Cost of Capital

Submitted to -- Dr Babita Kumar

Submitted by – Pujita (L-2019-BS-24-MBA)
Reva Gupta (L-2019-BS-27-MBA)
 Meaning
• A company's cost of capital is the average cost of the various capital
components (or securities) employed by it.
• Put differently, it is the average rate of return required by the
investors who provide capital to the company.
• The cost of capital is a central concept in financial management. It is
used for evaluating investment projects, for determining the capital
structure, for assessing leasing proposals, for setting the rates that
regulated organizations like electric utilities can charge to their
customers, so on and so forth.
 Concept
• A firm's cost of capital is the weighted average cost of various sources of
finance used by it, viz., equity, preference, and debt. Weighted Average
Cost of Capital (WACC) is calculated as follows:

(WACC = (Proportion of equity)(Cost of equity) + (Proportion of preference

preference) (Cost of preference) + (Proportion of debt) (Cost of debt)
Suppose, Company uses equity, preference and debt in following
proportions : 50, 10, 40 respectively.
Component cost – 16 %, 12% and 8 % respectively.

WACC = (0.5) (016) + (0.10) (12) + (0.4) (8)

= 12.4 %
 Important points to consider
• Only three types of capital is taken in this.
• Leaving out short term debt for calculation of WACC, which is not
correct.
• To ensure simplification and consistency, non-interest bearing
liabilities such as trade creditors are not included.
 When To Invest?
Firm’s rate of return on investment > Cost of capital Equity
shareholder’s benefits
Illustration: Consider a firm which employs equity and debt in equal
proportions and whose cost of equity and debt are 14% and 6% respectively.
WACC = (0.5)(14) + (0.5)(6)
= 10%
Now, If firm invest RS 100 million on project (whose rate of return = 12%)
Return of equity fund employed = [Total return on project – Interest on debt]/
Equity funds
= (100)(.12)- (50)(0.06) 18% (return on equity)
50 > 14% (cost of equity)
= 18 %
 BASIS Company cost of
Capital
Meaning The company cost of capital
is the rate of return
expected by the existing
capital providers
Dependency It reflects the business risk
of existing assets and the
capital structure currently
employed.
Project cost of
capital
The project cost of capital is
the rate of return expected
by capital providers for a
new project or investment
the company proposes to
undertake.
It will depend on the
business risk and the debt
capacity of the new project.
 Conditions for using WACC
• The business risk of the new investment is the same as the average
business risk of existing investments. In other words, the new
investment will not change the business risk complexion of the firm.

• The capital structure of the firm will not be affected by the new
investment. Put differently, the firm will continue to follow the same
financing policy.

This assumes that new investments will be similar to existing

investments in terms of business risk and debt capacity.
 Cost of Debt
• Conceptually, the cost of a debt instrument is the yield to maturity of
that instrument. Let us apply this concept to different types of debt
instruments such as debentures, bank loans, and commercial paper.
• Cost of Debenture is the value of rD in the following equation:
rD I + (F – P0)/n
0.6 P0 + 0.4 F
Where,
P0 = current market price of the debenture
I = annual interest payment
n = number of years left to maturity
F = maturity value of the debenture
 Contd…
Example, Consider, the debenture of XYZ limited.
Face Value = Rs 10,000
Coupon rate = 12 %
Remaining period to maturity = 4 years
Current market price = Rs 1040

rD = 120 + (1000 -1040)/4

(0.6)(1040)+ (0.4)(1000)
= 10.7%
 Contd…

• A bank loan is not traded in the secondary market. Hence, the cost of
a bank loan is simply the current interest the bank would charge if the
firm were to raise a loan now.

