Cost of Capital and Leverage

Weighted Average Cost of Capital or Overall

Cost of Capital
• The term Cost of Capital is used to denote composite
or weighted average or overall cost of capital.
• Once the component costs have been calculated,
they are multiplied by the proportions of the
respective source of capital to obtain the WACC.
• Here weighted average concept is used not the
simple average. The simple average Cost of Capital is
not appropriate to use because firms hardly use
various sources of funds equally in the Capital
Structure.
• The main reason behind the computation of
overall Cost of Capital is to use this rate as the
decision criterion in Capital Budgeting or
Investment Decision.
• Generally, it may be stated that this Cost of
Capital is taken to be the cut-off rate for
determining the profitability of proposed
projects.
 Steps for calculation of WACC
Step 1: Compute the specific cost of each source
of capital.
Step 2: Calculate the proportion (or %) of each
source of capital to the total capital (weight).
Step 3: Multiply the cost of each source by its
proportion in the Capital Structure.
Step 4: Add the weighted component cost to get
the WACC.
• WACC may change due to change in the cost of
each component; change in the relative
importance of each company, i.e. the change in
proportion or weight; or change in both.
• Weighted average Cost of Capital can be computed
by using the following three types of weight:
1. Book value weight
2. Market value weight
3. Marginal book value weight
 Leverage
• Leverage refers to the use of fixed costs in an
attempt to increase (or lever up) profitability.
• According to James Horne, leverage is “the
employment of assets or funds for which the
firm pays a fixed cost or fixed return”.
 Operating Leverage

• Operating leverage refers to the use of fixed

costs in the operation of a firm.
• If a firm’s ratio of fixed costs to total cost is nil,
it should not have operating leverage.
• The operating leverage may be defined as the
tendency of the operating profit to vary
disproportionately with sales.
• Thus operating leverage appears from the
existence of fixed operating expenses.
• Operating leverage is the firm’s ability to use
fixed operating costs to magnify the effect of
change in sales on its earnings before interest
and tax (EBIT).
• High operating Leverage refers to greater risk
because in this situation a small sales decline
will cause a big Operating Profit decline.
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• Degree of Operating Leverage implies that by
using Fixed Operating Costs, a small change in
sales is magnified into a larger change in
operating income.
• A value of DOL = 3 implies that a 1% increase
in sales will result in 3% increase in operating
income (EBIT).
 Financial Leverage
• Financial Leverage results from the use of fixed
financing costs by the firm. Financial Leverage is
acquired by choice.
• It is used as a means of increasing the return to
common shareholders.
• The British expression of financial leverage is gearing.
Thus the use of fixed interest/dividend bearing
securities such as debt and preference capital along
with the owner’s equity in the total capital structure
of the company is described as financial leverage.
• Sometimes, financial leverage is also known as
trading on equity. But the term trading on equity
is used for the term financial leverage only when
the financial leverage is favourable.
• The leverage is said to be favourable so long as
the company earns more on assets purchased
with the funds than the fixed costs of their use.
• Negative or unfavourable leverage occurs when
the firm does not earn as much as the funds cost.
• The company resorts to trading on equity for providing the equity
shareholders, a higher rate of return than the general rate of
earning on its capital employed.
• For instance, in case a company borrows a sum of Rs. 1 lakh at
10% interest per annum, and earns a return of 15%, the balance
of Rs. 5,000 per annum after payment of interest belongs to the
shareholders.
• But if the company can earn a return of only 8% on Rs. 1 lakh
employed by it, the loss of equity shareholders’ is Rs. 2,000 per
annum. Thus it is clear that although financial leverage creates
additional risk to equity shareholders, it has at the same time the
potentiality to enhancing their return. That is why the financial
leverage is sometimes called a double-edged sword.
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 Example Problem
• The capital structure of a firm is as under:
Rs
20,000 Equity Shares of Rs. 10 each: 2,00,000
4,000 10% Preference Shares of Rs. 100 each: 4,00,000
4,000 10% Debentures of Rs. 100 each: 4,00,000
Compute the EPS for each of the following levels of EBIT:
(i) 1,50,000 (ii) 1,20,000 and (iii) 2,00,000 The firm is in
50% tax bracket. Compute also the financial leverage
taking EBIT level under (i) as the base
 EBIT-EPS Analysis
• The EBIT-EPS analysis, is a method to study the effect of leverage,
essentially involves the comparison of alternative methods of
financing under various assumptions of EBIT.
• A firm has the choice to raise funds for financing its investment
proposals from different sources in different proportions.
• For instance, it can (i) exclusively use equity capital (ii) exclusively
use debt, (iii) exclusively use preference capital, (iv) use a
combination of (i) and (ii) in different proportions; (v) a
combination of (i), (ii) and (iii) in different proportions, (vi) a
combination of (i) and (iii) in different proportions, and so on. The
choice of the combination of the various sources would be one
which, given the level of earnings before interest and taxes, would
ensure the largest EPS.
 Example
• Suppose a firm has a capital structure exclusively comprising of ordinary
shares amounting to ₹ 10,00,000. The firm now wishes to raise additional ₹
10,00,000 for expansion.
• The firm has four alternative financial plans:
• (A) It can raise the entire amount in the form of equity capital.
• (B) It can raise 50 per cent as equity capital and 50 per cent as 5%
debentures.
• (C) It can raise the entire amount as 6% debentures.
• (D) It can raise 50 per cent as equity capital and 50 per cent as 5%
preference capital.
• Further assume that the existing EBIT are ₹ 1,20,000, the tax rate is 35 per
cent, outstanding ordinary shares 10,000 and the market price per share is
₹ 100 under all the four alternatives. Which financing plan should the firm
select?
 Combined Leverage
• Operating leverage explains the degree of
operating risk as it measures the relationship
between quantity produced and sold and EBIT.
• Financial leverage explains the degree of
financial risk as it measures the relationship
between EPS and EBIT.
• Both these leverages are closely related to the
firm’s capacity to meet its fixed costs (both,
operating and financial).
• If both these leverages are combined, a
composite leverage should be obtained.
Composite leverage, therefore, expresses the
relationship between quantity produced and
sold and EPS.
Composite leverage = OL x FL
CL =
CL =