Cost of Capital

General concept of Cost of Capital Problems faced in computing the firms cost of capital Methods of computing cost of capital

Basic Notion of Cost of Capital

The discount rate is the projects opportunity cost of capital for discounting its cash flows. The projects cost of capital is the min acceptable rate of return on funds committed to the project. The min acceptable rate, or the required rate of return is a compensation for time and risk in the use of capital by the project. Since different projects have different risk, each project has its own cost of capital.

A firms cost of capital will be the overall, or average or required rate of return on the aggregate of the investment projects. k can be set as a standard for establishing the required rates of return of the individual investment projects. Objective method for calculating the riskadjusted cost of capital is to use the Capital asset pricing model.

Significance of the Cost of Capital

Vital importance in financial decision making. It is an useful standard for Evaluating investment decisions-k, min required rate of return, wealth of SHs unchanged Designing a firms debt policy Firms aim to minimize the overall cost of Debt Appraising the financial performance of Top Management Comparison of actual with the standard

Concept of Cost of Capital

Opportunity Cost: Choosing among alternatives of comparable risk. Shareholders Opportunities and Values: Whose Opp.Cost-Cos or SHs. In all equity firms, Ke=K, Max SHs wealth Creditors claim: Legal obligation to pay interest and return Principal. Should earn to pay back Risk differences: Diff rates of return for different securities. High risk high return. Firm should earn sufficient return to pay back to people who have contributed.

Overall and Specific Cost of Capital

Many sources of capital Cost of capital of each source differ Combined capital of all sources of capital is called overall, or average cost of capital. Combined relevant to the weights of each component of capital. Overall capital is also called WACC

Definition

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It is defined as the minimum rate of return that a firm must earn on is investment for the market value of the firm to remain unchanged. Assumptions: Firms business risk and financial risk is unaffected by the acceptance and financing of projects Business risk and Financial risk. Firms financial structure is assumed to remain fixed. Interest paid on debt is tax deductible.

To sum up, k consists of the following three components. The riskless cost of the particular type of financing Business risk premium b The financial risk premium f k = rk + b + f

Explicit and Implicit costs

The explicit cost of any source of capital is the discount rate that equates the PV of the cash inflows that are incremental to the taking of the financing opportunity with the PV of is incremental cash outflows. Similar to computation of IRR Explicit cost of retained earnings, gifts is 100%, since no outflows The implicit cost of capital of funds raised and invested by the firm may, therefore be defined as the rate of return associated with the best investment opportunity for the firm and its shareholders that would be foregone, if the projects presently under consideration by the firm were accepted. Cost of retained earnings- Implicit cost

Measurement of Specific Costs

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k is overall cost Combined cost of the specific costs associated with specific sources of financing. Two steps, The computation of the different elements of the cost in terms of the cost of the different sources of finance. The calculation of the overall cost of combining the specific costs into a composite cost.

Cost of Debt

Relatively easy Data required1. Net cash proceeds/inflows (Issue price of debt/ amount of loan for a specific source of debt 2. Net cash outflows in terms of the amount of periodic interest payment and repayment of principal in installment or in lump sum on maturity. Interest payments are tax deductible in determining net taxable income

Cost of perpetual debt

It is the rate of return which the lenders expect Debt carries a certain rate of interest rate The coupon rate can said to represent an approx of cost of debt. But it is before tax cost, ki = I / SV Where ki is the before tax cost of debt I is the Interest paid SV is the sales proceeds of the bond or debenture kd = I (1- t)/ SV

Cost of Redeemable Debt

Kd =
I (1 t ) ( f d pr Pi ) / Nm ( RV SV ) / 2

Cost of Preference Shares

Is conceptually difficult as compared to the cost of debt. No obligation on part of the company to pay interest No risk of legal bankruptcy Prior right on dividends over shareholders PS div is cumulative until paid

Redeemable preference shares Po(1-f) = d1/(1+kp) + d2/(1+kp)2+dn+Pn/(1+kp)n Po = Sales price F = floatation costs D = dividends Pn = repayment of Principal

Cost of Equity

According to Dividend approach cost of equity capital is cal on the bass of a required rate of return in terms of future dividend to be paid. Ke is defined as the discount rate which equates the PV of al expected future dividends per share with the net proceeds of the sake(or the current market price of a share.

To calculate ke two elements are needed. Net proceeds from sale of a share/current market price (adjusted for floatation costs/discount/premium) Dividends and capital gains expected. In case of dividends investors expect a rate of div which will not be constant but will grow. Growth of dividend may be either at a uniform normal rate perpetually or in any other form,

Po(1-f) = Do(1+g)/(1+ke) +Do(1+g)2/(1+ke)2. +Do(1+g)n/(1+ke)n Simplyfying, Po = D1/(ke -g) or Ke = D1/Po +g D1= the expected dividend Po= Net proceeds or current market price G=growth in expected dividends For different growth assumptions Po(1-f) = Do(1+g)/(1+ke) +Do(1+g)2/(1+ke)2. +Do(1+g)n/(1+ke)n

Based on certain assumptions, MV of shares depends upon the expected dividends. Investors can formulate subjective probability distribution of dividends per share expected to be paid in various future periods. Do > zero Dividend payout ratio is constant Investors can accurately measure the riskiness of the firm so as to agree on the rate at which to discount the dividends

Cost of Retained Earnings: kr

There is no obligation on the part of a firm to pay a return on retained earnings. If earnings are not retained, they would have been paid out to ordinary share holders as dividends As the SH forgo dividends, firm is implicitly required to earn on the retained earnings. They belong to the SHs, it is similar to additional investment in new equity shares.

This implies that a Shareholder can be expected to require the same return on retained earnings as he would expect from new equity investment. Ke may be said to represent the opportunity cost of retained earnings. It is the starting point to calculate kr Some adjustments to be made. No floatation cost Ke is based on current market price Ke is to be adjusted for tax

Kr can be expressed as follows: Kr = ke +Do/Po + g ; where taxes and brokerage apply Kr = (Do/Po +g) (1-t)(1-B)

Computation of Overall cost of Capital

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OCC is the weighted average of the cost of each specific type of fund Wt avg is not simple average different proposition of sources of fund K or ko involve the following source Assigning weights to specific costs Multiplying the cost of each sources by the appropriate weights

Dividing the total weight by the total weights Crucial point. The Determination of the Weights Historical Weights Marginal Weights etc,