Atif Ghayas, Lovely Professional University Unit 07 : Cost of Capital Notes

Unit 07: Cost of Capital

CONTENTS
Objectives
Introduction
7.1 Discount Rate
7.2 Meaning of Cost of Capital
7.3 Importance of Cost of Capital
7.4 Weighted Average Cost of Capital
7.5 Cost of Equity Capital
7.6 Steps in the calculation of WACC
7.7 International Dimensions in Cost of Capital
Keywords
Self Assessment
Answers for Self Assessment
Review Questions
Further Readings

Objectives
After studying this unit, you will be able to:
• understand the meaning and concept of Cost of capital.
• analyze the significance of Cost of capital.
• compute the cost of Debt.
• compute cost of Preference Shares,
• compute cost of Internal Equity,
• compute cost of External Equity
• understand the concept of WACC.
• compute the WACC.
• analyse the international dimension in Cost of Capital.

Introduction
In the previous chapter, we discussed capital budgeting techniques. In the capital budgeting
decisions, the estimation of cash flow and the discount rate is very crucial. The discount rate is
based on a certain required rate of return from the project which becomes the basis for accepting or
rejecting the project. That required rate is the cost of capital of a firm. Apart from its usefulness as
an operational criterion to accept/reject an investment proposal, cost of capital is also an important
factor in designing capital structure. In this chapter, we will discuss the cost of Debt, Cost of Equity,
and the overall cost of capital in a firm.

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Evaluating an investment project requires two basic inputs:

Estimates of the project’s cash flows

Discount rate

Discount Rate
The opportunity cost of capital or the cost of capital for a project is the rate for discounting the cash
flows. The project’s cost of capital is the minimum required rate of return on funds invested in the
project, which depends on the riskiness of its cash flows. The firm represents the aggregate of
investment projects undertaken by it. The firm’s cost of capital will be the average required rate of
return on the total investment projects undertaken by the firm.

Meaning of Cost of Capital

A firm needs various factors of production like capital, labor, land etc. for its production process.
Every factor employed in the production process has to be rewarded in some form. Capital is
rewarded through Interest or dividend, labor with salary and wages, land with rent and
entrepreneurship with profits. Cost of capital is the return required by the providers of capital to
the business as a compensation for their contribution to the total capital. When a firm has procured
finances, it has to pay some additional amount of money besides the principal amount. The
additional money paid by the firm is the cost of using the capital.

Importance of Cost of Capital

The computation of the firms cost of capital is very important due to the following reasons:
• Evaluation of investment options: The main purpose of measuring the cost of capital is for
evaluating the investment projects. The project’s NPV is calculated by discounting its cash
flows by the cost of capital. In the IRR method, the investment project is accepted if it has an
internal rate of return greater than the cost of capital.
• Designing of optimum credit policy: The debt policy of a firm is significantly influenced by
the cost consideration. Debt helps to save taxes as interest on debt is a tax-deductible expense.
The interest tax shield reduces the overall cost of capital.
• Performance Appraisal: The cost of capital framework can be used to evaluate the financial
performance of top management.Cost of capital is used to appraise the performance of a
particular project or business.

Opportunity cost of capital:

The opportunity cost is the rate of return foregone on the next best alternative investment
opportunity of comparable risk. Thus, the required rate of return on an investment project is an
opportunity cost. For example, you may invest your savings of Rs. 100,000 either in 6.5 per cent 3-
year Fixed deposit in a Bank or 7 per cent, 3-year postal certificates.

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Shareholders’ Opportunity Cost:

The manager should consider the required rate of all the shareholders’ in evaluating the investment
decisions. In an all-equity financed firm, the equity capital of ordinary shareholders is the only
source to finance investment projects.Firm’s cost of capital is equal to the opportunity cost of equity
capital, which will depend only on the business risk of the firm.

Creditors’ Opportunity cost:

Different investors are exposed to different degrees of risk. Unlike equity shareholders, the firm is
under a legal obligation to pay interest and repay principal to the creditors. Debt holders are
exposed to the risk of default by the firm.
Preference shareholders hold claim prior to ordinary shareholders but after debt holders.
Preference dividend is fixed, the firm will pay it after paying interest but before paying any
ordinary dividend. Dividends is paid to the ordinary shareholders from cash remaining after
interest and preference dividends have been paid.

