Bhavan’s College

TY BMS-A
Sem 5 (2010-2011)

The Cost of Capital

Subject: Financial Management

Submitted To: Prof. Riddhi Sharma

Cost Of Capital 2010-11

Certificate

This is to certify that the following students of TY BMS – A,

Bhavan’s College, Andheri have successfully completed the project
titled “The Cost of Capital” for the subject “Financial Management”
as a part of the project submission for the academic year 2010-2011
{Sem 5} :

Names Roll numbers

Vrinda Menon 31
Rohit Mohite 32
Seena Saje 33
Arundathi Nair 34
Samiksha L Narsingh 35
Deep Nevgi 36

_____________________
Prof. Riddhi Sharma

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Declaration

We hereby declare that the following document presented for the

subject “Financial Management”, is an authentic work done by us. It is
true & original to the best of our knowledge.
The study was undertaken as a part of the course curriculum of TY
BMS, Semester 5 for the academic year 2010-2011. This project
includes the co-operation & hard work of the following students:

Names Roll numbers

Vrinda Menon 31
Rohit Mohite 32
Seena Saje 33
Arundathi Nair 34
Samiksha L. Narsingh 35
Deep Nevgi 36

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Acknowledgement

This project bears the imprint of many people, without whose

support, we could not have completed it. The project has been made
possible by the direct & indirect co-operation of many, who have
inspired us at every stage.

Firstly, we could like to extend our warm gratitude toward our

guide teacher, Prof. Riddhi Sharma, who always facilitates us in
gaining particle knowledge. We express our sincere indebtedness &
profound gratitude to our parents & friends, who have supported us in all
manners & made us capable to complete this project.

Lastly, we would like to forward our gratitude to our friends &

other faculty members who have always endured and stood by us &
without whom we could not have envisaged the completion of our
project.

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Index

1.
Introduction………………………………………………………
…………….6

2.
Concepts…………………………………………………………
……………….8

3. Mode Of Measuring Cost Of

Capital………………………………11

4. Weighted Cost of
Capital…………………………………………………15

5. Preliminaries to be
remembered………………………………………17

6. Determining the
proportions…………………………………………...18

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7. Factors affecting
WACC………………………………………………….19

8. Common
Misconceptions………………………………………………..21

9.
Conclusion………………………………………………………
……………24

10.
Bibliography……………………………………………………
……………25

Introduction
Financial management entails planning for the future of a person or
a business enterprise to ensure a positive cash flow. It includes the
administration and maintenance of financial assets. Besides, financial
management covers the process of identifying and managing risks.

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The primary concern of financial management is the assessment

rather than the techniques of financial quantification. A financial
manager looks at the available data to judge the performance of
enterprises. Managerial finance is an interdisciplinary approach that
borrows from both managerial accounting and corporate finance.

Thus in simple words, Financial Management is the process of

managing the financial resources, including accounting and financial
reporting, budgeting, collecting accounts receivable, risk management,
and insurance for a business. It includes both how you are financing it as
well as how you manage the money in the business. This may be
generally called “cash/capital budgeting”. Capital budgeting (or
investment appraisal) is the planning process used to determine whether
a firm's long term investments such as new machinery, replacement
machinery, new plants, new products, and research development projects
are worth pursuing. It is budget for major capital, or investment,
expenditures.

The standard practice in capital budgeting is to look at the cash

flows from the point of view of explicit cost funds ( also referred to as
investor claims) & apply the weighted average cost of capital of the firm
as the discount rate. The items on the financing side of the balance sheet
are called capital components. The major capital components are equity,
preference & debt. Capital, like any other factor of production, has a
cost.

A company’s cost of capital is the average cost of 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.

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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 settling the rates that
regulated organizations like electric utilities can charge to their
customers, so on & so forth. This project discusses how a company’s
cost of capital is calculated.

The cost of capital is the cost of a company's funds

(both debt and equity), or, from an investor's point of view "the
expected return on a portfolio of all the company's existing
securities". It is used to evaluate new projects of a company as it is the
minimum return that investors expect for providing capital to the
company, thus setting a benchmark that a new project has to meet.