• Suppose that XYZ Limited has a 300 million outstanding bank loan on
which it is paying an interest of 13 percent. However, if XYZ Limited
were to raise a loan now the bank would charge 12 percent. This then
represents the cost of the bank loan.
 Contd…

• A commercial paper is a short-term debt instrument which is issued

at a discount and redeemed at par. Hence the cost of commercial
paper is simply its implicit interest rate.
• Suppose, XYZ Limited has outstanding commercial paper that has a
balance maturity of 6 months. The face value of one instrument is
1,000,000 and it is traded in the market at 965,000. The implicit
interest rate for 6 month is:
1000000 – 1 =0.0363 or 3.63%
965000
• Annualised rate = (1.0363)^2 -1 = 0.0739 0r 7.39%
 Average cost of debt
DEBT INSTRUMENT FACE VALUE MARKET VALUE COUPON RATE CURRENT VALUE

Non convertible Rs 100 million Rs 104 million 12% 10.7%

debenture

Bank loan Rs 200 million Rs 200 million 13% 12%

Commercial paper Rs 50 million Rs 48.25 million N.A. 7.39%

Total 352.25 million

Average cost of debt = 10.7% (104/352.25) + 12% (200/352.25) + 7.39

(104/352.25)
= 10.98%
 Contd…

Post-tax cost of debt = Pre-tax cost of debt (1 –Tax rate)

= 10.98% (1 – 0.35) Assuming, Tax rate = 35%
= 7.14%
 Cost of preference
• Preference capital carries a fixed rate of dividend and is redeemable in
nature.
• Preference dividend, unlike debt interest, is not a tax deductible
expense and hence does not produce any tax saving.
• Suppose, Preference stock of XYZ ltd.

Face Value = Rs 100 Yield on preference stock = 11 + (100 - 95)/ 5

Dividend Rate = 11% (0.4)(100) + (0.6)(95)
Maturity Period = 5 years
= 12.37%
Market price = Rs 95
 Cost of equity : CAPM approach
• Equity finance may be obtained in two ways:
(i) retention of earnings, and
(ii) issue of additional equity.
• The cost of equity or the return required by equity shareholders is the
same in both the cases.
• The only difference is in floatation costs. There is no floatation cost for
retained earnings whereas there is a floatation cost of 2 to 6 percent
or even more for additional equity.
• Cost of equity is difficult to measure as compared to cost debt or
preference because equity holders are not entitled to a promised or
predetermined return according to a financial contract.
 Approaches used to
estimate cost of equity

Capital asset The bond yield The dividend

The earnings-price
pricing model plus risk premium discount model
approach
( CAPM) approach approach approach
 The Intuition Underlying the CAPM
• Investors are risk-averse. So, they require a higher expected return to
bear higher risk.
• To understand what is a relevant measure of risk, it is useful to
decompose the total risk associated with a security into two
components:
Total risk= Unique risk+ Market risk

The unique risk of a security represents
that portion of its total risk which stems
from firm-specific factors like the
development of a new product, a
labour strike, or the emergence of a
new competitor.
The market risk of a security (Systematic
risk) represents that portion of its risk which
is attributable to economy-wide factors like
the growth rate of GDP, the level of
government spending, money supply,
interest rate structure, and inflation rate.
 Contd…

• The CAPM is reflected in the following equation that relates the

expected rate of return of an investment to its systematic risk.
E(R)i = Rf + [E(R)m – Rf] / βi

where,
E(R)i = Expected Return of Security
Rf = Risk – free rate
E(R)m = Expected Return on the Market Portfolio
βi = systematic risk of security
 Factors that
determine CAPM

Risk free Market risk

Beta
return premium
• Risk free return = The risk-free rate is the return on a security (or a
portfolio of securities) that is free from default risk and is
uncorrelated with returns from anything else in the economy.

• Market-risk premium: The market risk premium is the difference

between the expected market return and the risk-free rate. It can be
estimated on the basis of:
• Historical data
• Forward looking data.
 Contd…
• Historical Risk Premium: The historical risk premium is the difference
between the average return on stocks and the average risk-free rate
earned in the past.

