ke)2...............Dn/(1+ke)n+Pn/(1+ke)n Where MP0= current market price of equity share D= dividend payment for different year

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Cost of Capital Ke= cost of equity Pn= market price of share at the time of sale Cost of equity capital can be calculated with the help of following methods: (a) Dividend Model (b) Dividend plus Growth Model -When dividend grows at constant rate -when dividend grows at different rates (c) P/E (Price Earning Method)

(a) Dividend Model: As stated earlier cost of equity is the function of stream of future dividends. Therefore, the cost of equity can be calculated by equating the stream of expected dividend to its current market price of the share. In case of fresh equity shares net proceeds will be taken in place of current market price as shown below; i.

Cost of New Equity

Ke= D1/NP Where NP= net proceed from the issue of share capital i.e. issue price+-flotation cost ii.

Cost of Existing Equity

Ke= D1/MP0 Where MP0= current market price of the share or market price of the share at the beginning of the year one. Numerical 7: A company has issued equity share of 100 Rs each at a discount of 5%. Flotation charges are 10% of the issue price. The company expect to pay dividend at 10%. Determine the cost of equity capital.

Solution:

Ke= D1/ NP = 10/ 100-5(1-f) = 10/85.5 =11.69% Numerical 8: A company’s shares are traded in stock market at Rs. 90 per share of face value of Rs. 100 each. Find out the cost of equity capital if the company is expecting to declare a dividend of Rs. 5 per share at the end of the year. Solution: Calculation of the Cost of Equity Capital

Ke

= D1/ MP =Rs. 5/ 90 = 5.55%

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Cost of Capital (c) Dividend plus Growth Model: It is impractical to think that there will be no growth or growth rate will remain same in the dividends in future as discussed in the previous pares. If there is change in the earning of the firm then dividend declared will also change. Dividend plus growth model take into account the growth expected in the dividends in the future. Constant growth rate Formula to calculate cost of equity is Ke= D ---------------- + g MP0 or NP Where MP0= Current Market Price NP= Net Proceed form the Issue of Shares g= Growth Rate Numerical 9: A company declares a dividend of Rs. 5 last year and expected to have a growth rate in dividend equal to 10%. Find out the cost of equity capital if the current market price of the share is (a) Rs. 60 and (b) Rs. 70. Solution: Calculation of Cost of Equity

(a) If share price is Rs 60 Ke

= D1/MP +g

D1

= D0(1+g)

D1

= Rs. 5(1+10% of Rs. 5) = Rs. 5.5

So

Ke

= Rs.5.5/60 +10% = 19.16%

(b) If Share price is Rs. 70 Ke

= D1/MP + g =5(1+10%)/MP +10% = 17.85%

Numerical 9: A company’s current market price of equity share is Rs. 30. The company has paid a dividend of Rs. 2 per share and investors expect a growth rate of 6% per year in dividends. You are required to compute: (i)

Company’s equity cost of capital

(ii)

If the company’s cost of capital is 8% and anticipated growth rate is 4% per annum, calculate market price if the dividend of Rs. 2 is to be paid at the end of the year.

Solution: (i) The cost of equity capital Ke

= D1/MP +g = Rs. 2(1+6%)/ Rs. 30 + 6% = 13.06%

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Cost of Capital (i) Market Price of the equity share can be obtained with the help of same formula as follows: Ke

=D1/MP +g

MP

= D1/Ke-g = Rs. 2/ .08-.04 = Rs. 50

(d) Price Earning (P/E) Approach: In this approach price of the equity share depends upon the earnings of the company Earnings include both retained earnings and dividend paid to shareholders. Therefore this approach assumes that investor capitalize stream of all future earnings of the firm to calculate the price of the share. The cost of equity can be obtained in this approach using the following formula Ke= E/NP Where Ke= Cost of Equity E= Earnings per Share NP= Net Proceeds from Equity Share Alternatively

Ke = EPS/ MP0 or = 1 ------------P/E ratio

Where E= total earning available to equity shareholder MPo = current market value of equity share Note: In case of new equity issue net proceeds from the equity share will replace current market value per share. So the formula will be Numerical 10: Following information is provided for X Ltd. Current market price= Rs.100 Current earning = Rs. 40,00,000 Shares outstanding =2,00,000 Additional fund needed= Rs. 6,00,000 Flotation cost = Rs. 10 per share or 10% The X Ltd can sell share at a discount of 10%. Find out the cost of equity assuming that company’s earnings are stable. Solution: As stated above the cost of equity can be obtained with the help of following formula Ke = EPS/NP EPS= Total earnings / number of equity shares outstanding =40,00,000/ 2,00,000 = Rs. 20 per share NP = Net proceeds from issue of equity shares = 100 – discount - flotation cost

