Cost of Capital & Capital Structure

Cost of Capital: Cost of capital refers to the opportunity cost of making a

specific investment. It is the rate of return that could have been earned by putting the
same money into a different investment with equal risk. Thus, the cost of capital is the rate of
return required to persuade the investor to make a given investment. It is the required return
necessary to make a capital budgeting project, such as building a new factory, worthwhile.

Components of Cost of Capital

1: Equity shares/Common stock/Ordinary shares: It is the most important

sources of finance for fixed capital and it represents the ownership capital of a firm. The
salient features of this issue are that the equity shareholders are to bear all losses or run risks
that may arise as owner of the company. They are entitled to the residue (surplus) that is left
after the fixed rate of preference dividend and debenture interest is paid of course, the
dividend so received depends on recommendation made by the directors Since they are the
owners of the company they enjoy the rights and exercise control. Cost of common stock is
usually calculated as:

i: Using CAPM model: rs = RRF + (RM– RRF) B

ii: Using Dividend model:

rs = (Dividend per share for next year/Current market price) Growth rate of
dividend

OR

rs = (D1 / MV) G

Where: Growth = ROE (Retention ratio)

Advantages:

 It does not impose any burden 011 the economic activities of the company since no
dividend is declared and paid if there is no sufficient profit.
 The company can acquire fixed assets which may be utilized throughout its life by
issuing such shares. On the contrary, it is non-refundable (expect in case of
liquidation) and does not create any charge.
  Long-term loans can be taken by pledging fixed assets which are acquired by the issue
of equity shares.
 Controlling power will remain in the hands of the equity shareholders if the equity
share capital is greater than other loan/debt capital As a result, instability is decreased.
 Equity shareholders earn more dividend than preference shareholders if there is
sufficient profit.

Disadvantages:

 If the entire capital structure consists of equity shares only, the equity shareholders
may try to control the entire undertaking which may be inimical to the interests of the
latter.
 If excess capital is invested in the business by way of equity shares, the same may
result in idle capital which increases cost and at the same time leads to over-
capitalisation.
 The investors who do not want to take any risks or who want to be assured regarding
the rate of return on their investments do not like to prefer equity shares since the
return on investments is not guaranteed.
 Trading on equity is not possible if the entire capital structure is composed of equity
shares.

2: Preferred stock: These are also called Preference Shares since the preference
shareholders are entitled to receive a fixed rate of dividend before the dividend is received by
the equity shareholders as also to priority of repayment of capital before the equity
shareholders in the event of liquidation. Firms may resort to this technique as long-term
capital owing to the above advantages. Since they have no voting rights, they do not have to
take any risk and, hence, ownership is not affected. Cost of Preferred stock is usually
calculated as:

rp = (Dividend per year/ Net Price of stock)

OR

rp = (D1 / P0)

Advantages:

 It does not cause any economic burden on the company.

 The rate of equity dividend can be increased by the issue of such shares as fixed rates
of dividend is paid on these shares (which is less) and the surplus may be declared in
the form of dividend or the retention may be increased, i.e., the benefit of trading on
equity is possible.
 Controlling right is not transferred since preference shareholders have no voting
rights.
 The investors prefer this type of share since the rate of dividend is fixed and have got
priority as regards repayment of capital.
 These shares are helpful for raising funds for a long period since they do not create
any charge over the assets.

Disadvantages:

 The dividend paid on Preference Shares in not an allowable deduction at the time of
computing taxable income. As a result, cost of capital is increased in comparison with
Debenture and others.
 The promoters — by investing a smaller part of capital through equity shares — can
control the entire undertaking by issuing these shares.

Types of Preference Shares:

a: Redeemable: These shares are redeemed at the end of the stipulated period. In India,
according to Section 80 of the Companies Act, 1956, these shares are redeemed either out
of fresh issue of equity shares or by creating Capital Redemption Reserve Fund out of
Profit and Loss Account and/or General Reserve, a sum equal to the face value of the
shares.

