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In economics and accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company.

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- 1. Cost of Capital the main objective of a business firm is to maximize the wealth of its shareholders in the long run , the management should invest only in those projects which give a return in excess of cost of funds invested in the projects of the business. the difficulty will arise in determination of cost of funds , if it is raised from different sources & different quantum's The various sources are in the form of equity and debt The cost of capital is the rate of return the company has to pay to various suppliers of funds in the company. The cost of capital is used as the discount rate or as the target rate of return for comparing with a projects Internal rate of return cost of capital is defined as “ The minimum rate of return that a firm must earn on its investments so that the market value per share remains unchanged”
- 2. Cost of Capital cost of capital is to be determined to help in managerial decision making like acceptance of capital investment proposals, appraisal of profitability and viability of sub-units, restructuring of capital, raising of additional finances etc Cost of capital is the minimum rate of return which consists of risk free rate + premium for risk associated with the particular business [The risk of the business can be categorized into (a) Business Risk (b) Financial Risk] Therefore , the business and financial risk associated with a particular firm calls for payment of additional return to the providers of capital and debt called as risk premium. The long term requirements of the firm is generally met from the following sources :- 1. Equity share capital 2. Preference Share capital 3. Retained Earnings 4. Debentures & Bonds 5. Term Loans from Banks & Financial Institutions
- 3. Cost of Capital The cost would be differing for different sources It depends on :- 1. Rights and obligations of the firm 2. Rights of providers of long term funds 3. Risk associated with each source of finance 4. The expectations of the investors 5. Market rate of return of different sources of finance 6. Participation in management 7. Stability and growth of the firm 8. Firms ability to meet out financial obligations 9. Personal taxation of investors 10. Opportunity cost of funds
- 4. Cost of Capital 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 1. Evaluating investment decisions, 2. Designing a firm’s debt policy, and 3. Appraising the financial performance of top management.
- 5. 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. OCC .Equity shares Risk .Preference shares .Corporate bonds .Government bonds .Risk-free security
- 6. Cost of Capital The cost of capital consists of the following elements:- 1. Cost Of Equity Capital ( Ke) 2. Cost Of Retained Earnings ( Kr) 3. Cost Of Preference Share capital ( Kp) 4. Cost Of Debt, included both debentures, bonds and term loans ( Kd)
- 7. Cost of Equity Capital Dividend Yield Method :- As per this method , the cost of equity is defined as “ the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale ( or the current market price) of a share”. This method is based on the assumption that the market value of equity shares is directly related to the future dividends on those shares , Another assumption is that the future dividend per equity share is expected to be constant and the company is expected to earn at least this yield to keep the equity share holder content. Ke = D1/ P0 Where Ke= Cost Of Equity Capital ( After Tax) D1= Annual dividend on equity capital in period 1 P0 = Current market Price of the equity. This method emphasis on future expected dividend to be constant. It does not allow for any growth rate. But in reality, a shareholder expects the return to grow over time. this approach has no relevance for the company
- 8. Cost of Equity Capital Dividend Growth Model:- Equity share holders will normally expect dividend to increase year after year and not to remain constant in perpetuity In this method an allowance for future growth in dividend is added to the current yield. It is recognized that the current market price of a share reflects expected future dividends This method is also called the “Gordon’s growth model” KE= D1/P0+ g Where D1= expected dividend per equity share P0 = Current market price per equity share g = growth rate in the dividend criticism :- 1. Future growth pattern is impossible to predict because it will be inconsistent and uneven 2. Historic growth rate is used for predicting future growth 3. Calculating cost of equity ignoring the cost of other funds may not be valid 4. The dividend growth rate depends on the earnings of the company which is difficult to forecast. P0P0
- 9. Cost of Equity Capital Sometimes the dividend growth rate model formula for calculation of cost of equity share capital is also written as follows, if the last declared dividend is known as :- KE = D0 (1+g)/P0 +g D0 =recent dividend paid per equity share P0 =current market price per share g = constant annual growth rate of dividends
- 10. Cost of Equity Capital Price Earning Method :- This method takes into consideration the earning per share (EPS) and the market price of the share This is based on the assumption that the investor capitalizes the stream of future earnings of the share and the earnings of the company need not be uniform on the nature of dividend and also it need not be disbursed to the shareholders It is based on the argument that even if the earnings are not disbursed as dividend , it is kept in the retained earnings and it causes future growth in the earnings of the company as well as increase in the market price of the share KE = E/M WHERE E= Current Earning Per share M= market price per share The growth rate model as in the case of dividend also apply on the model
- 11. Cost of Equity Capital Capital Asset Pricing Model (CAPM) The capital asset pricing model divides the cost of equity into two components, the near risk free return available on investing in government bonds and an additional risk premium for investing in particular share or investment. Putting this all together the CAPM assesses the cost of equity capital for investment as follows:- K E = RF + B I (RM – RF) WHERE RF =risk free rate B I =beta of the investment RM = average market return/ return on the market potfolio.