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Cost of Capital = 100- 10% of 100- 10 =80 Rs. Therefore Ke= Rs,20/ Rs.80 =.25 or 25%

5.4: Cost of Retained Earnings: Retained earning is that portion of profit which is not distributed to shareholder as dividend. It is like saving of the shareholders. Though it is argued that retained earning has no cost but it is not true. Retained earnings always involve opportunity cost. For instance if the retained earning would have distributed to the shareholder as dividend, they would have invested it in the shares of the same or shares of the other firm to earn a return at least equal to ke. Therefore firm must earn on its retained earning equal to ke to ensure that market price of the shares do not fall. If return on retained earnings is less than ke (cost of equity) than market price of the shares will fall. Since cost of retained earning is the dividend income foregone by the shareholder that is why it is called opportunity cost. This is the best example of implicit cost since nothing is paid out of the pocket. It is also be remembered that cost of retained earnings is not exactly equal to cost of equity as cost of equity involve brokerage cost or flotation cost which is absent in case of retained earnings. Moreover cost of equity also involves corporate dividend tax which is paid by the company at the time of declaration of the dividend to shareholder. Thus cost of retained earnings will be always be lower than cost of new equity capital because new equity capital involve flotation cost. The cost of retained earning can be calculates as follows: (i) If there are no taxes and flotation cost

Kr=Ke It means there will be no difference in the cost of retained earnings and cost of equity. (ii) If there are taxes and flotation cost

Kr= Ke(1-t)(1-f) It means the cost of equity will be adjusted for the tax rate and flotation cost which is not involved cost of retained earnings. Therefore in this case cost of retained earnings will be lower than the cost of equity.

6. Weighted Average Cost of Capital (WACC): Weighted average cost of capital can be calculated once the specific cost of each component is calculated. Weighted average cost of capital or overall cost of capital is the sum of product of weight of each source of fund with their respective cost. The cost of capital of each component should be calculated on an after tax basis. While calculating WACC, different types of weight namely market value weight, book value weight, target weight or marginal rates can be used. The calculation of WACC involves the following steps: (i) Calculation of the cost of each component (ii) Finding out and ascertain which weight to use (iii) Calculation of sum of the product of each cost component and their respective weight. For example, if a firm is using only two sources of finance viz. debt and equity capital then WACC can be calculated as follows: WACC= Kd*Wd +Ke*We

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Cost of Capital Similarly if a firm is using more than two sources of fund then equation can be extended in similar fashion. Assignment of the Weights: As discussed in the previous part, weighted average cost of capital or overall cost of capital can be obtained by addition of the product of individual cost of each component with their respective weights. Therefore we need weight of each source of finance in overall capital structure in order to calculate WACC. There are four types of weights which can be used. These are: 1) Historical Weight Historical weights can be of two types; i) Book Value Weight; ii) Market Value Weight 2) Target Weight 3) Marginal Weights Book Value Weights: Book value means the amount recorded in the books of accounts of the firm. So book value weight of individual source of finance is the respective proportion of source in overall capitalization. For instance; book value of equity share can be obtained as: No. of Equity Share* Face Value or Equity Share Recorded in the Books of Account Book value of preference share and debt can also be obtained in the similar fashion. Advantages of Book Value Weights: i) Easy to calculate and use as these are available from the records. ii) WACC based on book value weight provide more stable cost of capital as book value weights doesn’t change on day today basis. iii) Stable cost of capital can be used for accepting or rejecting more than one project. Market Value weight: Market value of different source of finance especially Equity Shares can be obtained by multiplying market price of equity share with total number of equity shares of the firm. For instance if total number of equity share is 100000 shares and market price of one equity share is Rs. 12, then total market value of equity shares will be 100000*12= Rs. 12,00,000. Market value of equity share may be different than the book value of the firm. One should remember here is that the market value of debt will remain equal to the book value of debt as the debt or loan is not traded on stock market. There are certain advantages of using market value weight in place of book value weights. These advantages are: i)

