Chapter 1

COST OF CAPITAL
Reason behind Cost of Capital???

O
ne of the widely discussed concepts, in the business world today, is the concept of
EVA - Economic Value Added — Companies all over the world are using the concept
to measure corporate performance. EVA is a measure of any corporation's true
profitability, and is calculated as after-tax operating profits less the annual after-tax
cost of all the capital a firm uses.

The basic theme behind the EVA is simple to understand. We know that a firm is only
profitable if it is earning profits after deducting all costs including the cost of that
capital which it is using. Mostly, when companies report their profits they account for
the cost of a source of capital (DEBT), in shape of interest costs, from its incomes
BUT fail to take the cost of its very own EQUITY financing. Therefore, a firm can
report a positive net income yet it may still be in loss in an economic sense. EVA
accounts for all the costs of different sources of capital to reflect the true profitability of
the firm.

There are many factors that influence a firm's cost of capital and many are beyond its
control such as the level of interest rates, tax policies, and the regulatory environment.
However, any firm's can control its financing and investment policies, especially which
types of capital it uses and the types of investment projects it undertakes, have a
deep effect on its cost of capital.
In this chapter, we will see that estimating a firm's cost of capital is an important
process which is also beneficial in assessing any project’s viability that if the project is
giving a positive EVA it should always be undertaken, the process of estimating the
cost of capital is technical and requires judgment. Firms that manage this process
effectively will be able to produce positive economic value for their shareholders.
1. OVERVIEW.

We all know that "non-current" assets and "working capital" of any business are financed,
either by Equity or Debt.
NCA + WC = DEBT + EQUITY

If we consider an all equity company, it obviously has financed all its assets from only one
source and that would be EQUITY. The share holders have invested their money in the shares
of that company and that money comprises the Equity. The company, than, must be able to
make sufficient return on that equity finance to pay the required return to its shareholders.
Theoretically the cost for the company and for the shareholders should always be same but
this may vary due to the different tax implications on an individual and a company.
For every company, the required rate of return by its shareholders, on their finance, is the cost
for the company arranging that finance. In other words the required rate by shareholders is
when be paid by the company, becomes the cost for the company of arranging that finance.
Similarly the cost of capital for the shareholders is that opportunity cost which that shareholder
has forgone in order to invest in the company.
 The cost of capital for the company is measured as an after tax cost.
 The cost of capital for an individual is measured as a pre-tax cost.

1.1. Cost of equity and cost of debt.

The cost of debt is always lower than the cost of equity; this may have two or more reasons.
The most obvious reasons are, first, debts are less risky and secondly the company may have
the tax benefit on the cost (interest payment) of debt.
To understand this reason we must have an understanding of the relationship between RISK
AND RETURN. Higher the risk, higher is the expectations of return and lower the risk, lower is
the expectation of returns. We have already discussed, either we finance our company with
debt or with equity, the company has to pay the required return on investment of the
respective financers. These payments are the cost to the company for arranging or for using
that specific source.
To understand better we must know the risk and return relationship and we must know our
risky and less risky sources. Following diagram can help understanding the concept.

To understand the relationship between Risk and Return, we should know they have a
directly proportionate relationship. This means, higher the risk larger the return, lower the risk
lesser the returns. Overall return has both, risk free and risky returns, in it. Every investor
needs a risk free return but to maximize one's wealth, one should have an element of risk in
investment. The best example of risk free return is government bonds or treasury bills.
Government bonds are known as risk free as no government is deemed to be insolvent.
 If we move from less risky to our high risk sources the next source we find is the
SECURED LOANS. Secured loans are a bit riskier than the govt bonds so any
investor, if, lending us the secured loan, the company should consider a risk premium
and pay him a higher return as per his expectation.
  UNSECURED LOANS are more risky than secured loans, as in the event of
dissolution, the payment is made after paying the secured loans.
 Thirdly, PREFERANCE SHARES (mezzanine finance) are less risky than ordinary
shares but more risky than both the debts. In the event of dissolution they are paid
after paying the debts. Similarly, when a company earns a profit, preference dividend is
paid after the interest payments. They may not get any share if company has no
money left to pay. These features make them more risky and any investor, if taking risk
and financing the company with preference shares, ask for higher return making more
costly for the company to arrange finance from this source.
 Lastly ORDINARY SHARES are the riskiest investment as share of profits are received
in the end (after paying to all financers, debt and preference shareholders) and there
required rate of return is even higher.

