Name: Hashmi Hareshbhai Sutariya

Subject name: financial management

Roll no: 33 MBA – semester (2) Division : A

Institute name: S.K Patel institute of management

Question: 1 Define cost of capital (WACC), cost of debt, cost of equity, cost of preference share
in detail.

Cost of capital (WACC)

Definition Weighted Average Cost of Capital – WACC?

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which
each category of capital is proportionately weighted. All sources of capital, including common
stock, preferred stock, bonds, and any other long-term debt, are included in a WACC
calculation.

A firm’s WACC increases as the beta and rate of return on equity increase because an increase
in WACC denotes a decrease in valuation and an increase in risk.

The purpose of WACC is to determine the cost of each part of the company’s capital
structure based on the proportion of equity, debt, and preferred stock it has. Each component
has a cost to the company. The company pays a fixed rate of interest on its debt and a fixed
yield on its preferred stock. Even though a firm does not pay a fixed rate of return on common
equity, it does often pay dividends in the form of cash to equity holders.

The weighted average cost of capital is an integral part of a DCF valuation model and, thus, it is
an important concept to understand for finance professionals, especially for investment
banking and corporate development roles. This article will go through each component of the
WACC calculation.

Cost of capital does not refer to the cost of some specific source in the financial decision-
making. It should be the over- all cost of all sources and we should consider the weighted cost of
capital. Weights are given in proportion to each source of funds in the capital structure ; then
weighted average cost of
capital is calculated. For calculating the weighted average cost of capital, we should know the
capital structure of the company.

The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of
capital. It had been used by many firms in the past as a discount rate for financed projects, since
using the cost of the financing seems like a logical price tag to put on it Companies raise money
from two main sources: equity and debt. Thus the capital structure of a firm comprises three
main components: preferred equity, common equity and debt (typically bonds and notes). The
WACC takes into account the relative weights of each component of the capital structure and
presents the expected cost of new capital for a firm.

How do we find out the values of the components in the formula for WACC? First let us note
that the "weight" of a source of financing is simply the market value of that piece divided by the
sum of the values of all the pieces. For example, the weight of common equity in the above
formula would be determined as follows:

Market value of common equity / (Market value of common equity + Market

value of debt +Market value of preferred equity)

So, let us proceed in finding the market values of each source of financing (namely the debt,
preferred stock, and common stock)

The market value for equity for a publicly traded company is simply the price per share
multiplied by the number of shares outstanding, and tends to be the easiest component to find
The market value of the debt is easily found if the company has publicly traded bonds.

Frequently, companies also have a significant amount of bank loans, whose market value is not
easily found. However, since the market value of debt tends to be pretty close to the book value
(for companies that have not experienced significant changes in credit rating, at least), the book
value of debt is usually used in the WACC formula The market value of preferred stock is again
usually easily found on the market, and determined by multiplying the cost per share by number
of shares outstanding

Now, let us take care of the costs Preferred equity is equivalent to perpetuity, where the holder is
entitled to fixed payments forever. Thus the cost is determined by dividing the periodic payment
by the price of the preferred stock, in percentage terms The cost of common equity is usually
determined using the capital asset pricing model.

The cost of debt is the yield to maturity on the publicly traded bonds of the company. Failing
availability of that, the rates of interest charged by the banks on recent loans to the company
would also serve as a good cost of debt.

Since a corporation normally can write off taxes on the interest it pays on the debt, however, the
cost of debt is further reduced by the tax rate that the corporation is subject to.

Thus, the cost of debt for a company becomes (YTM on bonds or interest on loans) × (1 − tax
rate).

In fact, the tax deduction is usually kept in the formula for WACC, rather than being rolled up
into cost of debt, as such

WACC = weight of preferred equity × cost of preferred equity + weight of common equity × cost
of common equity + weight of debt × cost of debt × (1 − tax rate)

Cost of equity
This is the largest source of finance to any limited company and usually forms the base on which
other finances are raised. Equity is the total sum of the company’s ordinary share capital plus the
company’s retained earnings also known as revenue reserves.

It is sometimes argued that the equity capital is free of cost. The reason for such argument is
that it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike
the interest rate or preference dividend rate, the equity dividend rate is not fixed. It is fallacious
to assume equity capital to be free of cost. As we have discussed earlier, equity capital involves
an opportunity cost; ordinary shareholders supply funds to the firm in the expectation of
dividends and capital gains commensurate with their risk of investment. The market value of
the shares determined by the demand and supply forces in a well functioning capital market
reflects the return required by ordinary shareholders. Thus, the shareholders’ required rate of
return, which equates the present value of the expected dividends with the market value of the
share, is the cost of equity. The cost of external equity would, however, be more than the
shareholders’ required rate of return if the issue prize where difference from the market price
of the shares.