WACC based on MV weight approximate the current or actual cost of capital

ii) Banks and financial institutions lend their money on the basis of actual cost of capital of the projects. iii) Since projects are taken at current cost so WACC based on market weight will be more suitable while accepting or rejecting a proposal. Though cost of capital based on market weights presents true cost of capital but it has some limitations too. i)

The market value of the shares fluctuate on day to day basis, so it is not possible to calculate stable cost of capital which can be used at two different point of time.

ii)

Market value of share may not represent true value of share at a time as market

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Cost of Capital value of share is influenced by many factors viz. bearish and bullish conditions , insider trading , slow done in the market, etc. Therefore cost based on market value will be of no use in financial management. iii) Market value of some securities may not be easily available all the times. So, the use of market value weight or book value weight depends on various factors such as philosophy of the management, timing of the project, conditions of stock markets, etc. 2. Marginal Weights: Marginal weights are used when a firm is raising the finance for a particular project. So, the marginal weights mean the proportion in which the firm wants to raise additional fund from different sources. In other word, the proportions in which additional funds are raised to finance the investment proposal are known as marginal weights. The WACC calculated on the basis of these weights are also called incremental cost of capital. Though marginal weights seem to be theoretically sound as we are comparing additional cost with the additional revenue from the project but there are some shortcomings of the marginal weight system. Marginal weights are not suitable if the company is planning for long term investment decisions. A particular source may be cheaper in present scenario but may prove to be wrong in the future. Target Weights: Target weight present the proportion in which a company intend to finance it long term financial capital requirements. Thus target weight means the proportion of debt and equity in the long term capital structure of the company. Though in the short run the concept of optimal capital structure may be irrelevant but in the long run every firm strive for the minimum cost through optimal capital structure.. If company is already working under optimal capital structure then target weights will be equal to historical weights of the company. Calculation of Weighted Average Cost of Capital: Numerical 12: The following information is given in the Balance Sheet of a company; Equity Share Capital (Face Value of Rs. 10)

Rs.8,00,000

Preference Share Capital (Face Value of 100 each)

Rs. 4,00,000

10% Debentures (Face Value of Rs. 100 each)

Rs. 8,00,000 ...............................

Total

Rs. 20,00,000

Other Information; Equity shares are currently selling at Rs. 20 per share. The company paid a dividend of Rs. 2 per share last year. The dividend is expected to grow @ 5% p.a. The preference shares and debentures are traded in the market at Rs. 90 and 70 per share respectively. The tax rate applicable to the company is 40%. Find out weighted average cost of capital using: (i)

Book Value Weight

(ii)

Market Value Weight

Solution: Calculation of specific cost of capital of each source Kd

= I(1-t)/MP = Rs. 10(1-.4)/70

= 8.57%

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Cost of Capital

Kp

= PD/MP = Rs. 15/90 = 16.67%

Ke

= D1/MP +g = Rs. 2(1+5%)/ 20 +5% = 10.5%+5% = 15.5%

(i)

Calculation of WACC Based on Book Value Weights:

Source of Capital

Book Value(Rs.)

Weight (w) (Total of book value/ respective book value)

Cost of Capital(k)

W×COC

or (COC)

Equity Share Capital

8,00,000

0.4

.155

0.062

15% Preference Share Capital

4,00,000

0.2

.1667

0.0333

10% Debentures

8,00,000

0.4

.857

0.3428

Total

1.0

.1295

So, WACC is (.1295×100) =12.95% (ii)

Calculation of WACC based on Book Value Weights:

Source of Capital

Market Value(Rs.)

Weight (w) (Total of Book Value/ Respective Book Value)

Cost of Capital(k) or (COC)

W×COC

Equity Share Capital (Rs.20 ×8,000 Shares)

16,00,000

0.635

15.5

9.84

15% Preference Share Capital

3,60,000

0.142

16.67

2.36

5,60,000

0.222

8.57

1.902

25,20,000

1.0

(Rs. 90 × 4,000 Share) 10% Debentures (Rs. 70× 8,000 Shares) Total

14.10

So, WACC is 14.10%. Numerical 13: The following information is available from the balance sheet of ABC Ltd. Equity share capital (Rs. 10 per share)

Rs. 10,00,000

Retained earnings

Rs. 2,50,000

Preference shares (Rs. 100 per share)

Rs. 5,00,000

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Cost of Capital Debentures (Rs. 100 per debenture)