These are some reasons why Equity is considered to be more costly than the debt.

2. COST OF EQUITY.
Cost of equity is the rate of return required by the shareholders; the returns are either in shape
of dividends or in shape of increase in price of a share in market. this can be calculated by one
of the following ways:

 Dividend valuation model (DVM).

 Capital asset pricing model (CAPM).

2.1. Dividend valuation model.

We now understand the cost of an equity portion is not more than the money the shareholders
are receiving as dividends. This is the valuation of shares in terms of cash returns of dividends
into the future. This cash return is normally perpetuity. We know we calculate perpetuity as:

Present Value of PERPETUITY=

We can say now

Share price =

………………………………. Equation (i)

By rearranging the formula we can get the cost of equity as

Where
Po = Ex-Div market price of the share,
d = constant dividend p.a.
Ke = Cost of Equity.

Example 1
The ordinary shares of MUZAFFAR Ltd are quoted at Rs. 5 per share ex div. A dividend of
40 paisa per share has just been paid and there is expected to be no growth in dividends.
Required:
What is the cost of equity?
 Solution:

Ke = 0.08 or 8%

2.2. The Idea of Ex-Div:

As the time passes the share price of an individual share tend to rise as there is an
expectation of dividend to be received. The Cumulative of Dividend (CUM-DIV) is a price
inclusive of dividend. And when a company pays that dividend the share price in market falls
making it an excluding dividend price (EX-DIV). We always use ex-div price of a share in the
formula.

Example 2
The ordinary shares of Muzaffar Ltd are quoted at Rs 2 per share. A dividend of 15 paisa is
about to be paid. There is expected to be no growth in dividends.
Required:
What is the cost of equity?

Solution
The dividend is about to be paid so this means the price quoted in Cum div. to have an ex-div
price we should subtract current dividend from the market price.

Price less dividend = Ex-div price

2.00 – 0.05 = 1.85

Ke = 0.027 or 2.7%
2.3. Growth in dividends:
Now let us re structure the formula for Cost of Equity incorporating growth in it, the formula will
be as follows:

OR Ke=

Where: g = constant growth rate in dividends,

do = Current Dividend.
d1 = Dividend paid in one year's time.

Always remember we need next year’s dividend (d1). If we are given current dividend we have
to grow it with a growth rate to make it an expected dividend of next year

Example 3
Muzaffar Ltd has a share price of Rs. 4.00 ex-div and has recently paid out a dividend 20
paisa. Dividends are expected to growth at an annual rate of 5%

Required:
What is the cost of equity?
If we are not given the growth rate in question, we have read the formula for growth in F5, and
that was as follows:

Ke = 0.1025 or 10.5%

When growth is not known we can find the growth with two different methods. One is historic
method and the formula is

1+g =

Where "n" is the number of years or number of growth periods.

Example 4
Muzaffar Ltd paid a dividend of 20 paisa per share 4 years ago, and the current dividend is 33
paisa. The current share price is Rs. 6 ex div.
Required:
a) Estimate the rate of growth in dividends.
b) Calculate the cost of equity.

Solution:

or 13.33%
 b)

Ke = 0.1957 or 19.57%

Another method of calculating the growth is by GORDON’s GROWTH MODEL. Gordon's

growth model is given as:

G=rb OR g=bre

Where

Re= Return on reinvested funds, ROE=

b= proportion of Retained Funds b=

Example 5
The ordinary shares of Muzaffar Ltd are quoted at Rs. 5.00 cum div. A dividend of 40 paisa is just
about to be paid. The company has an annual accounting rate of return of 12% and each year
pays out 30% of its profits after tax as dividends.
Required:
Estimate the cost of equity.
g = .12 x .70 = 0.084 (30% payout ratio, 70% retention ratio)

or 17.826%

2.4. CAPITAL ASSET PRICING MODEL (CAPM)

To calculate cost of equity with the help of CAPM we have to have a recap of portfolio theory
to derive the formula of CAPM.

PORTFOLIO THEORY:
Investors can reduce the risk without any impact on return, by holding a mix of investments.

ASSUMPTIONS:
The key assumptions for portfolio theory are:
 The investors are RATIONAL. Rational means if an investor has an option to invest
in any one of the two investments. Where both have same risk but different return,
obviously he will invest in one with higher return.
 The investors are RISK AVERSE. Risk Averse means if an investor has an option to
invest in any of the two investments. Where both have same return but different risk,
obviously he will invest in one with lower risk.

