COST OF CAPITAL
Prepared by Sumit Goyal- LPU
CONTENTS
Introduction
Significance
Cost of Equity
Dividend capitalization Approach
Earning Based Approach
Cost of External Equity
Prepared by Sumit Goyal- LPU
CONTENTS
Cost of Debt
Cost of Redeemable Debt
Cost of Perpetual Debt
Post Tax Cost of Debt
Cost of Preferred Capital
Assigning Weights
Opportunity Cost of Capital
WACC
Prepared by Sumit Goyal- LPU
LEARNING OBJECTIVES
Explain the general concept of the opportunity cost of
capital
Distinguish between the project cost of capital and the
firms cost of capital
Learn about the methods of calculating component cost
of capital and the weighted average cost of capital
Recognize the need for calculating cost of capital for
divisions
Understand the methodology of determining the
divisional beta and divisional cost of capital
Illustrate the cost of capital calculation for a real
company
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Cost of Capital
Viewed from all investors point of
view, the firms cost of capital is the
rate of return required by them for
supplying capital for financing the
firms
investment
projects
by
purchasing various securities.
The rate of return required by all
investors will be an overall rate of
return a weighted rate of return.
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Cost of Capital
Introduction and Significance
Cost of capital is an extremely important
input requirement for capital budgeting
decision.
Without knowing the cost of capital no firm
can evaluate the desirability of the
implementation of new projects.
Cost of capital serves as a benchmark for
evaluation.
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Opportunity Cost Of Capital
The basic determinant of cost of capital is the
expectations of the suppliers of capital.
The expectations of the suppliers of capital are
dependent upon the returns that could be
available to them by investing in the alternatives.
The returns provided by the next best alternative
investment is called opportunity cost of capital.
This could serve as basis for cost of capital.
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Cost of Debt
Cost of Perpetual/ Irredeemable Debt
Issued at Par
Issued at discount or premium
rd
I
NP
After tax cost of debt = rd (1-T)
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Example
A company issues Rs. 50000, 8%
debentures at par. Compute the cost of
capital.
Y ltd. Issues Rs 50000, 8% debentures at
premium of 10%. Compute the cost of
capital
Z ltd. Issues Rs 100000, 9% debentures at
a premium of 10%. The cost of flotation are
2%. The tax applicable is 60%. Compute
the cost of capital.
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Cost of Debt
Cost of redeemable debt
A) YTM (Yield to Maturity) or trail and error
method
Before tax
After tax
Po
Ct
(1 r )
t1
R
(1 rd )N
It is obtained by process of trail and error to match the
price of the debt with those of the present value of cash
outflows of coupon payment and repayment of principal
at an assumed rate
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Cost of Debt
B) Shortcut method
Before tax
After tax
I + 1/n (RV-NP)
(RV+NP)
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Problem
For a bond paying 11% coupon
annually and redeemable after three
years at Rs 105 that sells for Rs 95.
Tax rate is 40%.
11x0.6 11x0.6 11x0.6
105
95
2
3
1 rd (1 rd ) (1 rd ) (1 rd )3
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Problem
A 5 year Rs.100 debenture of a firm
can be sold for a net price of Rs.
95.90. the coupon rate of interest is
14%. And the debentures will be
redeemed at 5% premium on
maturity. The firms tax rate is 35%.
Compute YTM and after tax cost of
debenture.
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Practical Problem
A company issue Rs 10,00,000 , 10%
redeemable debentures at a discount
of 5%. The cost of flotation amount
to Rs. 30,000. the debentures are
redeemable after 5 years. Calculate
before and after tax cost of debt
assuming a tax rate of 50%.
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Cost Of Preference Capital
Preference capital is in between pure debt and equity
that explicitly states a fixed dividend.
The dividend has claim prior to that of equity holders.
But unlike interest on the debt the dividend on
preference capital is not tax deductible.
