Cost of Capital

Cost of capital is the return required by the investor. Common stock capital Retained Earnings Preferred stock capital Debt Capital Weighted average cost of capital 15% 12% 14% 13% 13.5%

Cost of Common Stock Capital (ke) i. Dividend model: It is followed on a growing or a stable company. Stable Company: Stable Companies are those which have no investment opportunity, same rate of return & same dividend. Capital Asset Pricing Model (CAPM)

ii.

1. Stable Company, (ke)= =

100
100 = 10%

2. Growing Company, (ke)= ( D1= Next year dividend

F= Floatation cost per share G= Growth rate of dividend

+ G ) 100

PO= Current Market Price per share

Example: Bata Shoe Ltd. paid a dividend of tk 30 per share last year which is expected to grow @ 8%. The current market price of share is tk 520. Floatation cost is tk 5 per share. What is the cost of common stock of bata shoe ltd. ?

DO= 30 D1=30(1+0.08) =32.4 Ke= ( = 14.29% Capital Asset Pricing Model ( CAPM): CAPM expresses the relationship between I. II. Market risk & expected return( cost of capital) Expected return & price of the share +0.08) 100

Ke= RF + ( RM RF ) Rf = risk free return Rm = Market return / return of market portfolio = Systematic Risk / Market risk Systematic Risk / Market risk: they are selected by market forces/ external forces or macro factors that cannot be avoided.

Beximco 1.50 Square 2.00 Square Ke= RF + ( RM RF ) = .10 + (.14-.10)2 = .18 actual rate 17.5%

Beximco Ke= RF + ( RM RF ) = .10 + (.14-.10)1.50 = .16 actual rate 17%

Beximco should be selected as its actual rate of return is higher than expected rate of return. Higher the degree of market risk, higher the expected return. Unsystematic risk: Internal factors of the company e.g. management problem. Retained Earnings: =

Cost of Retained Earnings (KR)

(kr)= (

+ G ) (1-Tp) 100

Tp = personal tax return of a shareholder Example: Bata Shoe ltd. paid the dividend of tk 30 last year which is expected to grow at the rate of 8%. The current market price of the share is tk 520. The floatation cost is tk 5 per share. Average income tax rate of share is 20%. What is the cost of I. II. Common Stock Capital Retained Earnings

(kr)= ( = 11.38%

+ 0.08) (1-0.20) 100

Cost of retained earnings is always less than cost of common stock because of two reasons: 1. In case of financing by retained earnings, there will be no floatation cost. 2. In case of financing by retained earnings, the common stock holders can avoid the payment of the tax on their dividend income. Cost of Preferred Stock Capital (KP): 1. Cost of Irredeemable preferred stock Capital

KP=

100

2. Cost of Redeemable preferred stock Capital KP=

NSV= Net Sales Value = N= No. of years

Example: A company issued 15% preferred stock of tk 100. Par value of which current market price is tk 120 and floatation cost of tk 2 per share. What will be the cost of Preferred stock a) If it is issued forever(Irredeemable) b) If it is for 5 years

a) If it is issued forever(Irredeemable): KP =

100 = 13.64%

b) If it is for 5 years: KP= = 12.38% Cost of Debt Capital (KD):

100

Cost of institutional loan is simply, Kd=IR (1-T) 100 Interest is exempted from tax = .15(1-.30) 100 = 10.5% 1. In case of Irredeemable debt capital: Kd = (1-T) 100

2. In case of Redeemable debt capital: Kd = (1-T) 100

Example: A company issued 16% debenture of tk 3000 par value. The current market price of the debenture is tk 3200 and floatation cost is 1% of current market price. The company tax rate is 30%. What is the cost of debt capital of the company if a) If the debenture is issued forever b) If the debenture is issued for 6 years. Solution:

a) If the debenture is issued forever Kd =

(1-.30) 100

0.70 100

= 10.6% b) If the debenture is issued for 6 years Kd = = 10.26% (1-0.30) 100

Consider the following capital structure of a company Sources of Capital Common Stock Capital Retained Earnings 15% Preferred Stock 16% Preferred Stock 14% Debenture 13% Debenture Amount in Lakh 200 300 100 150 250 500 0.13 .20 .065 .10 .165 .333 Weighted

1. The company paid tk 8 dividend of the company. Stock sold last year which is expected to grow at the rate of 5%. The current market price of the share is tk 90 and floatation cost is tk 3 per share. 2. Par value of 15% Preference share capital is tk 100 issued for 5 years. The current market price is tk 120 and floatation cost is tk 4 per share. 3. The par value of 16% Preference share is tk 1000 and market price is tk 1100. Floatation cost os 1% of market price. 4. The company issued 14% debenture on 2000 tk par value of which is current market price is 1800 tk. 5. The company issued 13% debenture of the tk 4000 par value for 5 years. The current market price of the share is 4200 tk and floatation cost is 1% par value. 6. The corporate tax rate is 25% and shareholder average income tax is 15%. You are required to calculate the weighted average capital of the company.