CAPITAL ASSET PRICING MODEL says:

Ke = Rf + (Rm - Rf) β
Where:
Ke = Cost of Equity
Rf = Risk free rate of return
Rm = return on market portfolio.
Rm - Rf = Risk premium
 To understand, suppose BETA is 0.5:

If market tends to fall by 10%, the company will fall by 5%.

And when BETA is 2, if market tends to fall by 10% the company will fall by 20%. (in terms of
share prices).

EXAMPLE 6:
The Market return is 18%. TIM ltd has a beta of 1.5 and the risk free return is 7%.
REQUIRED:
What is the cost of capital?

Solution:
Ke = Rf + β (Rm - Rf)
Ke = 0.07 + 1.5 (0.18 - .07)
Ke = 0.235 or 23.5%

EXAMPLE 7:
The risk-free rate of return is 9%
The market risk premium is 7%
The beta factor for HAFIZ plc is 0.6
Required:
What would the expected annual return?

Solution:
Ke = Rf + β (Rm - Rf)
Ke = 0.09 + 0.6 (.07)
Ke = 0.132 or 13.2%

2.5. IMPLICATIONS OF CAPM:

 If the investor wants to avoid risk altogether, he must invest in a portfolio consist of
Government bonds i.e. risk free securities.
 If the investor invest in an undiversified portfolio of shares, he will suffer both systematic
and unsystematic risks
 If any investor invests and holds a balanced portfolio of all the stocks and shares in a
stock market, he will suffer systematic risk which is as same as the average systematic
risk in the market.
 Individual shares have a systematic risk which is different from average systematic risk of
the market.

3. COST OF DEBT (Kd)

Cost of debt is the rate of return that debt providers require on fund that they provide. We
expect the "Kd" to be lower than the "Ke".

Most of the time we use different terminology for the debt, he may use Loan notes, Bonds or
Debentures to be the loans obtainable by a company. Similarly, Government issues loans and
use the words like GILTS or TREASURY BILLS.

ALWAYS REMEMBER:
 Loans are always quoted at nominal value of Rs 100 or Rs 1,000 per unit.
 Interest paid on loans are stated as a percentage of the nominal value (of 100), this may
also refer to as Coupon rate
 The interest is always charged on nominal value, no matter whatever is the market value
of that debt.
KINDS OP DEBT:
Debts may be:
 Irredeemable, never paid back.
 Redeemable at par (nominal value), premium or discount.
 Convertible.

3.1. IRREDEEMABLE DEBTS:

Irredeemable debts are never to be paid back. Therefore the interest payments are in
perpetuity. We know our perpetuity formula, we can say that

Where:
Kd = Cost of Debt.
I = Interest rate paid.
Po = Ex-interest price of debt.
T = Tax rate
Example 8
The 12% irredeemable loan notes of Muzaffar plc are quoted at Rs. 110 ex int. Corporation tax
is payable at 30%.
Required:
What is the net of tax cost of debt?

3.2. REDEEMABLE DEBTS:

We know the return an investor earns is a cost to the firm. To have the rate of return earned by
an investor, if we calculate the IRR from an investor’s point of view we can say that the IRR
reflects his return from his investment and from the company’s perspective it is a Cost of debt.
We have to go through following steps to deal with redeemable debts:
 7-column analysis.
 Cash flows per year,
 Discount at 5% and at 10%
 Find IRR with interpolation formula.
Example 9
Muzaffar Ltd has 10% loan notes quoted at Rs. 102 ex int redeemable in 5 years' time at par.
Corporation tax is paid at 30%.
Required:
What is the net of tax cost of debt?
Solution:
Present Present
Cash Present Present
Years Value factor Value factor
flows Value Value
@ 5% @ 10%

0 Market Price (102) 1.00 -102 1.00 (102.00)

1-5 Interest Payment (1-t) 7 4.33 30.31 3.79 26.54

5 Redeemable Value 100 0.78 78.35 0.62 62.09

6.66 (13.37)
Example 10
The 10% loan notes of Muzaffar plc are quoted at Rs 120 ex int. Corporation tax is payable at
30%. They will be redeemed at a premium of Rs 20 over par in 4 years time
Required:

What is the net of tax cost of debt?

 Using redeemable debt calculation.
 Using irredeemable debt calculation.