- 12. Cost of Retained Capital The retained earnings are the distributable profits available for equity shareholders kept with the company without distributing them in the form of dividend. Some argue that the retained earnings are cost free funds available with the company , on which no returns are payable If the retained earnings are distributed among the equity shareholders ,the amount would have been reinvested to earn return on it. Therefore , the cost of retained earning may be considered equivalent to the return foregone by the equity shareholders and it is the opportunity cost of funds not available for investment by the individual shareholder In other words the retained earnings has a cost equivalent to the opportunity rate of earnings foregone by the equity shareholder. Hence the cost of equity includes the retained earnings
- 13. Cost of Retained Capital The retained earnings are the distributable profits available for equity shareholders kept with the company without distributing them in the form of dividend. Some argue that the retained earnings are cost free funds available with the company , on which no returns are payable If the retained earnings are distributed among the equity shareholders ,the amount would have been reinvested to earn return on it. Therefore , the cost of retained earning may be considered equivalent to the return foregone by the equity shareholders and it is the opportunity cost of funds not available for investment by the individual shareholder In other words the retained earnings has a cost equivalent to the opportunity rate of earnings foregone by the equity shareholder. Hence the cost of equity includes the retained earnings
- 14. Cost of Retained Capital Opportunity cost approach:- the cost of retained earnings is basically an opportunity cost of such funds to them. It is equal to the income that they would have earned by placing these funds in alternative investment. If the retained earnings are distributed to the equity shareholders , they attract personal taxation of individual shareholder and therefore cost of retained earnings is calculated as follows:- KR = D ( 1-t) KR = Cost of retained earnings D= Dividend rate T= Individual tax rate
- 15. Cost of Retained Capital Right Offer Approach :- according to this approach the shareholder is entitled to profits retained . Suppose if the company distributed the retained profits in the form of dividend to the equity shareholders and again calls back the money by right offer, the dividend paid by the company to the shareholder attract tax liability and the shareholder are in a position to invest only to the extent of dividend received from the company. If the retained earnings are kept within the company , the prices of shares will increase to the extent of retained earnings which will attract capital gain tax on individual shareholders. Therefore , it will not change the position of the shareholder whether profits are retained or distributed to shareholder. The following formula can be used according to this approach to calculate cost of retained earnings Kr = D ( 1- Ti)/ P(1-Tc) Where D= Dividend rate Ti= marginal tax rate on individual shareholder Tc= Capital Gain tax
- 16. Cost of Preference Share Capital Cost Of Irredeemable Preference Shares : KP = Dp/ NP Where Dp = Preference Dividend NP= Net proceeds received from issue of preference shares after meeting issue expenses Cost Of Redeemable Preference Shares:- KP = D + ( Rv- Sv)/N (Rv+Sv)/2 Where D= Preference dividend Rv = Redeemable value of preference share at time of redemption Sv= Sale value of preference share less discount & floatation cost N= Number of years of redemption
