CHAPTER 2 COST OF CAPITAL INTRODUCTION Capital components

CHAPTER- 2 COST OF CAPITAL

INTRODUCTION Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.

� When we talk about the “cost” of capital, we are talking about the required rate of return on invested funds � It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return � Any investment which does not cover the firm’s cost of funds will reduce shareholder wealth (just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth)

The Cost of Capital A firm will invest only if the expected rate of return exceeds the cost of capital. For a firm under rate-ofreturn regulation, if the permitted rate of return is set above the cost of capital (or the required rate of return), the firm will over-invest; conversely, if the permitted rate is set below the cost of capital, the firm will under-invest. “A cut-off rate for the allocation of capital to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock. ” JAMES C. VAN HORNE 4

1. 2. 3. 4. As an acceptance criterion in capital budgeting As a determinant of capital mix in capital structure decisions As a basis for evaluating the financial performance As a basis for taking other financial decisions. SIGNIFICANCE OF THE COST OF CAPITAL 1) 2) 3) 4) 5) Conceptual controversies regarding the relationship between the cost of capital & the capital structure Historic cost & future cost. Problems in computation of cost of equity Problems in computation of cost of retained earnings Problems in assigning weights. DETERMINATION OF COST OF CAPITAL

1. HISTORICAL COST - BOOK COSTS RELATED TO PAST. 2. FUTURE COSTESTIMATED COST FOR THE FUTURE 8. IMPLICIT COSTOPPORTUNITY COST. 7. EXPLICIT COSTSDISCOUNT RATE WHICH EQUATES PRESENT VALUE OF INFLOW &OUTFLOW 3. SPECIFC COST OF SECIFIC SOURSE OF CAPITAL 4. COMPOSITE COSTCOMBINED COST OF VARIOUS SOURCES, WACC 6. MARGINAL COSTADDITION TO THE AVERAGE COSTOF CAPITAL 5. AVERAGE COSTCOMBINED COST OF VARIOUS CORPORATE SECURITIES

v v v v v 1. COST OF DEBT COST OF REDEEMABLE DEBT 2. COST OF PREFERENCE CAPITAL COST OF REDEEMABLE PREFERENCE CAPITAL 3. COST OF EQUITYSHARE CAPITAL DIVIDEND YIELD METHOD DIVIDEND YIELD PLUS GROWTH IN DIVIDEND METHOD. EARNING YIELD METHOD 4. COST OF RETAINED EARNINGS COST OF SPECIFIC SOURCE OF FINANCE � WEIGHTED AVERAGE COST OF CAPITAL � MARGINAL COST OF CAPITAL � CAPITAL ASSET PRICING MODEL WEIGHTED AVERAGE COST OF CAPITAL

� The cost of debt is the rate of interest payable on debt. The cost of debt is generally easier to calculate �Equals the current interest cost to borrow new funds �Current interest rates are determined from the going rate in the financial markets �The market adjusts fixed debt interest rates to the going rate through setting debt prices at a discount (current rate > than face rate) or premium (current rate < than face rate)

� BEFORE TAX COST OF DEBT In case debt issued at par. In case debt issued at premium or discount NP IN CASE OF PREMIUM= P+ %PREMIUM NP IN CASE OF DISCOUNT = P - %DISCOUNT v AFTER TAX COST OF DEBT � interest expense is tax deductible Therefore, when a company pays interest, the actual cost is less than the expense, than the formula will be

� The debt is issued to be redeemed after a certain period during the life time of a firm. Such a debt is known as redeemable debt. The formula to calculate the redeemable amount to be given to debenture holder is : - � Kdb= cost of debt before tax Kda= cost of debt after tax � I= interest N= no. of years � RV= redeemable value of debt � NP= net proceeds � T= tax rate

� Financial institutions requires principal to be amortized in installments. A company may issue a bond or debenture to be redeemed periodically. The amount of interest goes on decreasing each period as it is calculated on the outstanding amount of debt. Formula will be : - � Vd= present value of debt, � INTEREST 12…n=annual interest, Pn= periodic payment for 1, 2, n numbers of years for maturity, Kd= cost of debt.