For an investment to be worthwhile, the expected return on

capital must be greater than the cost of capital. The cost of capital is the
rate of return that capital could be expected to earn in an alternative
investment of equivalent risk. If a project is of similar risk to a
company's average business activities it is reasonable to use the
company's average cost of capital as a basis for the evaluation. A
company's securities typically include both debt and equity, one must
therefore calculate both the cost of debt and the cost of equity to
determine a company's cost of capital.

Concepts

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To deeply understand the working & calculating of the cost of

capital, it is necessary to understand certain concepts related to it. Some
important concepts & components of the cost of capital are as under:

1. Opportunity Cost of Capital ( Implicit cost): The opportunity

cost is the rate of return the shareholder forgoes by not putting his funds
elsewhere because they are retained by the management it is the rate of
return on the best possible investment that are retained by the
management. It is the rate of return on best possible investment that the
shareholders and the firm would forego if the projects presently under
consideration by the firm were accepted. Opportunity cost is technically
referred to as the implicit cost of capital. It is a cost in the sense that it is
the rate of return at which the shareholders could have invested these
funds, had they been distributed to them.

EXAMPLE: If the profits are distributed than the shareholders can

invest such profits in the stock market where they can earn a return up to
24% p.a. In this case opportunity coat capital can be regarded as 24% for
retained earnings.

2. Specific Cost of Capital (Explicit Cost): The explicit cost of

capital is associated with the raising of funds. It involves two steps:

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1. Calculation of the specific cost of each type of capital- debt,

preference share, equity shares and retained earnings.
2. Calculation of weighted average cost capital by combining the
specific costs.
3. Cost of Debt: Long term debts are generally obtained through
the issue of debentures or bank loan from the financial institutions. The
issue of debentures involves a number of floatation expenses such as
printing, underwriting commission, brokerage, discount, etc. moreover,
debentures may be issued at premium or at discount. These floatation
costs and modes of issue have important bearing on the cost of debt
capital. It is therefore, necessary to ascertain the net proceeds from such
issue. It is customary to compute the cost of debt therefore, necessary to
ascertain the net proceeds from such issues. It is customary to compute
the cost of debt capital on an after tax basis as interest payment are
treated as tax deductible expenses.

4. Preference Shares: Capital stock which provides a specific

divided that is paid before any dividends are paid to common stock
holders, and which takes precedence over common stock in the event of
a liquidation is called preference share. Like common stock, preference
shares represent partial ownership in a company, although preferred
stock shareholders do not enjoy any of the voting rights of common
stockholders. Also unlike common stock, preference shares pay a fixed
dividend that does not fluctuate, although the company does not have to
pay this dividend if it lacks the financial ability to do so. The preference
capital is also referred to as the capital contributed by the preference
shareholders. The preference shareholders receive dividends in the fixed
rate but they do not enjoy voting rights.

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5. Equity capital: Equity capital is the invested money that, in

contrast to debt capital, is not repaid to the investors in the normal
course of business. It represents the risk capital staked by the owners
through purchase of the firm's common stock (ordinary shares). Its value
is computed by estimating the current market value of everything owned
by the firm from which the total of all liabilities is subtracted. On the
balance sheet of the firm, equity capital is listed as stockholders' equity
or owners' equity. It may also be called equity financing or share capital.

6. Retained earnings: In most cases, companies retain their

earnings in order to invest them into areas where the company can create
growth opportunities, such as buying new machinery or spending the
money on more research and development.
Should a net loss be greater than beginning retained earnings, retained
earnings can become negative, creating a deficit.
The retained earnings general ledger account is adjusted every time a
journal entry is made to an income or expense account.

Mode Of Measuring Cost Of Capital

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In making investment decisions, cost of different types of capital is

measured and compared. The source, which is the cheapest is chosen
and capital raised. Now the problem is how to measure the cost of
different sources of capital. In fact, there is no exact procedure for
measuring the cost of capital. It is based largely on forecasts and is
subject to various margins of error.

