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Chapter 5 - Cost of Capital SML 401 Btech
Chapter 5 - Cost of Capital SML 401 Btech
1. 2.
Minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price. In economic terms there are two approaches to define CoC: It is the borrowing rate of the firm, at which it can acquire funds to finance the proposed project It is the lending rate which the firm could have earned if the firm would have invested elsewhere
CoC is a combined cost of each type of source by which a firm raises funds.
CoC
Also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard return, etc. Assumption: that the firms business and financial risks are unaffected by the acceptance and financing of projects.
Business risk is the risk to the firm of being unable to cover fixed operating costs. Measured by: (EBIT/EBIT)/ (Sales/Sales) Financial risk is the risk of being unable to cover required financial obligations such as interest, preference dividends. Measured by: (EPS/EPS)/ (EBIT/EBIT)
Importance of CoC
Capital Budgeting Decisions Designing the Corporate Financial Structure Deciding about the method of financing in lieu with
capital market fluctuations Performance of top management Other areas eg., dividend policy, working capital
Measuring CoC
A realistic measure of CoC should have the following qualities of capital expenditure decisions: 1. It must account for the general uncertainty of expected future returns from investment proposals. 2. It must allow for the various degrees of uncertainty of expected future returns associated with different uses of funds. 3. It must allow for the effects of uncertainty associated with an incremental investment and the uncertainty of returns from the entire asset portfolio of the firm. 4. It must account for a variety of financing means available to a firm. 5. It must allow for the differential effects of financing combination on the amount and quality of residual net benefits accruing to shareholders. 6. It must reflect the changes in the capital market.
Cost of Equity Capital: the cost of obtaining funds through the sale of common stock. Cost of Preference Shares Cost of Debt Cost of Retained Earnings
must earn on the equity-financed portion of an investment project in order to leave unchanged the market price of the shares. It is the rate at which investors discount the expected dividends of the firm to determine its share value. The two approaches to measure ke are i. Dividend valuation approach and ii. Capital asset pricing model.
Cost of Equity
Most difficult and controversial cost to work out. Conceptually, the cost of equity ke may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares. The cost of equity capital is higher than that of preference and debt because of greater uncertainty of receiving dividends and repayment of principal at the end.
2 approaches to measure Ke
1. Dividend approach dividend valuation model: assumes that the value of a share equals the present value of all future dividends that it is expected to provide over an indefinite period. Ke accordingly is defined as the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share.
Formula
N
= D1(1+g)n-1/(1+ke)n
n=1
Po(1-f) = D1/(keg) or Ke = (D1/Po) + g; where D1 = expected dividend per share Po = net proceeds per share/current market price g = growth in expected dividends
(1+g2)/(1+ke)3 .+
Note 2: if we limit the dividend payment upto N years,
it has an EPS of Rs.25 and declared a dividend of Rs.15 per share in the current year. Its present P/E ratio is 8. It wants to price the issue at market price and floatation costs are expected to be 10% of the issue price. Determine required rate of return for equity shares before issue and after the issue. How will dividend tax under the Indian Income Tax Act affect your calculations? Cost of present equity: Ke=[EPS/P0(1-f)]=[D1/Po(1-f)]+g=reciprocal of P/E multiple g=%Retimes[EPS/Po(1-f)] Ke=1/8=.125=12.5% OR Ke=15/200+25/200(115/25)=.125=12.5%
Ke=15/200(1-0.10)+[25/200(1-0.10)](115/25)=15/180+(25/180)(0.40)=.1388=13.9% Under new tax laws: Po=D1/(Ke-g) OR Ke=D1/P0+g But 10% tax is paid by company out of profits. Thus, retained earnings or g alone is affected. Thus, revised formula for g is: g=EPS/P0[1-DPS(1+dt)/EPS] or g=[EPS-DPS(1+dt)]/P0 where, dt is dividend tax For existing issue, Ke=D1/P0+[EPS-DPS(1+dt)]/P0 Ke=15/200+[25-15(1+0.1)]/200=15/200+[2516.5]/200=15/200+8.5/200=.1175=11.75%
For further issue of equity, Ke=D1/P0(1-f)+[EPSDPS(1+dt)]/P0(1-f) Ke=15/200(1-0.1)+8.5/200(10.1)=15/180+8.5/200=23.5/180=0.13055=13.1% The new tax laws would result in: a. Lower cost of equity b. Perhaps it would promote investment also.