: Kd installment expected dividend D 1 D 2 D 3 PV= (1 + r) + (1 + r)2 + (1 + r)3 +. . . discounted rate, cost of equity capital Dt PV= [ ] t (1 + r) Assume D 1 grows at constant rate of g: D 1(1+g)2 + +. . . PV= (1 + r) + (1 + r)2 (1 + r)3 12

BEFORE-TAX AFTER-TAX n. Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. n. Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs. n. Only cost of debt is affected.

�A fixed rate of dividend is payable on preference shares. The cost of preference capital is a function of dividend expected by its investors. The cost of preference capital can be calculated as follows: In case PC issued at par. In case PC issued at premium or discount NP IN CASE OF PREMIUM= P+ %PREMIUM NP IN CASE OF DISCOUNT = P - %DISCOUNT Kp = Cost of preference capital, D= Annual preference dividend, P= Preference share capital proceeds, NP= Net proceeds.

� Redeemable preference shares are issued which can be redeemed or cancelled on maturity date. The cost of redeemable preference share capital can be calculated as: - � Kpr = cost of redeemable preference shares, D= annual preference dividend, MV= Maturity value of preference shares, NP= Net proceeds of preference shares.

�. the cost of equity is the maximum rate of return that the company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock. The cost of equity share capital can be computed as follows: � 1. DIVIDEND YIELD METHOD: - or Ke= cost of equity capital, D= expected dividend per share, NP= Net proceeds, MP= market price per share.

� 3(b) DIVIDEND YIELD PLUS GROWTH IN DIVIDEND METHOD : -When the dividends of the firm are expected to grow at a constant rate & the dividend pay out ratio is constant. 3© EARNING YIELD METHOD

Assumptions There are few assumptions behind the method: (a) future dividends are expected to grow at a constant rate perpetually; (b) future dividends can be discounted at a constant cost of equity capital; (c) future dividends remain a constant proportion of earnings over time; (d) the firm is an all-equity-financed firm, or it has a constant level of leverage (or a constant debt-equity ratio).

� The firm may choose to finance new projects using only internally generated funds (retained earnings) � These funds are not free because they belong to the common shareholders (i. e. , there is an opportunity cost) � Therefore, the cost of retained earnings is exactly the same as the cost of new common equity, except that there are no flotation costs:

FORMULA OF COST OF RETAINED EARNINGS Kr = COST OF RETAINED EARNINGS D = EXPECTED DIVIDEND NP = NET PROCEEDS OF SHARE ISSUE G = RATE OF GROWTH FORMULA OF COST OF RETAINED EARNINGS TO MAKE ADJUSTMENTS OF TAX & COST OF PURCHASING NEW SECURITIES Kr = COST OF RETAINED EARNINGS D = EXPECTED DIVIDEND NP = NET PROCEEDS OF SHARE ISSUE G = RATE OF GROWTH T = TAX RATE b = COST OF PURCHASING NEW SECURITIES, OR BROKERAGE COSTS COST OF RETAINED EARNINGS

�A firm’s overall cost of capital must reflect the required return on the firm’s assets as a whole � If a firm uses both debt and equity financing, the cost of capital must include the cost of each, weighted to proportion of each (debt and equity) in the firm’s capital structure � This is called the Weighted Average Cost of Capital (WACC)

1. WEIGHTED AVERAGE COST OF CAPITAL q As we have seen, a given firm may have more than one provider of capital, each with its own required return q In addition to determining the weights in the calculation of the WACC, we must determine the individual costs of capital q To do this, we simply solve the valuation equations for the required rates of return �

� We now need a general way to determine the minimum required return � Recall that 40% of funds were from debt. Therefore, 40% of the required return must go to satisfy the debt holders. Similarly, 10% should go to preferred shareholders, and 50% to common shareholders This is a weighted-average, which can be calculated as: Wd , Kd =weights & cost of debt Wp, Kp= weights & cost of preference capital Wcs, Kcs= weights & cost of common shareholders � �

�The weights that we use to calculate the WACC will obviously affect the result �Therefore, the obvious question is: “where do the weights come from? ” �There are two possibilities: �Book-value weights �Market-value weights

� One potential source of these weights is the firm’s balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity � We can calculate the weights by simply determining the proportion that each source of capital is of the total capital