In practice, it is a formidable task to measure the cost of equity. The difficulty bribes from two
factors;

1) It is very difficult to estimate the expected dividends.

2) The future earnings and dividends are expected to grow overtime.

Growth in dividends should be estimated and incorporated in the computation of the cost of
equity. The estimation of growth is not an easy task. Keeping these difficulties in mind, the
methods of computation the cost of internal and external equity are discussed next posts.

Ordinary Share Capital

It is that finance contributed by the ordinary shareholders of a business. This is raised through
the sale of the company‟s ordinary shares. It is finance contributed by real owners of the
company. This finance is only raised by limited companies. It is permanent finance to the
company and can only be refunded in the event of liquidation, i.e. in Kenya; a company cannot
buy back its own shares (ordinary shares).
This finance is paid ordinary dividends as return to the shareholder‟s investment. Ordinary
shares carry rights and usually each share is equal to one vote exercised in Annual General
Meetings.
Ordinary shares are quoted at the stock exchange where they are sold and bought by the public
through brokers. Ordinary share capital carries the highest risks in the company because it gets
its return after other finances have got theirs, and also in the event of liquidation it is paid last
(their voting right is assumed to be used wisely to minimize these risks.)
Ordinary dividends are not a legal obligation on the part of the company to pay. If the
company‟s profits are good, ordinary shareholders get the highest return because their
dividends are varied. This is the only type of finance that grows with time and this growth is
technically called growth in equity which is facilitated by retention of earnings.

Features of Ordinary share Capital

 It is a permanent finance to the company which can be refunded only during liquidation.
 It is the largest source of finance to the Ltd Company.
 This finance has a residual claim on profits and assets during liquidation.
 Ordinary share capital is entitled to voting powers, each share usually being equal to one
vote.
 This finance carries a varied return i.e. its dividends will vary with the profits made.
 Ordinary share capital carries no nominal cost to the company. i.e. dividends on ordinary
share capital are not a legal obligation to the company to pay.
 It is the only finance which will grow with time as a result of retention.
 This finance cannot force the company into liquidation i.e. it does not increase its
gearing; on the contrary, it decreases the gearing.
 It can be raised by limited companies only.

Advantages of Using Ordinary Share Capital by a Company

 Being a permanent finance the company will invest it in long term ventures without
inconveniencies of paying it back.
 Dividend payment (to ordinary shareholders) is not a legal obligation to the company, thus no
threat to liquidity of the company.
 This type of finance contributes valuable ideas towards the running of the company during the
Annual General Meeting.
 This finance is available in large amounts in particular if the company is quoted on the stock
exchange in which case it can raise substantial amounts of money to finance the company‟s
operations.

Disadvantages of Using Ordinary Share Capital to a Company

 The cost of ordinary share capital (ordinary dividend is paid in perpetuity).
 This finance may disorganize a company‟s policy in case shareholders‟ votes are cast against
the company‟s present operations and policies.
 It does involve a lot of formalities in its raising and it may take a long time to raise as the
company has to obtain permission from the capital market authority and other regulators.
 It is very expensive to raise as it involves a lot of costs commonly known as floatation costs
e.g. printing the prospectus and share certificates, advertising expenses, cost of underwriting the
issue, brokerage costs, legal fees, auditor‟s fees, cost of communication.
 The issue of ordinary share capital means that the company‟s secrets will be exposed to the
public through published statements which may be dangerous from competitors point of view.

Po=DIV1/ke-g

DIV=DIV0(1+g)
Preference Share Capital
This is finance contributed by quasi-owners or preference share holders. It is so called quasi-
equity because it combines features of debt finance and those of equity finance.
Preferred stock differ form common stock because it has preference over common stock in the
payment of dividends and in the distribution of corporation assets in the event of liquidation.
Preference means only that the holders of the preferred shares must receive a dividends (in the
case of an ongoing firm) before holders of common share are entitled to anything. Preferred
stock is a form of equity form a legal and tax stand point. It is important to note. However, the
holders of preferred stock sometimes have no voting privilege. Preferred stock is sometimes
convertible in to common stock and is often callable. So we can say that preferred stock is a
hybrid form of financing combing features of debt and common stock.
 It is called preference share capital because it is accorded preferential treatment over
ordinary shareholders in terms of,

