CHAPTER 1 INTRODUCTION

The link between accounting information and the cost of capital of firms is one of the most fundamental issues in accounting. Standard setters frequently refer to it. For example, Arthur Levitt (1998), the former chairman of the Securities and Exchange Commission, suggests that high quality accounting standards reduce capital costs. Similarly, Neel Foster (2003),a former member of the Financial Accounting Standards Board (FASB) claims that More information always equates to less uncertainty, and people pay more for certainty. In the context of financial information, the end result is that better disclosure results in a lower cost of capital. While these claims have intuitive appeal, there is surprisingly little theoretical work on the hypothesized link. In particular, it is unclear to what extent accounting information or firm disclosures reduce nondiversifiable risks in economies with multiple securities. Asset pricing models, such as the Capital Asset Pricing Model (CAPM), and portfolio theory emphasize the importance of distinguishing between risks that are diversifiable and those that are not. Thus, the challenge for accounting researchers is to demonstrate whether and how firms accounting information manifests in their cost of capital, despite the forces of diversification. This paper examines both of these questions. We define the cost of capital as the expected return on a firms stock. This definition is consistent with standard asset pricing models in finance (e.g., Fame and Miller, 1972, p. 303), as well as numerous studies in accounting that use discounted cash flow or abnormal earnings models to infer firms cost of capital (e.g., Botosan, 1997;Gebhardt et al. , 2001).1 In our model, we explicitly allow for multiple firms whose cash flows are correlated. In contrast, most analytical models in accounting examine the role of information in single-firm settings (see Verrecchia, 2001, for a survey). While this literature yields many useful insights, its applicability to cost of capital issues is limited. In single-firm settings, firm-specific variance is priced because there are no alternative securities that would allow investors to diversify idiosyncratic risks.

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We begin with a model of a multi-security economy that is consistent with the CAPM. We then recast the CAPM, which is expressed in terms of returns, into a more easily interpreted formulation that is expressed in terms of the expected values and covariances of future cash flows. Wes how that the ratio of the expected future cash flow to the covariance of the firms cash flow with the sum of all cash flows in the market is a key determinant of the cost of capital. Next, we add an information structure that allows us to study the effects of accounting information. We characterize firms accounting reports as noisy information about future cash flows, which comports well with actual reporting behavior. We demonstrate that accounting information influences a firms cost of capital in two ways: 1) direct effects where higher quality accounting information does not affect cash flows per se, but affects the market participants assessments of the distribution of future cash flows; and 2) indirect effects where higher quality accounting information affects a firms real decisions, which, in turn, influence sits expected value and covariances of firm cash flows. In the first category, we show (not surprisingly) that higher quality information reduces the assessed Variance of a firms cash flows. Analogous to the spirit of the CAPM, however, we show this effect is diversifiable in a large economy. We discuss what the concept of diversification means, and show that an economically sensible definition requires more than simply examining what happens when the number of securities in the economy becomes large Moreover, we demonstrate that an increase in the quality of a firms disclosure about its own future cash flows has a direct effect on the assessed covariances with other firms cash flows. This result builds on and extends the work on estimation risk in finance. In this literature, in formation typically arises from a historical time-series of return observations. In particular, Barry and Brown (1985) and Closet al.(1995) comp are two information vironments: in one environment the same a mount of information (e.g., the same number of historical timeseries observations) is available for all firms in the economy, whereas in the other information environment there are more observations for one group of firm s than another. They find that the betas of the high information securities are lower than they would be in the equal inform action case. They cannot unambiguously sign, however, the difference in betas for the low information securities in the unequal- versus equal-information environments. Moreover, these