� The problem with book-value weights is that the book values are historical, not current, values � The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate � Calculation of market-value weights is very similar to the calculation of the book-value weights � The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital

� It is important to note that market-values is always preferred over book-value � The reason is that book-values represent the historical amount of securities sold, whereas market-values represent the current amount of securities outstanding � For some companies, the difference can be much more dramatic than for RMM � Finally, note that RMM should use the WACC in its decision making process

The Cost of Equity may be derived from the dividend growth model as follows: P = D / RE – g Where the price of a security equals its dividend (D) divided by its return on equity (RE) less its rate of growth (g). We can invert the variables to find RE as follows: RE = D / P + g But this model has drawbacks when considering that some firms concentrate on growth and do not pay dividends at all, or only irregularly. Growth rates may also be hard to estimate. Also this model doesn’t adjust for market risk.

Therefore many financial managers prefer the security market line/capital asset pricing model (SML or CAPM) for estimating the cost of equity: RE = Rf + βI x (RM – Rf) or Return on Equity = Risk free rate + (risk factor x risk premium – risk free rate of return) Advantages of SML: Evaluates risk, applicable to firms that don’t pay dividends Disadvantages of SML: Need to estimate both Beta and risk premium (will usually base on past data, not future projections. )

WHAT ARE THREE TYPES OF PROJECT RISK? � Stand-alone risk � Corporate risk � Market risk

HOW IS EACH TYPE OF RISK USED? � Stand-alone risk is easiest to calculate. � Market risk is theoretically best in most situations. � However, creditors, customers, suppliers, and employees are more affected by corporate risk. � Therefore, corporate risk is also relevant.

Unique Risk (also called “diversifiable risk”): � Unique risk associated with the assets owned by the company � Industry risks, e. g. competition, innovation, R&D dependence, etc. � Risk related to outstanding debt (financial leverage) � Age, size and stability of the organization Market Risk (also called “systematic risk”): � Economic volatility � Inflation � Political or other events that impact stability or the value of assets � Changes in interest rates

example Capital asset pricing model (CAPM): Cost of equity capital = risk-free rate +beta (market rate - riskfree rate) Re = Rf + (Rm - Rf) Therefore, if we use the CAPM to estimate a firm’s cost of equity capital (Re, or the required rate of return), we have to estimate a firm’s beta, the risk-free rate of return, and the market risk premium (the difference between Rm and Rf). In the CAPM, the measure of market risk is known as beta ( ). For example, the returns from an asset with a beta of 0. 5 will fluctuate by 5% for each 10% fluctuation in the market’s returns. It has been shown that the required risk premium for an asset is directly proportional to its beta. Therefore, the holder of an asset with a beta of 0. 5 will require a risk premium only half as large as that offered by the market as a whole. If the market is efficient, the cost of equity capital will be equal to the expected rate of return. 33

� When a company sells securities to the public, it must use the services of an investment banker � The investment banker provides a number of services for the firm, including: �Setting the price of the issue, and �Selling the issue to the public � The cost of these services are referred to as “flotation costs, ” and they must be accounted for in the WACC � Generally, we do this by reducing the proceeds from the issue by the amount of the flotation costs, and recalculating the cost of capital

� The amount of flotation costs are generally quite low for debt and preferred stock (often 1% or less of the face value) � For common stock, flotation costs can be as high as 25% for small issues, for larger issue they will be much lower � Note that flotation costs will always be given, but they may be given as a dollar amount, or as a percentage of the selling price

� Optimal capital structure is achieved by finding the point at which the tax benefit of an extra dollar of debt = potential cost of financial distress. This is the point of: �Optimal amount of debt �Maximum value of the firm �Optimal debt to equity ratio �Minimal cost of WACC � This will obviously vary from firm to firm and takes some effort to evaluate. No single equation can guarantee profitability or even survival

� Firms with greater risk of financial distress must borrow less � The greater volatility in EBIT, the less a firm should borrow (magnify risk of losses) � Costs of financial distress can be minimized the more easily firm assets can be liquidated to cover obligations � A firm with more liquid assets may therefore have less financial risk in borrowing � A firm with more proprietary assets (unique to the firm, hard to liquidate) should minimize borrowing

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