Current share price P0=Rs.100 Company growth rate: upto 5th year 10% 6-10th year=8% 11th year & beyond=6% Then, P0
5
= 2*1.10(1.1)n-1/(1+ke)n +
n=1
10
D6(1.08)n-1/(1+ke)n +
n=6
D6(1.06)n-1/(1+ke)n +
n=11
expectations regarding the expected returns, variances and correlation of returns among all securities; All investors have the same information about securities; There are no restrictions on investments; There are no taxes; There are no transaction costs; and No single investor can affect the market price significantly.
B. Investors preference assumption is that all investors prefer the security that provides the highest return for a given level of risk or the lowest risk for a given level of return. That is, investors are risk averse.
the securitys risk that is attributable to firm-specific random causes; can be eliminated through diversification. Eg., management capabilities and decisions, strikes, unique government regulations, availability of raw materials, competition.
relevant portion of a securitys risk that is attributable to market factors that affect all firms; cannot be eliminated through diversification. Eg., interest rate changes, inflation or purchasing power change, changes in investor expectations about the overall performance of the economy and political changes. Since diversifiable risks can be eliminated through diversification, investors should be concerned with only non-diversifiable risks.
Market Portfolio
Systematic risk can be measured in relation to
the risk of a diversified portfolio which is commonly referred to as the market portfolio of the market. According to CAPM, the nondiversifiable risk of an investment/security/asset is assessed in terms of the beta coefficient. Beta is the measure of the volatility of a securitys return relative to the returns of a broad-based market portfolio. Beta coefficient of 1 would imply that the risk of the specified security is equal to the market.
Formula
ke = rf + (km rf); Where, ke = cost of equity capital; rf = the rate of return required on a risk free asset/security/investment km = required rate of return on the market portfolio
of assets that can be viewed as the average rate of return on all assets = the beta coefficient. for market portfolios is 1, while it is 0 for risk-free investments.
ke
rm rf 1
in beta. CAPM model suffers from the problem of collection of data. Beta measures only systematic risk. Example: =1.4, rf=8%, km=12%
ke=8%+1.4(12%-8%) =8%+1.4*4%=13.6%
limitations: 1. It does not incorporate floatation costs. 2. Difficult to get values. 3. Poorly diversified investors would be concerned with not only systematic but total risk. So, dividend approach is better.
The shareholders are paid a dividend yearly. Though, this payment is not tax-deductible but the company is required to make payments; since, if it does not pay, it cant pay dividends to the equity holders. Also, preference dividend, if unpaid, gets accumulated over years. Preference shares may be redeemable/irredeemable. (now irredeemable preference shares are not allowed. Have to be redeemed in maximum 10 years) Cost of preference share capital is the annual preference share dividend divided by the net proceeds from the sale of preference shares. Perpetual security (irredeemable) Cost of redeemable preference share
receive dividends over the equity shareholders. Moreover, preference shares are usually cumulative which means that preference dividend will keep getting accumulated unless it is paid. Further, non-payment of preference dividend may entitle their holders to participate in the management of the firm as voting rights are conferred on them in such cases. Above all, the firm may encounter difficulty in raising further equity capital mainly because the non-payment of preference dividend adversely affects the prospects of ordinary shareholders.
A. Irredeemable (perpetual)
kp=dp/P0(1-f); where,
dp=constant annual dividend, P0=expected sales price of preference share f= floatation costs Example: a 12% irredeemable preference share of face value of Rs.100, f=5%. What is kp if preference share issued at i. par, ii.10% premium, iii. 10% discount i. At par, kp=12/100(1-0.05)=12/95=12.63% ii. At 10% premium, kp=12/110(1-0.05)=11.48% iii. At 10% discount, kp=12/90(1-0.05)=14.03%
Example: 14% preference dividend on face value of Rs.100 to be redeemed after 10 years. Floatation cost is 5%. Kp?
N
Cost of Debt
Debt is the cheapest form of long-term debt from the companys point of view as: Its the safest form of investment from the point of view of creditors because they are the first claimants on the companys assets at the time of its liquidation. Likewise they are the first to be paid their interest. Another, more important reason for debt having the lowest cost if the tax-deductibility of interest payments.
Cost of Debt
It is the interest rate which equates the present value
of the expected future receipts with the cost of the project. The present value of tax-adjusted interest costs plus repayments of the principal is equated with the amount received at the time the loan is consummated.
Cost of Debt
Cost of debt is the after-tax cost of long-term funds through borrowing.
Net cash proceeds are the funds actually received from the sale of security. Flotation cost is the total cost of issuing and selling securities. Cost of perpetual/irredeemable debt Cost of redeemable debt
iii. At a premium of 10%, that is value received is 110,000. ki=12000/110,000=10.91% kd=10.91%(1-0.5)=5.45% So here (ii) 6.32% is highest cost followed by (i) 6% or (iii) 5.45%.