But premium on redemption of preference shares, if any, is to be adjusted against Share

Premium Account and/or Profit and Loss Account.

b. Irredeemable: These shares are non-refundable to the holders during the lifetime of
the firm.

c. Cumulative: If, in any year, the dividend on Preference Shares is not paid due to
insufficient profit or loss, the arrear dividends, together with the current one, will be paid
at a time out of sufficient profits in subsequent years, i.e., arrear dividends will
accumulate.
 d. Non-Cumulative: Dividend, if it is not paid due to insufficient profit in any year,
cannot be claimed by the shareholders, i.e., arrear dividends will not accumulate. But they
are to be treated at par with other preference shareholders regarding repayment of capital.

e. Convertible: Convertible Preference Shares are those which can be converted into
equity shares within a stipulated period of time.

f. Non-Convertible: Preference Shares which are not converted into equity shares are
called Non-Convertible Preference Shares.

g. Participating: In spite of having a fixed rate of dividend, these shareholders share in

the surplus of the company which may influence an investor to invest in this type of
Preference Shares.

h. Non-Participating: It is nothing but the Ordinary Preference Shares which carry only
the fixed rate of dividend.

3: Retained Earnings: Retained Earnings (RE) are the portion of a business's profits.
While it is arrived at through the income statement, the net profit is also used in both the
balance sheet and the cash flow statement. that are not distributed as dividends to
shareholders but instead are reserved for reinvestment back into the business.

4: Debentures/Bonds: A Debenture may be defined as an instrument executed by a

company under its common seal acknowledging indebtedness to some person to persons or
secure the sum advanced Debentures are called Creditor-ship Securities as these constitute
borrowed and/or loan capital of the company. A Debenture may be issued at par, at a
discount or at a premium, i.e., these are issued in the same manner as shares. The Debentures
is one of the important sources of raising finance for a company. In order to meet the initial
needs, a company can issue Debentures to secure long-term finance. Cost of debt is
calculated as:

i: Cost of debt (before Tax)

rd = (Total interest payments / Total outstanding debt) 100

ii: Cost of Debt (After Tax)

ri = rd (1-Tax )

Advantages
 It is desirable to raise a part of long-term finance by issuing Debentures since they can
help Trading on equity.
 Control of ownership and management in the firm is not at all affected since
Debenture-holders have no voting rights.
 Interest paid on Debentures is an allowable deduction in computing total taxable
income under the Income Tax Act.
 Flexibility in the capital structure is possible when Debentures are redeemed out of
surplus fund (i.e., from Reserve or Undistributed Profits).
 Since a fixed rate of interest is paid every year, the cautious investors prefer to invest
the money in Debentures rather than in shares.

Disadvantages

 The heavy stamp duty, duty on transfer, commission and brokerage add up to a big
amount which makes the cost of raising capital very high.
 If it is found that the rate of Debentures interest is higher than that of return on equity
capital, the issue of Debentures is not justified, since, in that case, the rate of return on
equity share capital will be reduced.

Types of Bonds/Debentures:

a. Redeemable: Redeemable Debentures are those which are redeemed either at par or at
a discount or at a premium after the expiry of the stipulated period. The same can be re-
issued even after redemption if not cancelled.

b. Irredeemable: These Debentures are not redeemed until and unless the company goes
into liquidation.

c. Convertible: Sometimes Debentures can be converted into Preference shares or Equity

shares at a fixed rate of exchange after a certain period. Such Debentures are called
Convertible Debentures.

d. Bearer: These Debentures are just like negotiable instruments and are transferable by
simple delivery, i.e., transfer of Debentures is not to be registered with the company.
Interest is paid at the end of the stipulated period to the person who will possess them,
i.e., interest is paid to the holders irrespective of identity.
 e. Registered: Here, the transfer of Debentures will be effected on execution of a transfer
deed or interest is payable or the repayment of Debentures is made to that person whose
name is registered in the books of the company.

f. Mortgage: When Debentures are secured by a charge on the assets of the company,
these are known as Mortgage Debentures.

g. Blank: When Debentures are issued without any security (i.e., Unsecured Debentures)
in respect of interest or the repayment of the principal, they are called Naked Debentures.
Solvency of the company is the only security.

Significance and relevance of cost of capital

1: Investment evaluation: The primary objective of determining the cost of capital is to
evaluate a project. Various methods used in investment decisions require the cost of capital as
the cut-off rate. Under net present value method, profitability index and benefit-cost ratio
method the cost of capital is used as the discounting rate to determine present value of cash
flows. Similarly a project is accepted if its internal rate of return is higher than its cost of
capital. Hence cost of capital provides a rational mechanism for making the optimum
investment decision.

2: Designing Debt Policy: The cost of capital influences the financing policy decision, i.e.
the proportion of debt and equity in the capital structure. Optimal capital structure of a firm
can maximize the shareholders’ wealth because an optimal capital structure logically follows
the objective of minimization of overall cost of capital of the firm. Thus while designing the
appropriate capital structure of a firm cost of capital is used as the yardstick to determine its
optimality.

