Cost of Capital

BALANCE SHEET
Liabilities Current Liabilities Long-term debt Preference Capital Equity Capital Retained Earnings Assets Current assets Fixed assets

The financing decision

Liabilities & Equity Current Liabilities Long-term debt Preference Capital Equity Capital Retained Earnings

Assets Current assets Fixed assets

The Investment Decision

Liabilities & Equity Current Liabilities Long-term debt Preferred Stock Common Equity

Assets Current assets

Capital Structure

 For

Investors the rate of return on a security is a benefit of investing. the Company that same rate of return is a cost of raising funds that are needed to operate the firm.

For

In

other words, the cost of raising funds is the firms cost of capital.

How can the firm raise capital?

Debt Preference

Capital Equity Capital Each of these offers a rate of return to investors This return is a cost to the firm Cost of capital actually refers to the weighted cost of capital - a weighted average cost of financing sources

Cost of capital can be defined as the minimum rate of return that the firm must earn on its investment for the market value of the firm to remain unchanged.

The Weighted Cost of Capital

To

calculate the firms weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt Cost of Preference Capital Cost of Equity Capital

Cost of Debt

Cost of Debt
For the issuing firm, the cost of debt is: the rate of return required by investors adjusted for flotation costs (any costs associated with issuing new bonds), and adjusted for taxes

Example: Tax effects of financing with debt

with stock 400,000 0 400,000 (136,000) 264,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000

EBIT - interest expense EBT - taxes (34%) EAT

Example: Tax effects of financing with debt

EBIT - interest expense EBT - taxes (34%) EAT

with stock 400,000 0 400,000 (136,000) 264,000

with debt 400,000 (50,000) 350,000 (119,000) 231,000

Now, suppose the firm pays $50,000 in dividends to the stockholders

Example: Tax effects of financing with debt

with stock EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) EAT 264,000 - dividends (50,000) Retained earnings 214,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000

After-tax cost of Debt

Before-tax cost of Debt

Tax Savings

After-tax cost of Debt

=
=

Before-tax cost of Debt

Tax Savings

33,000

50,000

17,000

After-tax cost of Debt

=
=

Before-tax cost of Debt

Tax Savings

33,000 OR

50,000

17,000

After-tax cost of Debt

=
=

Before-tax cost of Debt

Tax Savings

33,000 OR 33,000

50,000 50,000 ( 1 - .34)

17,000

After-tax cost of Debt

=
=

Before-tax cost of Debt

Tax Savings

33,000 OR 33,000

50,000 50,000 ( 1 - .34)

17,000

Or, if we want to look at percentage costs:

After-tax % cost of Debt

Before-tax % cost of Debt

1-

tax rate

After-tax % cost of Debt

Before-tax % cost of Debt

1-

tax rate

Kd

kd (1 - T)

After-tax % cost of = debt

before-tax % cost of debt

tax rate

Kd

= =
=

kd (1 - T) .10 (1 - .34) .066

Cost of debt is the discount rate that equates the present value of post-tax interest and principle repayments with the net proceeds of the debt issue

C( 1 T) F P t n ( 1 kd ) t 1 ( 1 k d )
n

For Perpetual Debt - Cost of Debt

C (1 T ) kd P

Problem
A company has 15% perpetual debt of Rs 1,00,000. The tax rate is 35%. Determine the cost of capital (before tax & after tax) assuming the debt is issued at : A at par B at 10% discount C at 10% premium

At par: Before Tax cost: After Tax cost:

15000/100000 = 15% 0.15*(1-0.35) = 9.75%

At discount: Before Tax cost: After Tax cost:

15000/90000 = 16.7% 0.167*(1-0.35) = 10.85%

At premium: Before Tax cost: After Tax cost:

15000/110000 = 13.6% 0.136*(1-0.35) = 8.84%

Example: Cost of Debt

Prescott

Corporation issues a $1,000 par, 20 year bond paying the market rate of 10%. Coupons (interest) are annual. The bond will sell at par, but flotation costs amount to $50 per bond. The tax rate is 34%.
is the pre-tax and after-tax cost of debt for Prescott Corporation?

