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Cost of Capital by VB-1

The document discusses the cost of capital, which represents the minimum rate of return that a firm must earn on its investments to maintain the market value of its shares. It has three main components: the normal rate of return, premium for business risk, and premium for financial risk. The cost of capital is made up of the costs of the various sources of financing like debt, preference shares, retained earnings, and equity shares, weighted according to their composition in the firm's capital structure. The cost of debt, preference shares, and equity are discussed, including how to calculate them for both perpetual and redeemable securities. The weighted average cost of capital (WACC) represents the overall cost of capital for the firm.

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34 views26 pages

Cost of Capital by VB-1

The document discusses the cost of capital, which represents the minimum rate of return that a firm must earn on its investments to maintain the market value of its shares. It has three main components: the normal rate of return, premium for business risk, and premium for financial risk. The cost of capital is made up of the costs of the various sources of financing like debt, preference shares, retained earnings, and equity shares, weighted according to their composition in the firm's capital structure. The cost of debt, preference shares, and equity are discussed, including how to calculate them for both perpetual and redeemable securities. The weighted average cost of capital (WACC) represents the overall cost of capital for the firm.

Uploaded by

Vineeta
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Cost of Capital

Cost of capital
• Cost of capital is simply what amount of money a firm is paying to its
shareholders against the capital contributed by them in form of debt
or equity or in the various combinations.
• According to Solomon Ezra Cost of capital is the minimum required
rate of earnings or the cut-off rate of capital expenditures.
• Thus, we can say that cost of capital is that minimum rate of return
which a firm, and, is expected to earn on its investments so as to
maintain the market value of its shares.
Comprises of three components:
• As there is always some business and financial risk in investing funds
in a firm, cost of capital comprises of three components:
• (a) the expected normal rate of return at zero risk level, say the rate
of interest allowed by banks;
• (b) the premium for business risk; and
• (c) the premium for financial risk on account of pattern of capital
structure.
• Symbolically cost of capital may be represented as,
• K = ro+ b+ f
• where K=Cost of capital
• ro=Normal rate of return at zero risk
level
• b=Premium for business risk.
• f=Premium for financial risk.
Overview of the Cost of Capital
• The cost of capital represents the firm’s cost of financing, and is the
minimum rate of return that a project must earn to increase firm
value.
• Financial managers are ethically bound to only invest in projects that they
expect returns to exceed the cost of capital.
• The cost of capital reflects the entirety of the firm’s financing activities.
• Most firms attempt to maintain an optimal mix of debt and equity
financing.
• To capture all of the relevant financing costs, assuming some desired mix of
financing, we need to look at the overall cost of capital rather than just the cost
of any single source of financing.
What sources of long-term capital do firms
use?
• The project’s 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 firm’s cost of capital will be the overall, or average, required rate
of return on the aggregate of investment projects
SIGNIFICANCE OF THE COST OF CAPITAL
• Cost of Capital determine company’s capital structure. Company
looks for the optimal mix of financing that provides adequate funding
and minimizes the cost of capital.

• Evaluating investment decision.

• Designing a firm’s debt policy.