Rs. 5,00,000 ------------------22,50,000 --------------------

Total

All these securities are currently selling in the market at following prices: Debentures Rs. 110 per debenture, Preference share Rs. 115 per share and equity share Rs. 25 per share. Anticipated external financing are: (a) Rs. 100 per debenture redeemable at par after 20 years .Flotation cost are 4% and coupon rate of 10%. Sale price Rs.115 (b) Rs. 100 15%Prefrence shares redeemable at 10% premium after 15 years. Flotation costs 5%. Sale price Rs. 100 (c) Equity shares Rs. 25 per shares with flotation cost of Rs. 2 per share. The dividend expected on the equity share at the end of the year is Rs. 3 per share; the anticipated growth rate in dividend is 5%. The corporate tax rate is 40%. Calculate weighted average cost of capital using (i)

Book value weight

(ii)

Market value weight

Solution: Calculation of specific cost of capital Cost of Debentures: Kd

=

I(1-t) +(RV-NP)/N --------------------------(RV+NP)/ 2

=

Rs. 10(1-.4) + (100-110.4)/20 -----------------------------------(100+110.4)/2

=

6 -.52 --------105.2

=5.20%

Cost of Preference Shares: Kp=

PD+(RV-NP)/N -----------------------= (RV+NP)/2

16.333

=

-------105

Rs.15+(115-95)/15 -------------------(115+95)/2

= 15.55%

Cost of Equity Capital: Ke

= D1/NP + g =Rs. 3/23 + 5% =18.04%

Cost of Retained Earnings

= D1/NP + g

= Rs. 2/ 25 + 5% = 13%

(Flotation cost is ignored while calculating retained earnings)

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Cost of Capital (i)

Calculation of WACC based on Book Value Weights: Source of Capital

Equity Share Capital

Book Value(Rs.)

Weight (w) (Total of Book Value/Respective Book Value)

Cost of Capital(k) or (COC)

W×COC

10,00,000

0.45

0.1804

0.0811

Retained Earnings

2,50,000

0.11

0.13

0.0143

15% Preference Share Capital

5,00,000

0.22

0.155

0.0341

10% Debentures

5,00,000

0.22

0.52

0.1144

22,50,000

1.0

Total

0.14094

So, WACC is (.1409×100)= 14.09% (ii) Calculation of WACC based on Market Value Weights: Book Value(Rs.)

Weight (W) (Total of Book Value/Respective Book Value)

Cost of Capital(K) or (COC)

20,00,000

0.575

18.04

10.37

Retained Earnings

5,00,000

0.144

13.0

1.87

15% Preference Share Capital

5,00,000

0.144

15.55

2.23

10% Debentures

4,75,000

0.136

5.20

0.70

34,75,000

1.0

Source of Capital Equity Share Capital

Total

W×COC

15.17

So, WACC is 15.17%. Note: (a) If both issue price and market prices are given for a security, in that case always use issue price in order to calculate cost of capital (b) The total market value of the equity share capital has been divided into equity and retained earnings in their book value ratio)

7: Risk-Return Analysis of Various Sources of Finance: An investor will supply the fund only when is adequately compensated for supplying his hard earned money. Therefore risk and return analysis of each source of fund is essential component of financial decision making. Risk can be defined as variability in the return from expected return from that security. It means higher the volatility or fluctuations in the return from the security results in higher risk. If the security provides stable return over period of time, it is known to be risk free or less risky security for instance interest on bank deposits or interest on government securities. There is no risk in case of government securities as the payment is guaranteed by the central or the state government. An investor will invest in risky securities if he is adequately compensated for the additional risk taken. For example if the rate of return on company debentures and bank deposits are same then investor will choose bank deposits as these involve lesser risk. If the rate of return on corporate debenture are higher than bank deposits, then investor will have to choose between the either of the two depending upon the risk

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Cost of Capital taking capacity and other factors. Thus, the risk and return analysis is of utmost importance for individual and firms both. The risk and return of various securities can be shown with the help of a diagram: Figure 1: Risk Return Trade-off

As it can be seen from the above figure, government securities provides the least return because it involve least possible risk or sometimes called risk free securities. If investor is ready to bear additional risk he will be expecting higher return or risk premium for the additional risk taken. Since equity shareholders are paid at last after paying to lender, government and preference shareholder, thus the equity share capital appear on the top of the list implying the most risky capital. As equity shareholders are ready to bear the highest risk they are compensated for the same as the return is highest in case of equity capital. Risk and return of other securities can also be seen in the diagram.