Risk Differences: Shareholders’ and Creditor Claims

The investors demand different rates of return on various securities as the risk level is different for
different type of security. Higher the risk of a security, the higher the rate of return required by
investors. Ordinary shareholders will require highest rate of return on their investment. Preference
share is riskier than debt, its required rate of return will be higher than that of debt. Required rate
of return of any security includes two rates—a risk-free rate and a risk premium. A risk-free
security will require compensation for time value and its risk-premium will be zero such as the
treasury bills and bonds. In case of risky securities, Investors expect higher rates of return. The
higher the risk of a security, the higher will be its risk-premium.
From the viewpoint of all investors, the firm’s cost of capital is the rate of return required by them
for supplying capital. The rate of return required by all investors will be an overall rate of return—a
weighted rate of return. Thus, the firm’s cost of capital is the ‘average’ of the opportunity costs (or
required rates of return) of various securities, which have claims on the firm’s assets.

Determination of the cost of Capital

The cost of capital can either be explicit or implicit.
• Explicit cost: The cash outflow of a firm towards the utilization of capital which is clear.
• Implicit cost: Not a cash outflow but is an opportunity loss of foregoing a better
investment opportunity.

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) represents a firm's average cost of capital from all
sources, including Equity shares, preferred shares, debentures, and other forms of debt. The
weighted average cost of capital is a common way to determine required rate of return because it

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expresses, in a single number, the return that both debenture holders and shareholders demand in
order to provide the company with capital. The WACC represents the minimum return that a
company must earn to pay to its creditors, owners, and other providers of capital. The WACC may
have the following components:

Cost of Debt

Cost of Equity
WACC
Cost of Pref Share
Capital

Cost of Retained
Earnings

1. Cost of Debt
Let’s first discuss the cost of debt for the business or the cost of borrowed funds. Debt can be raised
from financial institutions or public either in the form of public deposits or debentures (bonds). A
debenture may be issued at par or at a discount or premium as compared to its face value. The
contractual rate of interest forms the basis for calculating the cost of debt. The long-term debt can
be divided into redeemable debt and irredeemable debt and thus the cost of debt will include the
cost of irredeemable debt and cost of redeemable debt.

Cost of Long term

Debt

Cost of Cost of Redeemable

Irredeemable Debt Debt

Debt Issued at Par

The before-tax cost of debt (kd) is the rate of return required by debt providers. Before-tax cost of
debt issued and to be redeemed at par is equal to the contractual rate of interest (i).

= =

Where,
• Kd = Before tax cost of Debt
• i = Coupon rate of interest,
• B0 = Issue price of the bond (debt)
• INT = Amount of interest.

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Debt Issued at Discount or Premium

Both methods will give identical results only when debt is issued at par and redeemed at par.
Present Value method can be rewritten as follows to compute the before-tax cost of debt

Where,
• B0 = value of debenture today,
• Bn = repayment value of debt on maturity.

Above equation can be used to find out the cost of debt whether debt is issued at par or discount or
premium, i.e., B0 = F or B0> F or B0< F. Assume that in the previous example each bond is sold
below par for Rs. 94, kd is calculated as:

Kd will be found by trial and error.

• Try 17%

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15(3.922) + 100(0.333)
58.83 + 33.90
= 91.13 < 94
• Try 16%:
=15(4.038) + 100(0.354)
= 60.57 + 35.40
= 95.97 > 94

• By interpolation, we can findkd:

Short-cut method
If the amount of discount or premium is adjusted over the period of debt, Short-cut method can
also be used:

Using the data of previous example:

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Cost of the Existing Debt

The current cost of the existing debt is calculated as the current market yield of the debt. Suppose, a
firm has 11% debentures of Rs. 100,000 of Rs. 100 face value outstanding at 31 Dec 2020 to be
matured on 31 Dec 2025. A new issue of debentures could be sold at a net realizable price of Rs. 80
in the beginning of 2021.

Cost of the existing debt, using short-cut method, will be:

If T = 0.35, the after-tax cost of debt will be:

kd (1-T ) = 0.167(1-0.35) = 0.109

=10.9 %

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2. Cost of Equity
After the discussion on the debt capital in the previous section, we will now discuss the cost of
Equity capital. Equity is the amount of capital invested or owned by the owner of a company. The
cost of equity capital can be divided into cost of preference shares, cost of equity shares/external
equity and cost of internal equity or retained earnings.

3. Cost of Preference shares

The equity shareholders are paid a dividend in return of the capital provided to the firm. However,
payment of dividends to the preference shareholders is not legally binding on the firm. Even if the
dividends are paid, it is not a charge on earnings. Preference capital costs depend on the dividend
that investors anticipate receiving, which is determined by the firm's credit status and market
value. Preference shares that are redeemable and those that are irredeemable can be separated.