Present Present
Cash Present Present
Years Value factor Value factor
flows Value Value
@ 5% @ 10%

0 Market Price (120) 1.00 -120 1.00 (120.00)

1-5 Interest Payment (1-t) 7 4.33 30.31 3.79 26.54

5 Redeemable Value 120 0.78 94.02 0.62 74.51

4.33 (18.95)

Here the answer is 5.92%, but whenever we have the same value of outflow in time 0 and
inflow at the time of redemption, we can use a TRICK and we can easily use the formula of
perpetuity and we don't have to go through the whole IRR calculations. The formula would be
as follows:

The answer may be a little different, but remember IRR is an interpolation and is an estimate,
whereas this formula can give you accurate result. But remember to use this only and only if
"OUT FLOW at time 0, and INFLOW at redemption" are same. Or we can say that MARKET
VALUE IS EQUAL TO REDEMPTION value.

3.3. CONVERTIBLE DEBTS:

Convertible debts are the debts which have the option for the debt holder either to redeem
them at maturity, or to convert them in shares. With a view of maximizing the wealth of
shareholders, company may exercise any of the two, obviously whichever have the greater
value for shareholders.
 Example 11
Muzaffar has convertible loan notes in issue that may be redeemed at a 10% premium to par
value in 4 years. The coupon is 10% and the current market value is Rs 95.

Alternatively the loan notes may be converted at that date into 25 ordinary shares. The
current value of the shares is Rs. 4 and they are expected to appreciate in value by 6% per
annum.
Required:
What is the cost of the redeemable debt?

Solution:
First we have to calculate the redemption value, both the conversion value and redemption,
and we will use whichever is higher. Obviously our investor will be rational and go for the
higher amount.

Value of Bond in 4 years if converted into 25 shares,

= 25 x 4 x (1.06)4
= 126.247

Now, the investor will definitely go for conversion as par value of Rs 100 is less. We can use
our IRR formula to calculate the cost of debt.

Present Present
Cash Present Present
Years Value factor Value factor
flows Value Value
@ 5% @ 10%

0 Market Price (95) 1.00 -95 1.00 (95.00)

1-4 Interest Payment (1-t) 7 3.55 24.82 3.17 22.19

5 Redeemable Value 126.47 0.82 104.05 0.68 86.38

33.87 13.57

IRR = Kd = 13.6%

3.4. BANK DEBTS (non-tradable):

The calculation for the cost of bank debts is the easiest of all. For bank debts, we don't have
a change in the market value i.e. up or down, so the cost of debt is just the interest rate
adjusted for tax. The formula could be writer as:
Kd = i (1 - T)

Example 12
Muzaffar has a loan from the bank at 12% per annum. Corporation tax is charged at 30%
Required:
What is the cost of debt?

Solution:
Kd = 0.12 (1-0.3)
Kd = 8.4%
 3.5. PREFERENCE SHARES:
Preference shares are normally treated as debt rather than equity. But they are not tax
deductable. The cost of preference shares can be calculated using the dividend valuation model
with no growth.

Example 13
Muzaffar plc has 9% preference shares Rs. 100 are currently trading at Rs 140 ex-div.
Required:

What is the cost of the preference shares?

Solution:
=

Kp 6.4%

4. WEIGHTED AVERAGE COST OF CAPITAL (WACC):

WACC can be regarded as the opportunity cost of capital and this cost can be used to evaluate
any firm's investment project only if following conditions are met:
 Project is insignificant in relation to the size of the company.
 The company uses pooled funds approach and
 The company maintain its existing capital structure in long run (i.e same financial risk).
 The project has the same systematic risk (business risk) as the company has now.

Formula for WACC can easily be formulate as

WACC = W dKd (1-T) + WpKp + W eKe

Here Wd, Wp, and We are the weights used for debt, preferred, and common equity,
respectively.

Example 14
Muzaffar plc has 20 million ordinary 25 paisa shares quoted at Rs. 3, and Rs 8 million of loan
notes quoted at Rs 85.
The cost of equity has already been calculated at 15% and the cost of debt (net of tax) is 7.6%
Required:
Calculate the weighted average cost of capital.

Solution
Market
SOURCE Weight Cost WxC
Value (m)

EQUITY (w-1) 60 0.90 0.15 0.1347

DEBT (w-2) 6.8 0.10 0.08 0.0077

67 0.1425 WACC

WACC = 14.25%
 W-1
Market value of equity = 20 million shares of Rs.3 each = 60 million

W-2
Market value of debt = Rs 8 million loan of Rs 100 per loan note
= 0.08 million loan notes with market value of Rs 85 each
= Rs 6.8 million

5. USES OF WACC:

We use WACC in Investment appraisals (as cost of capital)

ONLY WHEN:
 Relatively small investment,
 Pooled funds are used for investment,
 Capital structure is unchanged,
 Project's risk profile is same as company's risk profile.