How long should the Should the arithmetic mean or the

measurement period be?
Sol: Use the longest possible
historical period, absent any trends
in risk premium over time.
geometric mean be used?
Sol: The arithmetic mean is the average of
the annual rates of return over the
measurement period whereas the
geometric mean is the compounded
annual return over the measurement
period.
 Contd…
Example:
YEAR PRICE RETURN
0 100 --
1 140 40%
2 154 10%

Arithmetic Mean = 40 + 10 Geometric mean = [(1+.40)(1+.10)]^2 – 1

2 = 1.54^2 – 1
= 25% = 24%

It is more consistent with the mean- It takes into account compounding and can
variance framework and can better better predict the average premium in the
predict the premium in the next period. long term.
 Contd…
• Forward looking risk premium: It is the assessment of premium based
on forward looking

Procedure for its calculation:

Step 1: Estimate the expected market rate of return using the constant
growth dividend discount model:
Expected market rate of return = Dividend yield + Constant growth rate

Step 2: Calculate the market risk premium:

Market risk premium = Expected market rate of return - Risk free rate
 Contd…
• Beta: The beta of an investment i is the slope of the following
regression relationship:
t
Where,
= Return on investment I in period t
Return on market portfolio in period t
= intercept of linear regression and
= slope of linear regression and
t = error term

To measure Beta =
beta estimate.xlsx
 Estimation issues
• Estimation period: risk of profile change of firm over longer period.
• Return interval: Prefer weekly or monthly returns to reduce non
trading bias.
• Market Index: In theory, the market portfolio must include all assets-
financial, real as well as human- and not just equity stocks but in
practice, the beta of a stock is estimated in relation to the index of
stock market.
• Statistical precision: The estimate of beta based on stock returns over
a particular time period is statistically imprecise because of standard
error.
 Bond yield plus risk premium approach
• In this, risk premium is added to the observed yield on the long-term
bonds of the firm to get the cost of equity, i.e.,

Cost of equity = Yield on long term bonds + Risk premium

• Most analysts look at the operating and financial risks of the business
and arrive at a subjectively determined risk premium that normally
ranges between 2 % and 6 %. While this approach may not produce a
precise cost of equity.
 Dividend growth model approach
• The price of an equity stock depends ultimately on the dividends
expected from it: Where,
P0 = Current price of the stock
r = Dt + g Dt = Dividend expected to be paid at
the end of the year t
P0 r = equity shareholder’s required rate
of return
g = expected growth rate
• Problems associated with it:
• First, it cannot be applied to companies that do not pay dividends or to companies that are
not listed on the stock market. Even for companies that pay dividends, the assumption that
dividends will grow at a constant rate may not be valid.
• Second, it does not explicitly consider risk. There is no direct adjustment for the risk
associated with the estimated growth. Of course, there is an implicit adjustment for risk as
the current stock price is used.
 Estimation of g
• Analyst forecast
• By looking at dividends for the preceding years, calculate the annual
growth rates, and average them.
Year Dividend (Rs) Rupee Change Growth percentage
1 3.00 --- ---
2 3.50 0.50 16.7
3 4.00 0.50 14.3
4 4.25 0.25 6.3
5 4.75 0.50 11.8

Average growth rate = 12.3%

 Contd…

• Retention growth rate method - Here, you first forecast the firm's
average retention rate (this is simply 1 minus the dividend payout
rate) and then multiply it by the firm's expected future return on
(10.7) equity (ROE).
g = (Retention rate)(Return on equity)

