Module 3

Cost

Of Capital

INTRODUCTION
2

The

projects cost of capital is the minimum

required rate of return on funds committed to the
project, which depends on the riskiness of its cash
flows.

The

firms cost of capital will be the overall, or

average, required rate of return on the aggregate of
investment projects

THE CONCEPT OF THE

OPPORTUNITY COST OF
CAPITAL
The opportunity cost is the rate of return foregone on the next
best alternative investment opportunity of comparable risk.

Opportunity cost of capital is given by the following formula:

where Io is the capital supplied by investors in period 0 (it

represents a net cash inflow to the firm), Ct are returns
expected by investors (they represent cash outflows to the
firm) and k is the required rate of return or the cost of capital.

Weighted Average Cost of

Capital vs. Specific Costs of
Capital
The cost of capital of each source of capital is known

as

component, or specific, cost of capital.

The overall cost is also called the weighted average cost of
capital (WACC).
Relevant cost in the investment decisions is the future cost or
the marginal cost.
Marginal cost is the new or the incremental cost that the firm
incurs if it were to raise capital now, or in the near future.
The historical cost that was incurred in the past in raising
capital is not relevant in financial decision-making.

COST OF DEBT
5

Debt

Issued at Par
kd i

Debt

INT
P

Issued at Discount or Premium

INT
kd i
NP / SV

Tax

adjustment

After tax cost of debt k d (1 T )

COST OF REDEEMABLE
DEBT
Before Tax

INT 1 / n( RV SV )
kd
1 / 2( RV SV )

After Tax

INT(1 t ) 1 / n( RV NP )
kd
1 / 2( RV NP )

EXAMPLE
7

a) X Ltd issues Rs 50,000 8% debentures at par. The tax rate

applicable to the company is 50%. Compute the cost of debt capital.
b) Y Ltd issues Rs 50,000 8% debentures at a premium of 10%. The tax
rate applicable to the company is 60%. Compute the cost of debt
capital.
c) A Ltd issues Rs 50,000 8% debentures at a discount of 5%. The tax
rate applicable to the company is 50%. Compute the cost of debt
capital.
d) B Ltd issues Rs 100,000 9% debentures at a premium of 10%. The
cost of floatation are 2%. The tax rate applicable to the company is
60%. Compute the cost of debt capital.
-> NP = 110,000 - (.02x110,000)

EXAMPLE
8

A company issues Rs 10,00,000 10% redeemable debentures at

a discount of 5%. The cost of floatation amount to Rs 30,000.
The debentures are redeemable after 5 years. Calculate
before tax and after tax cost of debt assuming a tax rate of
50%.
-> RV = 10,00,000
-> NP = (10,00,000-50,000-30000)
A 5 year Rs 100 debenture of a firm can be sold for a net price
of Rs 96.50. Coupon rate of interest is 14% and it will be
redeemed at 5% premium on maturity. The tax rate is 40%.
Compute after tax cost of debenture.
-> RV = 105
-> NP = 96.5

EXAMPLE
9

Assuming that a firm pays tax at 50% rate, compute the after tax
cost of debt capital in the following cases:
a) A perpetual Rs 100 bond sold at par, coupon rate being 7%
b) A 10year, 8% Rs 1000 bond sold at Rs 950 less 4%
underwriting commission.
-> Redeemable Or Irredeemable
-> RV = 1000
-> NP = 912

10

COST OF PREFERENCE
CAPITAL
Irredeemable

Preference Share
PDIV
kp
NP
Redeemable Preference Share
MV NP
D
n
Kp
1
( MV NP )
2

Example
11

Example
12

company issues 10,000 10% Preference Shares

of Rs 100 each. Cost of issue is Rs 2 per share.

Calculate the cost of preference shares if it is issued

A) at par
B) at a premium of 10%
C) at a discount of 5%

Example
13

company issues 10,000 10% Preference Shares

of Rs 100 each redeemable after 10 years at a
premium of 5%. Cost of issue is Rs 2 per share.
Calculate the cost of preference share capital.
MV NP
D
n
Kp
1
( MV NP )
2

-> MV = 10,50,000
-> NP = 980,000

Example
14

company issues 1000 7% Preference Shares of

Rs 100 each at a premium of 10% redeemable after
5 years at par. Calculate the cost of preference
share capital.
MV NP
D
n
Kp
1
( MV NP )
2
-> MV = 100,000
-> NP = 110,000

COST OF EQUITY CAPITAL

15

a) Dividend Yield Method:

DIV1
Ke
NP
DIV1
Ke
MP

b) Dividend Yield Plus Growth:

DIV1
Ke
G
NP

Example
16

A company issues 1000 Equity Shares of Rs 100 each at a premium

of 10%. They have been paying 20% dividend and will continue to
do so. Calculate the cost of equity share capital. Will it make any
difference if the market price is Rs 160?

DIV1
Ke
NP

a)
b)

Ke = 20/110 = 18.18%
Ke = 20/160 = 12.5%

DIV1
Ke
MP

Example
17

A) A company issues 1000 Equity Shares of Rs 100 each at par.

Floatation cost are expected to be 5% of the share price. They have
been paying Rs10 dividend per share and the growth in dividend is
expected to be 5%. Calculate the cost of equity share capital.
->NP = (100-5)

DIV1
Ke
G
NP

B) If the current market price is Rs 150, calculate the cost of equity.