What

 Pre-tax

cost of debt: 950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd) kd = 10.61%
After-tax

cost of debt: Kd = kd (1 - T) Kd = .1061 (1 - .34) Kd = .07 = 7%

Approximation for after tax cost of debt

( F P) C (1 T ) n kd ( F P) 2

Problem

Vikas limited issues 14% debentures, Face value Rs.100. The net amount realized per debenture is Rs.94. The debentures are redeemable at par after 10 years. The firm pays 50% tax on its income. What is the cost of debt?

7.88%

Cost of Preferred Capital

Redeemable Preference Capital

D F P t n (1 k p ) t 1 (1 k p )
Approximation

kp

D (F P) / n (F P) / 2

Cost of Perpetual Preferred Capital

kp =

D Po

Dividend Net amount realized

Example: Cost of Preferred

If

Prescott Corporation issues preferred capital, it will pay a dividend of $8 per year and should be valued at $75 per share. If flotation costs amount to $1 per share, what is the cost of preferred capital for Prescott?

Cost of Preferred Capital

D Po 8.00 74.00 Dividend Net Price

kp =

10.81%

Cost of Equity
The

cost of equity capital, may be defined as the minimum rate of return that the firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares (or net proceeds of the sale).

Cost of Equity
Dividend Capitalization Method

D1 D2 D Po ... 2 (1 ke ) (1 ke ) (1 ke )
If , D1 D2 ... D
ke D1 P o

Cost of Equity
Dividend Growth Model If Dividend is growing @ g% per year then,
Do (1 g )1 Do (1 g ) 2 Do (1 g ) n P0 ... 1 2 (1 ke ) (1 ke ) (1 ke ) n

t 1

D1 (1 g ) t (1 ke )

t 1

P o

D1 ke g

D1 ke g P0

Assumptions: market value of shares depends upon the expected dividends Do>0 dividend pay-out ratio is constant

Example
Suppose

that dividend per share of a firm is expected to be Rs.1 per share and is expected to grow at 6% per year perpetually. Determine the cost of equity capital, assuming the market price per share is Rs. 25 1/25 + .06 = 10.0%

Weighted Cost of Capital

The

weighted cost of capital is just the weighted average cost of all of the financing sources.

Weighted Cost of Capital

Source debt preferred equity

Cost 6% 10% 16%

Capital Structure 20% 10% 70%

Weighted Cost of Capital

(20% debt, 10% preferred, 70% equity)

Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16%)

= 13.4%

Problem

A company issues 15% debentures of Rs.100 for an amount aggregating Rs.1,00,000 at 10% premium, redeemable at par after 5 years. The company's tax rate is 35%. Determine the cost of debt.

Solution
( F P) C (1 T ) n kd ( F P) 2

15(1-.35) + (100-110)/5 = (110+100)/2 = 7.4%

Problem

A company issues 14% irredeemable preference shares of the face value of Rs. 100 each. Flotation costs are estimated at 5% of the expected sale price.What is the cost of preference capital, if preference shares are issued at:
i) par value ii) 10% premium iii) 5% discount

Solution
i) 14 / 100*(1 - 0.05) = 14.7%
14 / 110*(1 - 0.05) = 13.4%

ii)

iii) 14 / 95*(1 - 0.05) = 15.5%

Problem
Given the information determine the cost of new equity shares of Company X: Current market price of a share = Rs. 150 Cost of flotation per share on new share = Rs.3 Dividend paid over past 5 years: 1 2 3 4 5 10.50 11.02 11.58 12.16 12.76 Assume fixed dividend pay-out ratio Expected dividend on new shares at the end of current year = Rs. 14.10

Solution
Annual growth = 5%(app)

= 14.10/147 + 5% = 14.6%

Example
GA Ltd. has got Rs. 100 lakhs of retained earnings and Rs. 100 lakhs of equity through a fresh issue, in its capital structure. The equity investors expect a rate of return of 18%. The cost of issuing equity is 5%. Find the cost of retained earnings and cost of equity.

Solution

Cost of retained earnings:

kr = ke = 18%

Cost of external equity raised by the company:

ke = kr/ (1-f) = 0.18/ (1-0.05) = 18.95%

Example
A company is considering raising Rs. 80 lakhs by 14% institutional term loan. Calculate the cost of the term loan. Tax rate is 35%.

Solution
Cost of term loan = .14*80 (1-.35)/ 80 = .14*(1-.35) = 9.1% = Interest Rate * (1-T)