3: Project Appraisal: The cost of capital is also used to evaluate the acceptability of a
project. If the internal rate of return of a project is more than its cost of capital, the project is
considered profitable. The composition of assets, i.e. fixed and current, is also determined by
the cost of capital. The composition of assets, which earns return higher than cost of capital,
is accepted.

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.

To calculate WACC the analyst will multiply the cost of each capital component by its
proportional weight. The sum of these results is, in turn, multiplied by the corporate tax rate,
or 100%. WACC = (wd)(rd) + (ws)(rs) + (wps)(rps) + (wre)(rre)

Capital Structure
The capital structure of a company is the way a company finances its assets. A company can
finance its operations by either equity or different combinations of debt and equity. The
capital structure of a company can have a majority of the debt component or a majority of
equity, or an even mix of both debt and equity. Each approach has its own set of advantages
and disadvantages.

Capital Structure Theories

1: Irrelevance Theory/ Modigliani and Miller (MM) Propositions: It is a theory of
corporate capital structure that explains that financial leverage does not affect the value of a
company, if income tax and distress costs are not present in the business environment. The
irrelevance proposition theorem was developed by Merton Miller and Franco Modigliani, and
was a premise to their Nobel Prize-winning work, “The Cost of Capital, Corporation Finance,
and Theory of Investment.” This approach was devised by Modigliani and Miller during the
1950s. The fundamentals of the Modigliani and Miller Approach resemble that of the Net
Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy
theory, which suggests that the valuation of a firm is irrelevant to the capital structure of a
company. Whether a firm is highly leveraged or has a lower debt component in the financing
mix has no bearing on the value of a firm.

Modigliani and Miller (MM) Approach: The Modigliani and Miller Approach further states
that the market value of a firm is affected by its operating income, apart from the risk
involved in the investment. The theory stated that the value of the firm is not dependent on
the choice of capital structure or financing decisions of the firm.

Assumptions of MM proposition:
  There are no taxes.
 Transaction cost for buying and selling securities, as well as the bankruptcy cost, is
nil.
 There is a symmetry of information. This means that an investor will have access to
the same information that a corporation would and investors will thus behave
rationally.
 The cost of borrowing is the same for investors and companies.
 There is no floatation cost, such as an underwriting commission, payment to merchant
bankers, advertisement expenses, etc.
 There is no corporate dividend tax.

2: Pecking Order Theory (POT):

The Pecking Order Theory, also known as the Pecking Order Model, relates to a company’s
capital structure. Suggested by Donaldson in 1991 and later modified and made popular by
Stewart Myers and Nicolas Majluf in 1984, the theory states that managers follow a hierarchy
when considering sources of financing. The pecking order theory states that managers are
given a preference to fund investment opportunities using three sources:

i: Retained Earnings ii: debt iii: Equity financing

The pecking order theory arises from the concept of asymmetric information. Asymmetric
information, also known as information failure, occurs when one party possesses better
information than the other party, which causes an imbalance in transaction power.

Company managers typically possess more information regarding the company’s

performance, prospects, risks, and future outlook than external users such as creditors
(debtholders) and investors (shareholders). Therefore, to compensate for information
asymmetry, external users demand a higher return to counter the risk that they are taking. In
essence, due to information asymmetry, external sources of finances demand a higher rate of
return to compensate for risk.

3: Trade Off Theory/Static Trade Off Theory:

The trade-off theory states that the optimal capital structure is a trade-off between interest tax
shields and cost of financial distress. The trade-off theory of capital structure is the idea that a
company chooses how much debt finance and how much equity finance to use by balancing
the costs and benefits. The classical version of the hypothesis goes back to Kraus and
Litzenberger (1973) who considered a balance between the dead-weight costs of bankruptcy
and the tax saving benefits of debt. Often agency costs are also included in the balance. This
theory is often set up as a competitor theory to the pecking order theory of capital structure. A
review of the literature is provided by Frank and Goyal. An important purpose of the theory
is to explain the fact that corporations usually are financed partly with debt and partly with
equity. It states that there is an advantage to financing with debt, the tax benefits of debt and
there is a cost of financing with debt, the costs of financial distress including bankruptcy
costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding
disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal
benefit of further increases in debt declines as debt increases, while the marginal cost
increases, so that a firm that is optimizing its overall value will focus on this trade-off when
choosing how much debt and equity to use for financing.