While computing the cost of capital care should be taken about such
factors as the needs of the company, the conditions under which it is
raising its capital, corporate policy constraints and level of expectation.
In fact, a company raises funds from different sources, and therefore,
composite cost of capital can be determined after specific cost of each
type of fund has been obtained. It is therefore, necessary to determine
the specific cost of ea source in order to determine the minimum
obligation of a company, i.e., composite cost of raising capital.

In order to determine the composite cost of capital, the specific costs of

different sources of raising funds are calculated in the following
manner:-

(1) Cost of Debt:

In measuring cost of capital, the cost of debt should be considered first.
In calculating cost of debt, contractual cost as well as imputed cost
should be considered. Generally, the cost of debt (Debentures and long-
term debts) is defined in terms of the required rate of return that the
debt-investment must yield to protect the share holders' interest. Hence
cost of debt is the contractual interest rate adjusted further for the tax-
liability of the firm.

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As per Formula:-

                           Kd = (1 – T) R.

Here:                  Kd = Cost of debt capital

                          T = Marginal tax rate applicable to the company.

R = Contractual interest rate. 

Suppose, a company issues 9 % debentures. Its marginal tax rate is 50

%. The effective cost of these debentures will be as follows :- 

                              K = (1- 50) X 9

or                          K = .50 X 9 = 4.50 %

As because of the tax deductibility of interest, it is customary to compute

the cost of borrowed funds as an after tax-rate of interest.

When more debt finance is used, the cost of debt is likely to increase
above the actual rate of interest on account of two accounts- (a) The
contractual rate of interest will rise; and (b) hidden cost of borrowing
will also be taken into account. In this way, real cost of debt will be
higher, if company relies more and more on debt finance. If it were not
so, the management would always finance by this source of capital. 

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(2) Cost of Preference Shares:

Preference shares are the fixed cost bearing securities. The rate of
dividend is fixed well in advance at the time of their issue. So, the cost
of capital of preference shares is equal to the ratio of annual dividend
income per shares to the net proceed. The ratio is called current dividend
yield.

The formula for calculating the cost of preference share is:-

Kp = R

Here:             Kp = Cost of preferred capital

                     R = Rate of preferred dividend.

                     P = Net Proceeds.

For example, suppose a company issues 95 preference shares of Rs. 100

each at a premium of Rs. 5 per share. The issue expenses per share
comes to Rs. 3 . The cost of preference capital shall be calculated as
under :-

      9                9 
                Kp = ------------- or ------- = 8.82 %
                         100 + 5 – 3    102

The cost of preference share capital is not be adjusted for taxes, because
dividend on preference capital is paid after taxes as it is not tax
deductible. Thus, the cost of preference capital is substantially greater
than the cost of debt.

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(3) Cost of Equity Shares:

The calculation of equity capital cost is not an easy job and raises a host
of problems. Its purpose is to enable the management to make decisions
in the best interest of the equity holders. Generally the cost of equity
capital indicated the minimum rate which must be earned on projects
before their acceptance an the raising of equity funds to finance those
projects. several models have been proposed. Most not-able among them
are the models of Ezra Solomon, Myren J. Gordon, James E. Walter, and
the team of Modigliani and Miller.

Weighted Average Cost of Capital

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A company has to employ owner's funds as well as creditors' funds

to finance its project so as to make the capital structure of the company
balanced and to increase the return to the shareholders.

The total cost of capital is the aggregate of costs of specific

capitals. In financial decision making, the concept of composite cost is
relevant. The composite cost of capital is the weighted average of the
cost of various sources of funds, weights being the proportion of each
source of funds in the capital structure. It should be remembered, that it
is weighted average, and not the simple average, which is relevant in
calculating the overall cost of capital. The composite cost of all capital
lies between the leas t and the most expensive funds. This approach
enables the maximizations of corporate profits and the wealth of the
equity shareholders by investing the funds in a projects earnings in
excess of the cost of its capital-mix.

Weighted average, as the name implies, is an average of the costs

of specific source of Capital employed in a business, properly weighted
by the proportion, they hold in the firm's capital structure.

A company’s cost of capital is the weighted average cost of

various sources of finance used by it, viz., equity, preference, & debt.