For example, if the forecasted retention rate and return on equity are
0.60 and 15 percent, the expected growth rate is:
g = (0.6) (15%) = 9 percent.
 Earnings-Price Ratio Approach
• According to this approach,
Cost of equity = E1/P0
Where,
E1 (expected earnings per share for next year) = (current earnings per share)(1 + growth rate of
earnings per share)
P0 = Current market price per share
• This approach provides an accurate measure of the rate of return required
by equity investors in the following two cases:
o When the earnings per share are expected to remain constant and the dividend
payout ratio is 100 percent.
o When retained earnings are expected to earn a rate of return equal to the rate of
return required by equity investors.
• The first case is rarely encountered in real life and the second case is also
somewhat unrealistic.
 Determining the proportions (Weight)
• The appropriate weights are the target capital structure weights
stated in market value terms.
• The primary reason for using the target capital structure is that the
current capital structure may not reflect the capital structure that is
expected to prevail in future.
• Now, question arises, In calculating the weights for the target capital
structure, should one use book (balance sheet) values or market
values?
Example, Initial capital – Rs 100 million (10 years ago)
Market value increased to – Rs 450 million, Expected return -15%
At what value do you expect the return?
Market value
WEIGHTED AVERAGE COST OF CAPITAL

• The weighted average cost of capital (WACC) is the rate that a

company is expected to pay on average to all its security holders to
finance its assets.
• The WACC is commonly refered to as firm’s cost of production.
• Formula- WACC=WE rE + Wp rp+ Wd rd(1-t)
• For Example, the cost of equity, preference, and debt
for BPN Limited are 16 percent, 14 percent, and 12
percent respectively and the market value
proportions of these sources of finance are 0.60, 0.50,
and 0.35 respectively. The tax rate is 30 percent.
Given the information , the WACC is:
WACC= .60(16)+ .50(14)+ .35(12)(1-.30)
WEIGHTED MARGINAL COST OF CAPITAL

• It is the cost of raising an additional rupee of capital.

• The schedule showing the relationship between additional financing
and the weighted average cost of capital is called the weighted
marginal cost of capital schedule.
• WACC tends to rise as the firm seeks more capital.
PROCEDURE FOR DETERMING THE WEIHGTED
MARGINAL COST OF CAPITAL SCHEDULE
• Estimate the cost of each source of financing for various levels of its use.
• Identify breaking points (levels of capital at which atleast any one component of
the company WACC changes).
• Breakpoint for debt= Debt level at which at which
KD changes/ KD
• Breakpoint for equity= Debt level at which at which
Ke changes/ Ke
• Calculate the WAAC for various ranges of total
financing between the breaking points.
• Prepare the weighted marginal cost of capital
schedule which reflects the WACC for each level of
total new financing.
• ILLUSTRATION- To illustrate how the weighted
marginal cost of capital schedule is prepared, let us
consider an example. Shiva industries estimates plans
to use equity and debt in the following proportion:
• Equity: 40
• Debt:60
• Cost of its sources of finance for various levels of usage
are as follows:
Source of finance Range of new financing %
cost( Rs in million)
EQUITY 0-30 18

More than 30 20

Debt 0-50 10

More than 50 11
• SOLUTION
(DETERMINATION OF BREAKING POINT AND THE
RESULTING RANGE OF TOTAL NEW FINANCING FOR
SHIVA INDUSTRIES)

SOURCE OF COST Range of new Breaking Range of total

CAPITAL financing (Rs points (Rs in new financing
in Million) Million) (Rs in Million)

Equity 18% 0-30 30/0.4=75 0-75

20% Above 30 - Above 75
Debt 10% 0-50 50/0.6= 0-83.3
83.3
11% Above 50 - Above 83.3
• WEIGHTED AVERAGE COST OF CAPITAL FOR VARIOUS RANGES
OF TOTAL FINANCING FOR SHIVA INDUSTRIES