Cost of preference capital, rp is determined by equating
its cash flows to market price. No adjustment for tax
is required.
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Cost of Irredeemable Pref. Shares
Dt
rd
Po
Cost of redeemable Pref. Shares
Po
Dt
R
t
(1 rp )N
t 1 (1 rp )
N
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A company issues 10,000, 10%
preference shares of Rs. 100 each.
Cost of issue is Rs 2 Per share.
Calculate cost of Preference Shares if
these shares are issued
At par
At a premium of 10%.
At a discount of 5%.
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Practical Problems
A firm has issued Preference shares of
the face value of Rs. 100 with the
promised dividend of Rs. 12 per annum
after incurring a flotation cost of 2%.
A) What is the cost of preference share to the firm?
Assume that the firm will continue to have the same
level of Pref capital for times to come.
B) after a year the Preference share marketed at Rs.
100 face vale is trading in the market price of Rs.
90. Do you think the cost of pref share has changed .
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Practical Problems
A company issues 10,000 10% Preference
shares of Rs. 100 Each redeemable after
10 years at a premium of 5%. The cost of
issue is Rs. 2 per year. Calculate cost of
preference capital.
A company issues 1000, 7% preference
shares of Rs 100 each at a premium of
10% redeemable after 5 years at par.
Compute the cost of preference capital.
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Types Of Equity Capital
Equity capital is classified as
1) Internal: the profits that are not distributed but
retained by the firm in funding the growth, is
referred as internal equity, and
2) External: equity capital raised afresh to fund, is
called external equity
And external equity may have cost differential on account of
Floatation cost associated with raising fresh
equity,
Inability to deploy external equity
instantaneously,
Under-pricing of fresh issue.
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Cost Of Equity Capital
Cost of equity capital is most difficult to determine
because
It is not directly observable
There is no legal binding to pay any
compensation, and
It is not explicitly mentioned.
Does this mean that cost of equity is zero?
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Approaches
Cost Of Equity
Cost of equity is determined by
Dividend capitalization approach
CAPM based approach.
Both approaches are driven by market
conditions and measure the cost of equity in
an indirect manner.
The price to be used in any of the model is
the market determined.
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Dividend Capitalization
Approach
Dividend capitalization approach determines the cost of
equity by equating the stream of expected dividends to its
market price.
For constant dividend cost of equity is equal to
dividend yield.
P0
D3
D1
D2
D4
..........
.........
2
3
(1 re ) (1 re )
(1 re )
(1 re )4
if dividend isconstant i.e . D1 D2 D3 ...... D
Then P0
D
D
; or re
Dividend Yield
re
P0
D1
D1 (1 + g)
D1 (1 + g) 2
D1 (1 + g) 3
P0 =
+
+
+
...................
(1 + re )
(1 + re ) 2
(1 + re ) 3
(1 + re ) 4
then P0 =
D1
D1
; or re =
+g
re - g
P0
For constant growth of dividend at g
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A company has been in operational for the last
15 Years and its shares in the stock market are
currently trading at 120. the most recent
dividend by the firm was 10 per share.
Historically the dividend of the company has
been growing at 10% but a majority of financial
analysts are of the option that the firm would
grow at 12% P.A. Find out the cost of equity
From management analysis
From analyst analysis
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Cost of equity
The shares of a company are selling at Rs.
40 per share and it had paid a dividend of
Rs 4 Last year. The investors market
expects a growth rate of 5% per year.
Compute the companys equity cost of
capital.
If the anticipated growth rate is 7%,
calculate the indicated market price per
share.
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Earning based approach
Cost of equity = EPS/ MP
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Cost Of Equity
CAPM Approach
CAPM based determination of cost of equity
considers the risk characteristics that dividend
capitalization approach ignores.