Value Addition 3: Know More Various Sources of Finance Visit the link below to know about the various sources of finance to start up business. Source: https://www.extension.iastate.edu/agdm/wholefarm/html/c5-92.html

8. Factor Affecting Cost of Capital: As it is already discussed in the present chapter that cost of capital is the minimum expected rate of return of the supplier of the fund. The expected rate depends on various factors viz. risk characteristics of the firm, risk perception of the investor and overall business environment. Following are some of the factors that determine the cost of capital: 1. Risk Free Interest Rate: It is the interest rate on default free securities or risk free securities. Generally govt securities are considered as risk free securities as there is no default on periodic payment or maturity payment by the govt of India.` The cost of capital is addition of risk free rate and premium for the risk. 2. Financial Risk: Financial risk occurs because of higher payment of fixed financial charges. Therefore, the use of more and more debt fund by the firm will increase burden of interest payment and investors will assign higher risk factor to that firm. This risk is avoidable and can be reduced by effective financing decision making.

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Cost of Capital 3. Business Risk: It is related to the operating profits of the firms with regards to sales revenue. This is firm specific risk. Every project has its bearing on the business risk of a firm. If the firm choose to accept risky projects, then overall risk of the firm will increase. It will in turn affect future cash inflows of the firm. 4. Other Factors: Other factors that affect the cost of capital is the liquidity and marketability of the investment. Investors would assign less risk premium for highly liquid and marketable securities and investments than the less marketable securities.

Value Addition 4: Know More Determinants of Cost of Capital Visit the link below to know about the factors determining the firm’s cost of capital. Source: http://www.oeconomica.uab.ro/upload/lucrari/920071/33.pdf

Summary: 

The term cost of capital means the cost of the funds being raised by the firm. It should not be confused with cost in raising the fund.



Cost of capital is the concept of vital importance in the field of financing decision making. Long term capital decisions are based on the cost of capital concept.



Cost of capital plays an important role in deciding the debt component in overall capital structure of the firm. Debt is cheap source of fund as interest payment on debt is tax deductible. But debt also increases the financial risk of the firm as it a fixed charge on the earning of the firm.



Cost of capital can be used as a tool to measure the performance of top management. Performance of the management can be judged by comparing the actual profitability of the project undertaken by the management with cost of capital of the firm.



Cost of capital can be used as a tool to measure the performance of top management. Performance of the management can be judged by comparing the actual profitability of the project undertaken by the management with cost of capital of the firm.



Explicit cost of capital is the actual payment made by the firm to procure the fund. Implicit cost of capital is the notional cost of capital. It is also called opportunity cost of capital. Implicit cost of capital does not involve any outflow of fund.



Specific cost is the cost of each source of fund used. For example if firm is using three sources viz. equity shares, debentures and long term loan then respective cost of these three will be termed as specific cost.



When the specific cost of each source of finance is combined together it becomes combined cost or overall cost of capital. It is also known as composite cost or weighted average cost of capital (WACC).



Every firm needs to measure its cost of capital accurately and carefully because all long term investment decisions are taken on the basis of the cost of capital. If it is not calculated properly than some projects which are not profitable may be accepted thereby leading to loss of wealth of shareholders.

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Cost of Capital



Debt is one of important component of the overall cost of the firm. It plays an important role. The debt component can significantly increase or decrease the overall cost of capital (ko) of the firm thereby deciding the fortune of the firm.



Preference shares enjoy the advantages of both debt and equity capital. As the name suggest these share holder are paid first while declaring the dividend.



Equity shares involve an opportunity cost. The equity shareholder supplies the fund in expectation of dividend and capital appreciation of their share price in the market. Therefore the cost of equity (ke) can be defined as minimum rate of return that a company must earn to leave the market price of shares unchanged.



Dividend plus growth model take into account the growth expected in the dividends in the future.



In Price- Earnings approach price of the equity share depends upon the earnings of the company Earnings include both retained earnings and dividend paid to shareholders. Therefore this approach assumes that investor capitalize stream of all future earnings of the firm to calculate the price of the share.



Retained earnings is that portion of profit which is not distributed to shareholder as dividend. It is like saving of the shareholders. Though it is argued that retained earning has no cost but it is not true. Retained earnings always involve opportunity cost.



Weighted average cost of capital or overall cost of capital is the sum of product of weight of each source of fund with their respective cost. The cost of capital of each component should be calculated on an after tax basis.