- 17. Cost of Debt The capital structure of a firm normally includes the debt component also. Debt may be in the form of debentures , bonds , term loans from financial institutions and banks etc. The debt carries a fixed rate of interest payable to them ,irrespective of the profitability of the company. Then after the payment of fixed interest charge more surplus is available for equity shareholders and hence EPS will increase. Therefore , any payment towards interest will reduce the profit and ultimately the company's tax liability would decrease. This phenomenon is called “tax shield”. The tax shield is viewed as benefit accruing to a company which is geared. To gain the full tax shield , the following conditions apply:- 1. The company must be able to show a taxable profit every year to take full advantage of the tax shield 2. If the company makes loss , the tax shield goes down and cost of borrowing increases. Nominal & Real Cost Of Debt :- The real cost of debt will be less than the nominal cost as investors are not compensated for the real drop in value of their funds. Real Cost of Debt = Nominal Cost Of Debt / Inflation Rate
- 18. Cost of Debt Cost Of Perpetual Debt / Irredeemable Debt K D = Interest / NP K D = Cost of Debt I= Annual Interest Payment NP = Net Proceeds of issue of bond, debenture & term loan Cost Of Redeemable Debt K D = Interest+ ( Rv- Sv)/N ( Rv + Sv)/2 Rv= Redeemable value at the time of maturity Sv= Sale value – Flotation Cost & Discount N= Period Of Redemption Both the formula will give the KD ( Before Tax) For Converting into after tax cost we shall use :- KD ( After Tax) = KD ( Before Tax) * ( 1-t)
- 19. 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.
- 20. The Weighted Average Cost of Capital The following steps are involved for calculating the firm’s 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. WACC is in fact the weighted marginal cost of capital (WMCC); that is, the weighted average cost of new capital given the firm’s target capital structure. (1 ) (1 ) o d d d e o d e k k T w k w D E k k T k D E D E
- 21. Book Value Versus Market Value Weights Managers prefer the book value weights for calculating WACC: Firms in practice set their target capital structure in terms of book values. The book value information can be easily derived from the published sources. The book value debt—equity ratios are analysed by investors to evaluate the risk of the firms in practice.
- 22. Book Value Versus Market Value Weights The use of the book-value weights can be seriously questioned on theoretical grounds: First, the component costs are opportunity rates and are determined in the capital markets. The weights should also be market-determined. Second, the book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values.
- 23. Book Value Versus Market Value Weights Market-value weights are theoretically superior to book-value weights: They reflect economic values and are not influenced by accounting policies. They are also consistent with the market- determined component costs. The difficulty in using market-value weights: The market prices of securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.
- 24. Flotation Costs, Cost of Capital and Investment Analysis A new issue of debt or shares will invariably involve flotation costs in the form of legal fees, administrative expenses, brokerage or underwriting commission. One approach is to adjust the flotation costs in the calculation of the cost of capital. This is not a correct procedure. Flotation costs are not annual costs; they are one-time costs incurred when the investment project is undertaken and financed. If the cost of capital is adjusted for the flotation costs and used as the discount rate, the effect of the flotation costs will be compounded over the life of the project. The correct procedure is to adjust the investment project’s cash flows for the flotation costs and use the weighted average cost of capital, unadjusted for the flotation costs, as the discount rate.
- 25. The Cost of Capital for Projects A simple practical approach to incorporate risk differences in projects is to adjust the firm’s WACC (upwards or downwards), and use the adjusted WACC to evaluate the investment project. Companies in practice may develop policy guidelines for incorporating the project risk differences. One approach is to divide projects into broad risk classes, and use different discount rates based on the decision-maker’s experience.
- 26. The Cost of Capital for Projects For example, projects may be classified as: Low risk projects discount rate < the firm’s WACC Medium risk projects discount rate = the firm’s WACC High risk projects discount rate > the firm’s WACC