Determinants of cost of equity under CAPM
based approach include three parameters;
the risk free rate, rf = expected return on risk free
securities
the market return, rm and = expected risk on the market
, as measure of risk= expected risk of the project
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Cost Of Equity
CAPM Approach
,the primary determinant of risk governs
the cost of equity.
re = rf + x (rm rf)
Cost of Equity
re
rm
Risk Premium
(rm-rf)
rf
= 1 Risk,
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Practical Problem
A company is a listed at stock
exchange and the current price of its
share is Rs. 200. the earnings and
dividend had been growing at 10%
and the last dividend was 12. The
beta of the firm is estimated at 1.20
the expected market return is 16%
while the returns in govt. securities
are prevailing at 6%.
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Cost Of External Equity
Issuing of shares includes the cost like
merchant bankers, underwriting commission
etc.
If floatation cost is 5% of the issue price and cost of
internal equity determined either through DDM or
CAP-M is 16% then the cost
of fresh equity
shall be
Cost of internalequity
1 D1
re for externalequity =
=
+g
16.84% (16/0.95).
(1- f)
(1- f) P0
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Example
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Example
Suppose in the year 2002 the riskfree rate is 6 per cent, the market
risk premium is 9 per cent and beta
of L&Ts share is 1.54. The cost of
equity for L&T is:
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THE WEIGHTED AVERAGE
COST OF CAPITAL
The following steps are involved for calculating the
firms WACC:
Calculate the cost of specific sources of funds
Multiply the cost of each source by its proportion in
the capital structure.
Add the weighted
costs
to get the WACC.
k o k d (component
1 T) w d k d w
e
k o k d (1 T )
D
E
ke
DE
DE
WACC is in fact the weighted marginal cost of capital
(WMCC); that is, the weighted average cost of new
capital given the firms target capital structure.
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Prepared by Sumit Goyal- LPU
Calculate WACC
Sources of funds
Amount
After tax cost
Debt
15,00,000
Preference
12,00,000
10
Equity
18,00,000
12
Retained earning
15,00,000
11
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Continuing with the last example, if
the firm has 18000 equity shares of
Rs. 100 each outstanding and the
current market price is rs 300 per
share. Calculate the market value
weighted average cost of capital.
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Type of capital
Proportional
Before tax cost of
capital
Equity capital
25
24.44
Preference capital
10
27.29
Debt
50
7.99
Retained earnings
15
24.44
Before tax and after tax
Tax rate is 55%.
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Practical
Problem
You are required to determine the weighted average cost of capital
of the co using a) book Value b) market value. The following
information is available.
Debenture (Rs 100 Per debenture) 800000
Preference shares (Rs 100 Per share)
200000
Equity Capital (Rs 10 Per share)
1000000
All these securities are traded in the capital market. Recent prices
are debentures@105, Preference shares @90 and equity shares
@22.
Anticipated external financing opportunities are:
1. Rs 100 per debenture redeemable at premium of 10%: 20 Years
maturity: 8% coupon rate, 4% flotation cost, sale price Rs 100.
2. Rs 100 preference share redeemable at par: 15 years maturity, 10%
Dividend rate, 5 % flotation cost sale price Rs 100.
3. Equity shares Rs 2 Per share flotation costs, sales price Rs 22. In
addition the dividend expected on equity shares at the end of the
year Rs 2 per share: the anticipated growth rate in dividend is 5% and
the company has the practise all its earnings in the form of dividends.
The corporate tax rate is 50%.
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Sources of funds
Rs (Million)
Equity capital (10 million shares
@ 10 )
100
Preference capital, 11%(1,00,000
@ 100)
10
Retained earnings
120
Debentures @13.5% (5,00,000
@100)
50
Term loans
80
The next expected dividend per share is Rs 1.50.
the dividend per share is expected to grow at the
rate 7%. The market price per share is Rs. 20.
Preference stock, redeemable after 10 years is
currently selling for rs. 75 per share. Debentures,
by Sumit
LPU
redeemable after 6Prepared
years
areGoyalselling
for Rs 80 per
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