Risk can be defined as variability in the return from expected return from that security. It means higher the volatility or fluctuations in the return from the security results in higher risk. If the security provides stable return over period of time, it is known to be risk free or less risky security for instance interest on bank deposits or interest on government securities.



The expected rate depends on various factors viz. risk characteristics of the firm, risk perception of the investor and overall business environment.

Glossary: 

Net Proceeds: Net proceeds mean the amount recovered at the time of sale of any share or security. While calculating net proceeds adjustment has to be made for discount and premium on issue of security as well as any flotation cost on issue of securities.



Capital Budgeting Decisions: Capital budgeting decisions basically include decisions regarding investment in the long term assets of the firm.



Maturity: It means any future date when any security is to be repaid.



Flotation Costs: Flotation costs include those costs which are incurred in issuing the security. These costs may include underwriting commissions,



P/E: It is an abbreviation of price earning or price earnings ratio. It means “amount of investment required to earn a rupees in the stock market.” It should not be confused with EPS viz earning per share which mean amount earned on one share.



Trading on Equity: Use of debt in capital structure to produce gain to the residual owners i.e. equity shareholders.



Break Even Sales: It is the sales level where there is no profit and no loss to the

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Cost of Capital company. Thus, break even sales is the minimum amount of sales needed for making a profit. If total sales are more than break even sales, it will result into profit. 

Operating Risk (Business Risk): Basel II defines operating risk as “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” Thus business risk occurs because of failed internal management or market conditions which are beyond company control.



Financial Risk: Financial risk is the risk caused because of existence of fixed financial payments like interest on debentures or loans. It occurs because of debt content in capital structure. Higher amount of debt content in capital structure will results in higher financial risk.



Optimum Capital Structure: It is a capital structure or range of capital structure which results in maximum earning to equity shareholders (EPS). It results because of best mix of debt and equity capital in the overall capital structure of the firm.

Exercises: I. Objective Type Questions: A. State whether the following statements are true or false. a. Cost of debt is same as the cost of coupon interest rate. b. Financial risk cannot be controlled by the firm. c. Government securities involve the highest degree of risk. d. Since company is not obliged to pay dividend, cost of equity is nil. e. Retained earnings have no cost as these are internal funds. f. WACC based on market value weight and book value weight will always be same. g. Cost of debt requires tax adjustment. B. Fill in the Blanks: a. Combined or overall cost of all the sources of finance is also called …………………… b. ……………………….is the minimum rate of return that should be earned on equity capital. c. Cost of retained earnings is ………………………… form of capital cost. d. Cost of capital can be used as a ………………….for evaluating investment proposals. e. Cost of debt capital can be obtained either on ………………………or after tax basis. f. Short cut method of calculating cost of Preference Share capital can be used in …………………….. Preference shares only. Answers to Objective Type Questions: A. a. False; b. falls; c. False; d. False; e. False; f. False; g. True. B. a. WACC; b. Cost of equity capital; rate; e. before-tax basis;

c. Implicit; d. Yardstick/ standard/cut off f. Irredeemable.

II. Short Answer Type Questions: a. Define cost of capital. b. Explain implicit and explicit cost of capital c. What are basic assumptions for measurement of cost of capital? d. Write a short not on the following:

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Cost of Capital 

Target Weight



WACC



Cost of Retained Earnings

e. State different approaches to the computation of cost of equity capital. III. Long Answer Type Questions: a. What is WACC? Explain the procedure to calculate weighted average cost of capital taking an example. b. What are the advantages and disadvantage of using market value and book value weight in calculation of WACC? c. Differentiate between specific cost of capital and weighted average cost of capital giving suitable examples. d. Differentiate between marginal and target weights. Which one is better and why? IV. Numerical Questions: (a)A company has issued 10% debenture (irredeemable) for 2,00,000 Rs. The c ompany faces 50% tax bracket. Find the cost of debt if the debt is issued at I.

Par

II.

Discount of 20%

III.

Premium of 10% Answer (i)5%,(ii)6.25%,(iii)4.5%

(b)A company is planning to raise Rs. 10 lakh by the issue of 15% debentures of Rs. 100 each at 10% discount. The underwriting expense is expected to be 4%. Find out the cost of debenture in each of the following cases: I. II.

If denatures are irredeemable If debenture are redeemable at the end of 10 th year at 15% premium. Use short cut method.