Range of Source of Proportion Cost% Weighted

total new capital (2) (3) cost %
financing (1) (2)*(3)=(4)
(Rs in
Million)
0-75 Equity 0.4 0.18 .072
Debt 0.6 0.10 .060
WACC .132
75-83.3 Equity 0.4 0.20 .080
Debt 0.6 0.10 .060
WACC .140
Above Equity 0.4 0.20 .080
83.3
Debt 0.6 0.11 .066
WACC .146
DETERMINING THE OPTIMAL CAPITAL
BUDGET
• The optimal capital budget is amount of capital raised and invested at
which the marginal cost of capital is equal to the marginal return from
investing.
• To determine the optimal capital budget, compare the expected
return on proposed capital expenditure projects with marginal cost of
capital schedule.
• To illustrate, suppose Shiva Industries is developing its capital budget
for the forthcoming year. The company’s schedule of proposed
capital expenditure projects for the coming year is as follows.
Project Amount (Rs in Internal rate of
million) return
A 30 18%
B 40 16.5%
C 25 15.3%
D 10 13.4%
E 20 12%
• Optimal capital budget= 95 million {A=30 +
B=40 +
C=25}
• Projects D and E arec excluded as their expected
returns are lower than the marginal cost of capital.
FLOTATION COST AND COST OF
CAPITAL
• When a firm raises finance by issuing equity and debt, it almost invariably incurs
flotation or issue costs, comprising of items like underwriting cost, brokerage
expenses, fees for merchant bankers, advertising expenses, so on and so forth.
• We will be study how the flotation costs be handled in computing the cost of
capital.
• 1st – Adjust the WACC to reflect to reflect flotation costs.
• Revised WACC= WACC/1-Flotation costs
• 2nd Approach- Approach- Leave the WACC unchanged but to consider the flotation cost as
part of the project.
FACTORS AFFECTING THE WEIGHTED
AVERAGE COST OF CAPITAL
• Factors outside a Firms’s control-
• The level of interest rates- If interest rate increases, cost of debt, cost of
equity to the firm increases and vice versa.
• Market risk premium- It affects the cost of equity directly and cost of debt
indirectly.
• Tax rates- The corporate tax rate has a direct impact on cost of debt as used in
WACC. The capital gains tax rate on ordinary income has an indirect effect on
cost of equity relative to the cost of debt.
• Factors within a firm’s control-The cost of capital of a
firm is affected by its investment policy, capital
structure policy, and dividend policy.
• Investment policy- It is assumed that when making
investments decisions, the company is making investments
with similar degree of risk. If a company changes its
investment policy relative to its risk, both the cost of debt
and equity change.
• Capital structure policy- A firm has a control over its capital
structure, targeting an optimal capital structure. As more
debt is issued cost of debt increases. As more equity is
issued cost of equity increases.
• Dividend policy- The dividend policy of a firm may affect its
cost of equity.
Misconceptions surrounding cost of capital
• The cost of capital is too academic or impractical
• Current liabilities are considered as capital components
• The coupon rate on the firm’s existing debt is used as the pre-tax cost of debt
• The cost of equity is equal to the dividend rate or return on equity
• Retained earnings are either cost free or cost significantly less than the external
equity
• Depreciation has no cost
• Book value weights may be used to calculate WACC
• The cost of capital for a project is calculated on basis of the specific sources of
finance used for it
• The project cost of capital is same as firm’s WACC
HOW FINANCIAL INSTITUTIONS
CALCULATE COST OF CAPITAL
Financial institutions calculate cost of capital as post-tax weighted average cost of
the mix of funds employed for the project.
The cost of different sources of funds are taken as follows:
 Equity share capital: 15%
 Cash accruals/ Retained earnings: 15%
 Preference share capital: Preference dividend rate
 Subsidy/insentive loans: Zero cost
 Debt: Post tax rate of interest
 Covertible debentures: Convertible portion at 15% Non-convertible
portion at post-tax interest rate
COST OF CAPITAL
CALCULATION
Means of financing (A) Amount(Rs in Cost of Funds(C) Total cost (post-
millions) (B) tax) (D)= C*B

Equity and cash accruals 900 15% 135

Preference share capital 100 10% 10

Rupee term loans(@ 14%) 800 10.5% 84

Non convertible debentures 400 9% 36

(@12%)
Convertible portion of convertible 100 15% 15
debentures
Non-Convertible portion of 100 7.5% 7.5
convertible debentures (@10%)

Bank borrowing for working 200 11.25% 22.5

capital (@15%)

2600 310
the average cost of capital (post-tax) is:310/2600=11.92%