(a) Sharing in dividend- It receives its dividend before those of ordinary shareholders. Thus it is
said to be preferred to dividends.
(b) It is accorded preferential treatment in sharing of assets in the event of liquidation. Preference
shareholders get their claims on asset before ordinary shareholders get theirs. Thus it is said to be
preferred to assets.
In order for a share to be called a preference share it must be accorded the above preferential
treatment over and above ordinary share capital.
Advantages of Preferred Stock
By using preferred stock a firm can fix its financial cost and still avoid the danger or bankruptcy
if earnings are too low to meet these fixed charges. This is because preferred stock earners a
dividend but the company has discretionary power to pay it. The omission of payment doesn‟t
result in default.
Disadvantages of Preferred Stock
It has a higher after tax cost of capital that debt. The major reason for this higher cost is taxes
preferred dividends are no deductible for tax purpose, whereas interest expense on debt is
deductible.

If the preference shares are irredeemable then both will be permanent sources of finance to the
company.

 In case the preference share capital is irredeemable both will receive dividends in perpetuity.
Cost of Irredeemable preference shares

1)Irredeemable preference shares : are those shares issuing by which the company has no
obligation to pay back the principal amount of the shares during its lifetime. The only liability of
the company is to pay the annual dividends. The cost of irredeemable preference shares is:

Kp (cost of pref. share) = Annual dividend of preference shares/ Market price of the preference
stock

2) Cost of Redeemable preference shares

Redeemable preference shares are those shares which have a fixed maturity date at which they
would be redeemed.

Cost of Redeemable preference shares = Annual Dividen Number of years for redemption d +
(Redeemable Value - Sale value) / (Redeemable Value + Sale value) / 2

                         Or

Kp =( D +(RV - SV) / N) / ((RV + SV) / 2)

cost of debt:
Cost of debt is the interest rate that the company pays on its debt content of the capital
structure. It can be measured as before tax cost of debt or after tax cost of debt. Tax plays an
important role as the debenture interest expense is allowed as an expense for tax purposes.
Debt may be issued at par, at premium or at a discount. It may be irredeemable or redeemable.

a)Cost of Capital - Debt Issued at Par

The before tax cost of debt is the rate of return required by lenders. It is easy to compute
before tax cost of debt issued and to be redeemed at par,
It is simple equal to the conceptual of interest.            

Kd =i = Interest / Bo

Where Kd is the before tax cost of debt, i is the coupon rate of interest, Bo is the issue price of
the bond and in equation it is assumed to be equal to the face value, and interest is the amount
of interest. The amount of interest payable to the lender is always equal to:

Interest = Face value of debt X Interest rate

b)Cost of Capital – Debt Issued at Discount or Premium

Calculate the cost of capital using equation given below,

Bo = (INT1 /(1+Kd)1) + (INT2 / (1+Kd)2)----------------------------(INTn / (1+Kd)n) + (Bn / (1+Kd)n

Where Bn is repayment of debt on maturity and other variables.

Calculate the cost of capital of debt whether debt is issued at discount or premium the
following equation can be used,

Kd = (INT + 1/n (F-Bo)) / (1/2 (F+Bo))

It should be clear from the preceding discussion that the before tax cost of bond to the firm is
affected by the issue price. The lower the issue price, the higher will be the before tax cost of
debt. The highly successful companies may sell bond or debentures at a premium, this will pull
down the before tax cost of debt.

c) Cost of Capital – Cost of Debt Tax Adjustment

The Interest paid on debts is tax deductible. The higher the interest charges, the lower will be
the amount of tax payable by the firm this implies that the government indirectly pays a part of
the lender’s required rate of return. As a result of the interest tax shield, the after tax cost of
debt to the firm will be substantially less than the investor’s required rate of return. The before
tax cost of debt, Kd should, therefore be adjusted for the tax effect as followers:

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

It should be noted that the tax benefit of interest deductible would be available only when the
firm is profitable and is paying taxes. And unprofitable firm is not required to pay any taxes. It
would not gain any tax benefit associated with the payment of interest, and its true cost of debt
is the before tax cost.

It is important to remember that in the calculation of the average cost of capital, the after tax
cost of debt must be used not the before tax cost of debt.

d)Cost of Capital – Cost of Existing Debt

Sometime a firm may like to compute the “current” cost of its existing debt. In such a case, the
cost of debt should be approximate by the current market yield of the debt.