4. Irredeemable Preference Share

The corporation issues these shares for the duration of its existence; they are not redeemed. If the
preferred share is irredeemable, it may be regarded as a perpetual security. The following equation
yields the cost of preference shares:

Where:
● kp is the cost of preference share
● PDIV is the expected preference dividend
● P0 is the issue price of preference share

Illustration:
A company issues 15% irredeemable preference shares. The face value per share is Rs. 100, but the
issue price is Rs. 95. What is the cost of a preference share? What is the cost if the issue price is Rs.
105?
● Issue price Rs. 95:

15
= = 15.78%
95
● Issue price Rs. 105:

15
= = 14.28%
105

Redeemable Preference Share

These shares are issued for a particular period and at the expiry of that period, they are redeemed
and principal is paid back to their holders. The characteristics are very similar to debt and therefore
the calculations will be similar too. A Present Value formula can be used to compute the cost of
redeemable preference share:

= +
1+ 1+

Preference dividend is paid after the taxes have been paid, hence the cost of preference share is not
adjusted for taxes.

Cost of Equity Capital

Cost of equity is the return that an investor requires for investing in a company, or the required rate
of return that a company must receive on an investment or project. Equity capital can be divided
into external equity and internal equity internal equity is also called retained earnings.

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1. External equity: Firms could distribute the entire earnings and raise equity capital
externally by issuing new shares.
2. Internal Equity: Firms may use equity capital internally by retaining earnings.

The cost of the External equity will be more than the internal equity. As we already know that it’s
not legally binding for firms to pay dividends to ordinary shareholders. Ordinary shareholders
supply funds to the firm in the expectation of dividends and capital gains. The shareholders’
required rate of return, which equates the present value of the expected dividends with the market
value of the share, is the cost of equity.

Problems in calculating cost of Equity:

• Difficult to estimate the future or the expected dividends.
• Difficult to estimate the growth of dividends.

Cost of Internal Equity

Equity shareholders' rate of return on the retained earnings is known as the opportunity cost.

The Dividend-growth Model:

Normal growth:
As the dividend valuation model for a firm assuming dividends are expected to grow at a constant
rate (g) and dividend payout ratio is constant:

= +

The cost of equity is equal to the expected dividend yield (DIV1/P0) plus capital gain rate(g). The
keshows that if the firm would have distributed earnings to shareholders, they could have invested
it to earn a rate of return equal to ke. If a return on retained earnings is less than ke, the market price
of the firm’s share will fall.
Illustration:
Consider that a company's shares are currently trading for Rs. 80 and that the estimated dividend
per share for the upcoming year is Rs. if a continuous annual dividend growth rate of 10% is
anticipated.

Solution:

= +

4
= + 0.10
80
= 0.05 + 0.10
= 15%
The company should earn a return of minimum 15% on retained earnings to keep the current
market price unchanged.

Cost of External Equity

The cost of external equity is the minimal rate of return that the equity stockholders demand on
their own capital.
a. The Dividend-growth Model

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= +

In India, the new issues of ordinary shares are generally sold at a price less than the market price.

= +

Where:
• PI is the issue price of new equity

Illustration:
The current price share of a company is Rs. 100. The company wants to finance its capital
expenditures of Rs. 100 million either through retained earnings or by selling new shares. Issue
price of new shares will be Rs. 95. The dividend per share next year, DIV1, is Rs. 4.75 and it is
expected to grow at 6%.

Cost of internal equity:

= +

Cost of External equity:

b. Capital Asset Pricing Model (CAPM)

The CAPM provides a framework to determine the required rate of return on an asset and indicates
the relationship between return and risk of the asset. The risks, to which a security is exposed, can
be classified into two groups:
● Unsystematic Risk: also called company specific risk as the risk is related to the
company's performance.
● Systematic Risk: market specific risk under which a company operates e.g. inflation,
Government policy, interest rate etc.

Unsystematic Risk can be eliminated by an investor through diversification. As per CAPM method
business should be concerned solely with non-diversifiable risk. The non-diversifiable risks are
assessed in terms of beta coefficient.

Cost of capital under this approach can be calculated as:

= + −

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Where:
• Rf = Risk free rate of return
• β = Beta coefficient
• Rm = Rate of return on market portfolio

Components of the formula:

● The risk-free rate (Rf): The yields on the government Treasury securities are used as the
risk-free rate.
● The market risk premium (Rm – Rf): measured as the difference between the long-term
market return and the risk-free rate.

Required rate of return = Risk free rate + Risk premium

According to CAPM investors need to be compensated in two ways- time value of money and risk.
The second half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk.

Illustration:
For a company, Risk-free rate is 7%, Market risk premium is 9% and Beta of share is 1.3.