6. SUMMARY OF THE CHAPTER

We began this chapter by defining three capital components—debt, preferred stock, and common
equity—and then estimating each component’s cost of capital. After estimating the components’
costs, we calculated a weighted average cost of capital (WACC). As we will see in the following
two chapters, the WACC is a key element in the capital budgeting process. In this chapter we
calculated the WACC assuming that the target capital structure is a given. In further Chapters we
will discuss how firms determine their target capital structures and the effects of capital structure
on the WACC. The key concepts covered in this chapter are listed below:

 The cost of capital is sometimes referred to as a hurdle rate. For a project to increase
shareholders’ value, it must earn more than its hurdle rate.
 The cost of capital used in capital budgeting is a weighted average of the types of capital the
firm uses, typically debt, preferred stock, and common equity.
 The component cost of debt is the after-tax cost of new debt. It is found by multiplying the
cost of new debt by (1 _ T), where T is the firm’s marginal tax rate: kd(1 _ T).
 The component cost of preferred stock is calculated as the preferred dividend divided by
the current price of the preferred stock: kp _ Dp/Pp.
 The cost of retained earnings, ks, is the rate of return stockholders require on the
company’s common stock. There are two sources of equity capital: (1) internal equity
generated through additions to retained earnings and (2) external equity obtained by issuing
new shares of common stock.
 The cost of common equity can be estimated by three methods: (1) the CAPM approach, (2)
the bond-yield-plus-risk-premium approach, and (3) the dividend-yield-plus-growth-rate,
or DCF, approach.
 To use the CAPM approach, one (1) estimates the firm’s beta, (2) multiplies this beta by the
market risk premium to determine the firm’s risk premium, and (3) adds the firm’s risk premium
to the risk-free rate to obtain the firm’s cost of common equity: ks _ kRF _ (kM _ kRF)bi.
 To use the dividend-yield-plus-growth-rate approach, which is also called the discounted
cash flow (DCF) approach, one adds the firm’s expected growth rate to its expected dividend
yield: ks _ D1/P0 _ g.
 Companies generally hire an investment banker to assist them when they issue common
stock, preferred stock, or bonds. In return for a fee, the investment banker helps the company
with the terms, price, and sale of the issue. The banker’s fees are often referred to as
flotation costs. The total cost of capital should include not only the required return paid to
investors but also the flotation fees paid to the investment banker for marketing the issue.
 Two alternative approaches can be used to account for flotation costs. The first approach adds
the estimated dollar amount of flotation costs for each project to the project’s up-front cost—
 this lowers the project’s expected rate of return. An alternative approach is to adjust the
cost of equity. When calculating the cost of new common stock, the DCF approach can be
adapted to account for flotation costs. For a constant growth stock, this cost can be expressed
as: ke _ D1/[P0(1 _ F)] _ g. Note that flotation costs cause ke to be greater than ks.
 Flotation cost adjustments can also be made for preferred stock and debt. The flotation-
adjusted cost for preferred is calculated as Dp/Pn, where Pn is the price the firm receives on
preferred after deducting flotation costs. For debt, the bond’s issue price is reduced for
flotation expenses and then used to solve for the after-tax yield to maturity.
 Each firm has an optimal capital structure, defined as the mix of debt, preferred stock, and
common equity that minimizes its weighted average cost of capital (WACC):
 WACC = W dKd (1-T) + WpKp + W eKe
 The WACC represents the marginal cost of capital (MCC) because it indicates the cost of
raising an additional dollar.
 Various factors affect a firm’s cost of capital. Some are determined by the financial
environment, but the firm influences others through its financing, investment, and dividend
decisions.
 Market, or beta, risk reflects the effects of a project on the riskiness of stockholders,
assuming they hold diversified portfolios. Market risk is measured by the project’s effect on the
firm’s beta coefficient.
 Most decision makers consider all three risk measures in a judgmental manner and then
classify projects into subjective risk categories. Using the composite WACC as a starting
point, risk-adjusted costs of capital are developed for each category. The risk-adjusted cost
of capital is the cost of capital appropriate for a given project, given the riskiness of that
project. The greater the risk, the higher the cost of capital.