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Suppose that a company uses equity, preference, & debt in the following
proportions: 50, 10, and 40. If the component cost of equity, preference,
& debt are 16%, 12%, & 8% respectively, the weighted average cost of
capital (WACC) will be,

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

(Proportion of preference) (Cost of preference) +

(Proportion of debt) (Cost of Debt)

= (0.5) (16) + (0.10)(12) + (0.4)(8)

= 12.4%

wd we Think of the firm’s capital

THE FIRM’S structure as a pie, that you
CAPITAL
can slice into different
STRUCTURE IS wp shaped pieces. The firm
THE MIX OF
DEBT AND strives to pick the weights
EQUITY USED of debt and equity (i.e.
TO FINANCE slice the pie) to minimize
THE BUSINESS. the cost of capital.

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Preliminaries to be remembered
Bear in mind the following while applying the WACC formula:

 For the sake of simplicity, we consider only three types of capital

(equity, non convertible, non callable preference and non
convertible, non callable debt). We have ignored other forms of
capital like convictable or callable preference, convertible or
callable debt, bonds with payments linked to stock market index,
warrants, so on and so forth. Calculating these forms of capital is
somewhat complete. Fortunately, more often than not, they are a
minor source of capital. Hence excluding them may not make a
material difference.

 Date includes long-term debt as well as short-term debt (such as

working capital loans and commercial paper). Some companies
leave out short-term debt while calculating the WACC. In principle
this is not correct. Investors who provide short term debt also have
a claim on the earning of the firm. The company ignores the
claim; it will misstate the rate of return required on its investment.

 Non-interest bearing liabilities such as trade creditors are not

included in the calculation of WACC. This is done to ensure
consistency and to simplify valuation. True, non interest bearing
liabilities have a cost. This cost is implicitly reflected in the price
paid by the firm to acquire goods and services. Hence, it is already
taken care of before the free cash flow is determined.

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* The rationale for using WACC as the hurdle rate in capital

budgeting is fairly straightforward. If a firm’s rate of interest on its
investment exceeds its cost of capital equity share holders benefit.

Determining the proportions

For calculating the WACC we need information on the cost of

various sources of capital & the proportions (or weights) applicable to
them. We now look at how the weights should be established.
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, or the expected
capital structure the firm plans to have in future.
However, there may be some difficulties in actually using the
target capital structure, as against its conceptuality. A company may not
have a well-defined capital. The changing complexion of business
makes it difficult for the company to articulate its capital structure. Also,
many a times, the target capital structure may significantly differ from
the current capital structure.
Lastly, the debate is still on fire about whether to take book value
or market value. Finance scholars, however, believe that market values,
despite their volatility, are superior to book values, because in order to
justify its valuation the firm must earn competitive returns for
shareholders & debt holders on the current value (market value) of their
investments.

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Nonetheless, financial experts recommend the use of market value

weights unless market values are not available or highly unreliable or
distorted due to manipulative trading.

Factors Affecting WACC

The cost of capital is affected by several factors, some beyond the

control of the firm and others dependent on investment and financing the
firm.
1) Factors outside firms control – The three most important
factors, outside a firm’s direct control that have a bearing on the cost of
capital are the level of interest rates, the market risk premium, and the
tax rate.

2) The level of interest rate- If interest rate in the economy

raises, the cost of debit to firm increase and vice versa. Interest rate also
has a similar bearing on the cost of preference and cost of equity.
Remember that the risk free rate of interest is an important component of
the camp capital.

3) Market risk premium- The market risk premium reflects the

perceived riskiness of equity, stock and investor. The factor beyond the
control of individual firms, the market risk premium affect the cost of
equity directly and the cost of debt indirectly.

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4) Tax rate- The tax policy of the government has a bearing in the
cost of capital. The corporate tax rate has a direct impact on the cost of
debt as used in weighted average cost of capital.

5) Factors within a firms control- The cost of capital of a firm

is affected by its environment policy, capital structure policy and
dividend policy.