->MP = 150
DIV1
Ke
G
MP

18

COST OF EQUITY
CAPITAL
EarningsPrice

Ratio and the Cost of Equity

EPS1
ke
P0

Example: EPS
19

A firm is currently earning Rs 100,000 and its share is selling

at a market price of Rs 80. The firm has 10,000 shares
outstanding and has no debt. The earnings of the firm are
expected to remain stable, and it has a payout ratio of 100 per
cent. What is the cost of equity?
We can use expected earnings-price ratio to compute the cost
of equity. Thus:

20

THE CAPITAL ASSET

PRICING MODEL (CAPM)
As

per the CAPM, the required rate of return on

equity is given by the following relationship:

ke R f ( Rm R f )
Equation

requires the following three parameters

to estimate a firms cost of equity:

The risk-free rate (Rf)

The market risk premium (Rm Rf)
The beta of the firms share ()

Example
21

Suppose

in the year 2012 the risk-free 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:

Example
22

1)

T-Bill return is 8%, Systematic risk of ABC Ltd

is around 1.125 and Market/Index return of 12%.
Calculate the cost of ABC equity.

2)

T-Bill return is 10%, XYZ ltd Beta is 1.10 and

Index return is of 18%. Compute the cost of equity.

THE WEIGHTED AVERAGE

COST OF CAPITAL

23

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 component costs to get the WACC.
k o k d (1 T ) wd k e we
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.

24

The Cost of Capital for

Projects
For

example, projects may be classified as:

Low risk projects

discount rate < the firms WACC

Medium risk projects

discount rate = the firms WACC

High risk projects

discount rate > the firms WACC

Example
25

Source

Of Funds:

Debt
Preference Share
Equity Shares
Retained Earnings
Total

15,00,000
12,00,000
18,00,000
15,00,000
60,00,000

Solve Weighted Average Cost Of Capital.

5% cost
10% cost
12% cost
11% cost

Example
26

Source

Of Funds:

Debt
Preference Share
Equity Shares
Retained Earnings
Total

18,00,000
22,00,000
18,00,000
10,00,000
68,00,000

Solve Weighted Average Cost Of Capital.

10% cost
14% cost
12% cost
10% cost

27

CAPITAL STRUCTURE

Capital Structure
Theories:

28

Net operating income (NOI) approach.

Traditional approach and Net income (NI)

approach.

MM hypothesis with and without corporate tax.

Millers hypothesis with corporate and personal

taxes.

29

Net Operating Income (NOI)

Approach

According to NOI approach

the value of the firm and the
weighted average cost of
capital are independent of
the firms capital structure.
In the absence of taxes, an
individual holding all the
debt and equity securities
will receive the same cash
flows regardless of the
capital
structure
and
therefore, value of
the
company is the same.

Net Income (NI)

Approach

30

According to NI approach
both the cost of debt and the
cost of equity are independent
of the capital structure; they
remain constant regardless of
how much debt the firm uses.
As a result, the overall cost of
capital declines and the firm
value increases with debt.
This approach has no basis in
reality; the optimum capital
structure would be 100 per
cent debt financing under NI
approach.

Traditional Approach
31

The traditional approach

argues that moderate degree
of debt can lower the firms
overall cost of capital and
thereby, increase the firm
value. The initial increase in
the cost of equity is more than
offset by the lower cost of
debt. But as debt increases,
shareholders perceive higher
risk and the cost of equity
rises until a point is reached
at which the advantage of
lower cost of debt is more
than offset by more expensive
equity.

Cost
ke

ko

kd

Debt

Relationship between capital

structure and
the firm value :

32

First

stage: Increasing value

Second stage: Optimum value
Third stage: Declining value

33

Criticism of the
Traditional View

The contention of the traditional theory, that moderate

amount of debt in sound firms does not really add very
much to the riskiness of the shares, is not defensible.

There does not exist sufficient justification for the

assumption that investors perception about risk of
leverage is different at different levels of leverage.

34

MM Approach Without
Tax: Proposition I

MMs Proposition I is
that, for firms in the same
risk class, the total market
value is independent of
the debt-equity mix and is
given by capitalizing the
expected net operating
income
by
the
capitalization rate (i.e.,
the opportunity cost of
capital) appropriate to
that risk class.

35

MMs Proposition I: Key

Assumptions
Perfect

capital markets
Homogeneous risk classes
Risk
No taxes
Full payout

36

The cost of capital under

MM proposition I

37

Criticism of the MM
Hypothesis
Lending

and borrowing rates discrepancy

Non-substitutability of personal and corporate
leverages
Transaction costs
Institutional restrictions
Existence of corporate tax

MM Approach With Tax: Proposition II

38

MM

show that the value of the firm will increase

with debt due to the deductibility of interest
charges for tax computation, and the value of the
levered firm will be higher than of the unlevered
firm.

39

LEVERAGE

Operating Leverage
Operating Leverage -- The use of
fixed operating costs by the firm.

One potential effect caused by the

presence of operating leverage is that a
change in the volume of sales results in a
more than proportional change in
operating profit (or loss).

Degree of Operating
Leverage (DOL)
Degree of Operating Leverage -- The
percentage change in a firms operating
profit (EBIT) resulting from a 1 percent
change in output (sales).
DOL

Percentage change in
operating profit (EBIT)
Percentage change in
output (or sales)

Financial Leverage
Financial Leverage -- The use of
fixed financing costs by the firm. The
British expression is gearing.

Financial leverage is acquired by choice.

Used as a means of increasing the return to
common shareholders.

Degree of Financial
Leverage (DFL)
Degree of Financial Leverage -- The
percentage change in a firms earnings per
share (EPS) resulting from a 1 percent
change in operating profit.
DFL

Percentage change in
earnings per share (EPS)
Percentage change in
operating profit (EBIT)