Solution:
The cost of equity is:
= + −
ke = 0.07 + 0.09 × 1.3
= 0.187
= 18.7%

Dividend-growth Model vs. CAPM

The dividend-growth approach has limited application. First, it assumes that the dividend per
share will grow at a constant rate, g, forever. Second, the expected dividend growth rate, g, should
be less than the cost of equity, ke, to arrive at the simple growth formula. Dividend-growth
approach cannot be applied to those companies which are not paying any dividends or whose
dividend per share is growing at a rate higher than ke, or whose dividend policies changes
frequently.

Concept of WACC
Weighted average cost of capital is the expected average future cost of funds over the long run
found by weighting the cost of each specific type of capital by its proportion in the firm’s capital
structure.

Average v/s Weighted Average

Proportions of various sources of funds in the capital structure of a firm are different. The overall
cost of capital should take into account the relative proportions of different sources in order to be
representative.

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Steps in the calculation of WACC

1. Assignment of Weights
The aspects relevant to the selection of appropriate weights are: Historical weights versus Marginal
weights. Historical weights can be Book value weights or Market value weights.

The WACC (k0) can be calculated as:

Where:
● k0 = WACC
● kd (1 – T ) = After-tax cost of debt
● ke = Cost of debt equity
● D = Amount of debt
● E = Amount of equity

Marginal Cost
The marginal weights represent the percentage share of different financing sources the firm intends
to raise. The basis of assigning relative weights is, additional issue of funds and, hence, marginal
weights. What is commonly known as the WACC is in fact the weighted marginal cost of capital
Historical Cost
The use of the historical weights is based on the assumption that the firm’s existing capital structure
is optimal and, therefore, should be maintained in the future. The historical cost that was incurred
in the past in raising capital is not relevant in financial decision-making.

Book Value v/s Market Value Weights

● Market value weights: Use market values to measure the proportion of each type of
capital to calculate weighted average cost of capital.

● Book value weights: Use accounting (book) values to measure the proportion of each type
of capital to calculate the weighted average cost of capital.

There will be difference between the book value and market value weights, and hence, WACC will
be different. WACC will be understated if the market value of the share is higher than the book
value.

Advantages for the Book Value Weights

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Managers prefer the book value weights for calculating WACC as besides the simplicity of the use,
managers claim following advantages for the book value weights:
● It can be easily derived from the published sources.
● The book value debt-equity ratios are analyzed by investors to evaluate the risk of the
firms.

Illustration: WACC
A firm’s after-tax cost of capital of the specific sources is as follows:

Cost of debt 10%

Cost of preference shares 15%

Cost of equity funds 16%

Debt Rs. 3,00,000

Preference capital Rs. 2,00,000

Equity capital Rs. 5,00,000

Total: Rs. 10,00,000

Calculate the weighted average cost of capital, k0, using book value weights.
Solution:

Source of funds Amount Proportion

Debt 3,00,000 0.3 (30)

Preference capital 2,00,000 0.2 (20)

Equity capital 5,00,000 0.5 (50)

10,00,000 1.00 (100)

Source of funds Cost Weighted Cost

Debt 0.10 0.03

Preference capital 0.15 0.03

Equity capital 0.16 0.08

0.14

Weighted average cost of capital = 14%

International Dimensions in Cost of Capital

The Risk premium and Beta used depends on the view that a company has regarding capital
markets. If capital markets are integrated the appropriate equity risk premium should reflect a
world benchmark (say, MSCI World Index),
(RM – Rf )W.

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If markets are segmented (or if the shareholders hold domestic portfolios), then the appropriate
equity risk premium should be based on a domestic benchmark (RM – Rf )D.

Cost of capital does differ in different countries. In a segmented market the market portfolio (M) in
the CAPM formula would be the domestic portfolio instead of the world portfolio (W). Financial
integration or segmentation at the international level affects the cost of capital.

World CAPM:
Ri = Rf + βW (RM – Rf )W
Domestic CAPM:
Ri = Rf + βD (RM – Rf )D

The difference between these two models can be significant.

Illustration:
Compare the US$ cost of capital for IBM and Sony. US$ risk-free interest rate is 6%, global risk
premium 4%. IBM & Sony’s global equity betas in US$ estimated at 0.83 and 1.66 respectively.

Solution
US$ denominated cost of capital can be estimated using the following equation.
Ri = Rf + βiUS (RUS – Rf)
Where:
Ri == Expected Return from the capital market
Rf = Risk-free Return
βi = Systematic Risk
(RM – Rf) = Market Risk Premium

Given:
● Global Market Risk-premium: 4%
● Risk-free interest rate in US: 6%

Equity betas:
● For IBM: 0.83
● For Sony: 1.66

RIBM = 6% + 0.83 *4%

= 9.30%
RSony = 6% + 1.66 *4%
= 12.60%

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Keywords
Cost of capital, cost of, cost of equity, cost of internal equity, WACC, CAPM

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