6) Investment Policy- To estimate the cost of capital, we start

with the rates of return required on the outstanding equity and the debt
of the firm. These rates reflect how risky the firms existing assets are. If
a firm plans to invest in assets similar to those currently used, then its
marginal cost of capital would more or less be same as its cost of capital.
On the other hand, if the riskiness of it is proposed investment is likely
to be very different from the riskiness of its existing investments, the
marginal cost of capital should reflect the riskiness of the proposed
investment.

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Common Misconceptions

1) The concept of cost of capital is too academic or impractical-

Some companies do not calculate the cost of capital because they
regard it as academic or impractical. These misgivings about cost appear
to be unjustified. Such reservation can be dispelled by emphasizing the
following points:
i. The cost of capital is an important ingredient of discount cash
analysis. Since o counted cash flow analysis is now widely
used , cost of capital can scarcely be considered academic
ii. Out of the various inputs required for discounted cash flow
analysis, project like project cash flows and cost of capital, the
last one seems to be misplaced.

2) Current liabilities are considered as capital components-

Sometimes it is urged that accounts payable and accruals are

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sources of funding to the calculation of WACC. This view is not correct

because what is not provided by investors is not capital.

3) The coupon rate on the firm’s existing debt is used as pre tax cost
of debt-
The coupon rate of the existing debt reflects a historical cost. What
really matters in investment decision making is the interest rate of the
firm would pay if it issues debt today.

4) When estimating the market risk premium in some methods, the

historical average rate of return is used along with the current risk
free rate-
Consider the following instruction

 Historical average return on common stocks = 19 percent

 Historical return on long term treasury bond = 10 percent

 Current expected return on common stocks = 14 percent of

the differ between historic

 Current return on long term treasury bonds = 7 percent

Sometimes the market risk premium is calculated as the
difference between the historical average return on common
stocks and the current return on long term treasury bonds.

5) The cost of equity is equal to the dividend rate of return in equity

-
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It appears that the cost of equity is sometimes measured incorrectly. It

is measured as the current dividend rate or as return on equity. Only by
accident do these measures represent the cost of equity properly.

6) Depreciation has no cost –

Similar to the misconception that retained earnings are more or less
cost free, is the notion that depreciation generated funds are also vital &
cost free. Depreciation is capital already in the company.

7) Book value weights may be used to calculate the WACC-

Often firms use book value weights in the existing capital structure
to calculate WACC. This is not correct. Capital structure should
determine the weights for the WACC. If the target capital is not
specified, use the current market value weights.

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CONCLUSION
(1) Capital Budgeting Decision:
Cost of capital may be used as the measuring road for adopting an
investment proposal. The firm, naturally, will choose the project which
gives a satisfactory return on investment which would in no case be less
than the cost of capital incurred for its financing. In various methods of
capital budgeting, cost of capital is the key factor in deciding the project
out of various proposals pending before the management. It measures
the financial performance and determines the acceptability of all
investment opportunities. 

(2) Designing the Corporate Financial Structure:

The cost of capital is significant in designing the firm's capital
structure. The cost of capital is influenced by the chances in capital
structure. A capable financial executive always keeps an eye on capital
market fluctuations and tries to achieve the sound and economical
capital structure for the firm. He may try to substitute the various
methods of finance in an attempt to minimise the cost of capital so as to
increase the market price and the earning per share. 

(3) Deciding about the Method of Financing:

A capable financial executive must have knowledge of the
fluctuations in the capital market and should analyse the rate of interest
on loans and normal dividend rates in the market from time to time.
Whenever company requires additional finance, he may ave a better
choice of the source of finance which bears the minimum cost of capital.
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Although cost of capital is an important factor in such decisions, but

equally important are the considerations of relating control and of
avoiding risk. 

(4) Performance of Top Management: The cost of capital can be used

to evaluate the financial performance of the top executives. Evaluation
of the financial performance will involve a comparison of actual
profitabilities of the projects and taken with the projected overall cost of
capital and an appraisal of the actual cost incurred in raising the required
funds. 

(5) Other Areas: The concept of cost of capital is also important in

many others areas of decision making, such as dividend decisions,
working capital policy etc.

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BIBLIOGRAPHY

1. Financial Management – Prasanna Chandra

2. Financial Management – Khan & Jain

3. www.google.com

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