Assume tax rate of 50% in both cases. Answer (i)8.68%, (ii) 10.28% (c)A company issued 2000 8% preference shares of Rs. 100 each at a premium of 10%. These shares are redeemable after 5 years at a premium of Rs. 10 per share. The cost of issue is Rs. 2 per share. Find out the cost of preference share capital assuming tax rate of 50%. Answer Kp= 6.84% (d)A company has declared a dividend of Rs 5 per share last year and the expected growth rate in dividend is 8%. Find out the cost of equity capital if the price of the shares of the company is (i) Rs. 40 and (ii) Rs.50 Answer(i)21.5%, (ii)18.8% (e)ABC Ltd. Is planning to raise Rs. 1 lakh by issue of 10% preference share of Rs. 10 each at 10% discount. The underwriting expensed is expected to be 2%. Find out the cost of preference share capital in each of the following cases: I. II.

If preference shares are irredeemable If preference shares are redeemable at the end of 10 th year at 15% premium.

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Cost of Capital Answer (i)11.33% (ii) 12.48% (f)Equity share of RML Co Ltd is currently priced at Rs. 50. Dividend expected at the end of year one from now is Rs.5. The cost of equity for the companies of similar risk class is 15%. What is expected growth rate? What would be change in market price of the share if due to adverse conditions in capital markets the growth rate is revised and scaled down to 3%? Answer g=5%, MP= 36.58Rs (g)The following informations are available from the balance sheet of the company: Equity share capital (8000 shares of Rs. 100 each)

8,00,000

12% Preference share capital

8,00,000

18% term-loan

24,00,000 ----------------40,00,000

Determine the weighted average cost of capital of the company based on book value weight. It had been paying dividend at a rate of Rs. 20 per share (g=0). The market price of the shares is 150 Rs. Income tax is 40%. Answer WACC =10.47% (h)XYZ Ltd has the following capital structure: Equity shares (face value Rs.10 per share)

5,00,000

12% preference shares (Face value Rs. 100 per share)

4,00,000

8% debentures (Face value of Rs. 100 per share)

6,00,000

The company expected to pay dividend of Rs. 2 on equity share at the end of year which is expected to grow at 5% p.a. Current market price of equity share is Rs. 14. The preference share and debentures are being traded at 80% and 70% respectively. The company pays income tax @ 50%. Compute WACC based on book value and market value weights. Answer: WACC(Book Value) 12.7%, WACC (Market Value)14.36%

References: A. Work Cited and Suggested Readings: 1. Khan, M.Y., & Jain, P.K. (2011). Financial Management – Text, Problems and Cases(Sixth edition):TMH 2. Chandra, Prasanna (2008). Financial Management – Theory and Practice(seventh edition): TMH 3. Pandey, I.M.,(2010). Financial Management, Vikas Publications 4. Van Horne, James C., John Wachowicz, Fundamentals of Financial Management ,Pearson education. 5. Ross, Stephen A., Westerfield, Randolph and Jeffery Jaffe, Corporate Finance,TMH 6. Srivastava, Rajiv and Anil Mishra, Financial Management, Oxford University Press. 7. Singh, Preeti. Financial Management, Ane Books Pvt. Ltd. 8. Brealey, Richard A.,& Stewart C. Myers, Corporate Finance, Capital Investment and Valuation, MGH 9. Singh, S. & Kaur, R., (2012) Basic Financial Management, Mayur Paperbacks.

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Cost of Capital B. Web Links: 1. Visit the link http://www.accountingtools.com/cost-of-capital understanding on the concept of cost of capital. 2. Visit the link http://www.janhar.com/images/PDF/mar11.pdf significant of cost of capital in Investment decision making.

to to

gain

an

know

the

3. Visit the link http://web.utk.edu/~jwachowi/mcquiz/mc15.html to take a quiz on the concept of cost of capital. C. Video Links: 1. Visit the link http://www.investopedia.com/video/play/cost-capital/ to understand the concept of cost of capital. 2. Visit the link https://www.youtube.com/watch?v=EQZGqlemTv0 to understand the concept of cost of equity. 3. Visit the link https://www.youtube.com/watch?v=Vdq2jsZwgoo to gain an insight into the concept of cost of preferred stock and debt. 4.

https://www.youtube.com/watch?v=eqklo5TwW14

5.

https://www.youtube.com/watch?v=JKJglPkAJ5o

6.

https://www.youtube.com/watch?v=46oLXwClvkw

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