Co= In/(1+kd)n +PN/(1+kd)N ; if principal payment is made n=1 at the end of Nth year
Or,
n=1
installments
redeemed after 10 years. Net proceeds are after 5% floatation costs and 5% discount. The tax rate is 50%. What is the cost of debt? Year Cashflows 0 1000-5%of 1000(floatation)-5%ofdiscount =900 1-10 Rs. 15% of 1000(1-0.5)=Rs.75 10 Rs. 1000 (repayment)
10
By trial and error; kd =9% approx. Note: ki route is preferred over kd route.
rate=15%). The par value of debenture is Rs.100000. the floatation cost is 10%. Principal to be paid back in 5 equal installments at the year end. Tax rate is 50%. Net proceeds=100000-10%=90000 Outflows: Net coupon Principal Total Yr 1 15000(1-0.5)=7500 20000 27500 Yr 2 80000*.15(1-0.5)=6000 20000 26000 Yr 3 60000*.15(1-0.5)=4500 20000 24500 Yr 4 40000*.15(1-0.5)=3000 20000 23000 Yr 5 20000*.15(1-0.5)=1500 20000 21500 So, 90000=27500/(1+kd)+26000/(1+kd)2 +24500/(1+kd)3 +23000/(1+kd)4 +21500/(1+kd)5 By trial and error, kd=12% approx
dividends foregone by/withheld from the equity shareholders. Cost of retained earnings is the same as the cost of an equivalent fully subscribed issue of additional shares, which is measured by the cost of equity capital. Retained earnings are dividends withheld, that is, if were in the hands of the investors (shareholders) they could have earned on these by investing somewhere else. The assumption is that the firm is earning at least equal to ke on these retained earnings. So the cost kr is approximately equal to ke (a little less than ke because of floatation costs are not there, kr<ke)
Weighting can be using marginal or historical weights Why marginal weights? Because it is the new capital being raised for new investment that is important so the weighted cost of new capital is of relevance. Else, projects with costs higher than managerial costs may be accepted, giving negative results and vice-versa. But the problem is that if we go by marginal weighting, we may resort to too much borrowing and accept many projects because of lower cost at the moment. But, at a later date, company may have the problem of raising more finance. Marginal weights ignore long term view. Thus, the fact that todays financing affects tomorrows costs, is not considered in using marginal weights.
raise financing also in the proportion of existing capital structure considered superior. Historical weights can be divided into book value weights and market value weights. Calculations based on the book value weights are more easy operationally while those based on market values are more sound theoretically since the sale price of securities is going to be more close to the market value. But the problem is how to choose the market value because they fluctuate widely sometimes and almost everyday their values are different.
Debt 30% (Rs.6000) Preference shares 30% (Rs.6000) Equity 40% (Rs.8000)
Ko=WACC= wiki=30%*8%+30%*13%+40%*14%
=2.4%+3.9%+5.6%=11.9%
Note: ko calculated on the basis of market value is likely to be greater than the one calculated on the basis of book value since market values of equity and preference shares is usually higher than book value and hence their weight is more with respect to debt. For example, in the above example, market values are:
Debt 25% (Rs.60000) cost kd=8% Preference shares 29.17% (Rs.70000) cost kp=13% Equity 45.83% (Rs.110000) cost k=14% Total=240000 Ko=WACC= wiki=0.25*0.08+0.2917*0.13+0.4583*0.14=0.0200+0.03 792+0.06416=0.122082=12.21%
MV sometimes preferred to BV for the MV represents the true expectations of the investors. However, it suffers from the following limitations: 1. MV undergoes frequent fluctuations and have to be normalized; 2. The use of MV tends to cause a shift towards larger amounts of equity funds, particularly when additional financing is undertaken.
actual amount to be received from their sale Costs of specific sources of finance which constitute the capital structure of the firm are calculated using prevalent market prices.
Advantages of BV weights
The capital structure targets are usually fixed in terms of book value. 2. It is easy to know the book value. 3. Investors are interested in knowing the debtequity ratio on the basis of book values. 4. It is easier to evaluate the performance of a management in procuring funds by comparing on the basis of book values.
1.
b. Implicit cost: is the opportunity cost. It is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm were accepted. It is not concerned with any particular source of finance.
The explicit cost include only the CoC to be paid and ignores the other factors such as risk involved, flexibility and leverage characteristics which are adversely affected with an increase in debt contents in its capital structure and these changes imply additional but hidden costs.
of return and compare it with the expected (future) cost of capital while making capital expenditure decision. Historical costs (past costs) help in predicting the future costs and provide an evaluation of the past performance