Explicit Cost and Implicit Cost
• Money payments made by the firm to the owners of capital(Debt &
Equity) required to finance company’s project is known as explicit
cost.
• Example: A firm raises Rs 500,000 through the sale of 10%
debentures. There will be cash inflow of Rs 500,000 followed by
annual cash outflow of Rs 50,000.
Implicit Cost
• Estimated value of funds owned by the firm and used by it in
financing the projects.
• Example: Retained Earnings(undistributed profits of company
belonging to shareholders)
• Cost of retained earning = Opportunity cost of earning by investing
elsewhere by shareholders or by company itself.
• Opportunity cost is the rate of return foregone on the next best
alternative investment opportunity of comparable risk.
• It is not paid out of pocket so it’s not mentioned in accounting
records.
Measurement of Cost
• 1) Cost of debt
• 2) Cost of Preference Share capital
• 3) Cost of Equity Share Capital
• 4) Cost of Retained Earnings
• 5) Weighted Average Cost of Capital(WACC) or Overall Cost of Capital
Cost of Long-Term Debt
• The pretax cost of debt is the financing cost associated with new
funds through long-term borrowing.
• Typically, the funds are raised through the sale of corporate bonds.
• Net proceeds are the funds actually received by the firm from the
sale of a security.
• Flotation costs are the total costs of issuing and selling a security.
They include two components:
1. Underwriting costs—compensation earned by investment bankers for
selling the security.
2. Administrative costs—issuer expenses such as legal, accounting, and
printing
Cost of Debt
• Irredeemable debt • Face Value = xxxxx
• Kd= I/SV - Discount on issue
+ Premium on issue
• After tax cost of debt = • Issue Price xxxx
• [I*(1-t)]/SV - Flotation Cost
• Sales value xxxx
Cost of Long-Term Debt: After-Tax Cost of
Debt
• The interest payments paid to bondholders are tax
deductable for the firm, so the interest expense on debt
reduces the firm’s taxable income and, therefore, the
firm’s tax liability.
• The after-tax cost of debt, Kd, can be found by multiplying
the before-tax cost, I, by 1 minus the tax rate, T, as stated in
the following equation:
Kd = I/SV × (1 – T)
• Que1: If the cost of debt for Abc Ltd is 10%(effective rate) and it’s tax
rate is 30%, then calculate cost of debt.
• Kd after tax = Kd(1-tax)
• = 10(1-0.3)
• =7%
When debt is issued at par
• Jain & co sells a new issue of 6% irredeemable debentures to raise Rs
100,000 and realizes the full face value of Rs 100. Debts are issued at
par. Find cost of capital.
• Kd = I/SV
• = (6000/100,000)*100
• = 6%
Debts issued at Premium
• Jain and Co sells 5%, 100 irredeemable debentures of Rs 100 each @
10%. premium. The company falls in 30% tax bracket. Find cost of
capital.
• I = 5%(100*100) = 500
• SV = ?
• FV= 10000
• +Premium 1000
• 11000
• Kd = [I * (1-t)]/SV
• =[500(1-.3)]/11000
• =.0318 or 3.18%
Debts issued at discount
• A Company issues debt of Rs.10,00,000, 10% irredeemable debentures at
a discount of 5%. The cost of floatation amount to Rs.30,000. Calculate
before tax and after tax cost of debt assuming tax rate of 50%.
• before-tax cost of debt,
=100,000/920000 = .1086 or 10.86%

• (NP=Rs. 10,00,000-50,000 (discount) – 30,000 cost of floatation)


=
• After tax cost of debt, K da = K db (1-0.5)
• = 10.86 (1-0.5) = 5.43%
• A company has 10% perpetual debt of Rs 1,00,000. The Tax rate is
35% . Determine the cost of capital after tax assuming the debt is
issued at 1)par 2) 10%Discount 3)Premium10%
REDEEMABLE DEBT
• Kd = [I*(1-t) + (f +d+ pr –pi)/Nm]/(RV + SV)/2

• f= flotation cost, d= discount, pr is premium on redemption, pi is


premium on issue price.

• Kd = [I(1-t)+ (RV-SV)/Nm]/(RV+SV)/2
Cost of Preference Share Capital(Kp)
Preference shares generally pay a constant dividend every period.
Dividends are expected to be paid every period forever.
• Preference share valuation is an annuity, so we take the annuity
formula, rearrange and solve for K P.

• Kp = Annual Dividend of preference share/ Market Price


• Your company has issued 10%, preference shares of Rs 5000 that
have Face value is Rs 100. If the current market price is Rs 120, what
is the cost of a preference share?
• Annual Dividend = 10% of 100 = 10 per share
• Kp = 10/120
• = 0.0833% or 8.33%
Redeemable Preference Share
• Kp = [Dp + (RV-SV)/N]/ (RV- SV)/2

• Where, DP = Preference dividend,


• N = Period of preference share,
• RV= Redeemable value of preference share, and
• SV = Sales Value of preference shares
Baibhav Ltd., issued 10,000, 12%
preference shares of Rs 100 each .
The shares are to be redeemed
after 10 years at face value. The
flotation costs are Rs 5 per share.
Compute the cost of preference
share capital .
Solution:
RV = 100
Sales Value = 100- 5 = Rs 95
Annual Dividend= Rs 12 per share
Kp = [12 + (100-95)/10]/ (100+95)/2
= 12.5/97.5
=.1282 or 12.82%

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