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studies do not address the question of how an individual firms disclosures can influence its cost of capital within an unequal information environment. Rather than restricting attention to information as historical observations of returns, our paper uses a more conventional information-economics approach in which information is modeled as a noisy signal of the realization of cash flows in the future. With this approach, we allow for more general changes in the information on environment, and we are able to prove much stronger results. In particular, we show that higher quality accounting information and financial disclosures affect the assessed covariances with other firms, and this effect unambiguously moves a firms cost of capital closer to the risk-free rate. Moreover, this effect is not diversifiable because it is present for each of the firms covariance terms and hence does not disappear in large economies. This expected return is adjusted for the amount of financial leverage (debt) used in the firm. As discussed, the CAPM has several problems in arriving at an exact figure for the cost of capital, but it is useful in providing areasonable range of the cost of capital. This range can then be used a supper and lower bounds to help in the decision making process Remember that the CAPM determines the expected return on equity investment in a firm by adding a risk premium to the risk free rate. This expected return is adjusted for the amount of financial leverage (debt) used in the firm. As discussed, the CAPM has several problems in arriving at an exact figure for the cost of capital, but it is useful in providing areasonable range of the cost of capital. This range can then be used a supper and lower bounds to help in the decision making process. Thus, our model does not provide support for an additional risk factor capturing information risk.One way to justify the inclusion of additional information variables in a cost of capital model would be to note that empirical proxies for beta, which for instance are based on historical data alone, may not capture all information effects In this case, however, it is incumbent on researchers to specify a measurement error model or, at least, provide a careful justification for the inclusion of information variables, and their functional form, in the empirical specification. When making investment decisions, the financial manager needs to know the minimum expected return that is acceptable to the investors. This minimum acceptable return, called the cost of capital, is the price the firm pays for the use of money. Knowing the cost of capital, the manager can then make investment decisions by using the cost of capital as the discount rate in deciding

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upon whether or not to make a capital investment. The subsequent chapter on capital investment will show in detail how these investment decisions are made. The cornerstone of the investment decision, however, is to first determine the correct cost of capital. Two different approaches to determining the cost of capital are available: one uses the Capital Asset Pricing Model (CAPM), and the other uses the Weighted Average Cost of Capital (WACC). The nature of the prospective investment under consideration determines which approach should be used. In general, the CAPM provides market driven costs of capital for investments in projects which are not in the same business as the investing company. These market driven costs are adjusted for the financial leverage of existing firms, and the CAPM provides a means for ungearing the leverage. On the other hand, if the potential investment under consideration is in the same business (has the same business risk as defined below) and does not intend to alter its existing capital structure (that is, financial leverage of the business), then WACC is an appropriate and somewhat more reliable way of determining the cost of capital. The CAPM developed earlier provides the financial manager with a tool for determining the expected rate of return on an investment. Remember that the CAPM determines the expected return on equity investment in a firm by adding a risk premium to the risk free rate. This expected return is adjusted for the amount of financial leverage (debt) used in the firm. As discussed, the CAPM has several problems in arriving at an exact figure for the cost of capital, but it is useful in providing areasonable range of the cost of capital. This range can then be used a supper and lower bounds to help in the decision making process The WACC approach to determining the cost of capital uses a weighted average of the costs for all sources of finance in a firm - equity, debt, preferred shares, etc. With the weighted average approach it is evident that there are different costs for different levels of capital raised. The weighted average approach also provides the financial manager with an additional check on the CAPM -determined costs, thus adding more understanding to the reasonable rangeof costs. This chapter will examine both the CAPM and WACC approaches to determining the cost of capital. The concept of business risk will be discussed. The implications of financial leverage (debt) will be explored in the CAPM model and the changing levels of costs will be discussed in

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the weighted average approach. When calculating a cost of capital, it is the marginal cost of capital which is sought, that is, the cost for the next additional amount of capital. The CAPM approach should be used when there are changes to the leverage of the firm and/or when the marginal investment is not identical in risk to the existing firm. The weighted average cost should be used when there are no changes in the mix of capital being used and when the anticipated investment will be identical in risk to the existing firm. Next, we discuss the effects of disclosure regulation on the cost of capital of firms. Based on our framework, increasing the quality of mandated disclosures should in general move the cost of capital closer to the risk-free rate for all firms in the economy. In addition to the effect of an individual firms disclosures, there is an externality from the disclosures of other firms, which may provide a rationale for disclosure regulation. We also argue that the magnitude of the costof-capital effect of man dated disclosure will be unequal across firms. In particular, the reduction in the assessed covariances between firms and the market does not result in a decrease in the beta co efficient of each firm. After all, regard less of information quality in the economy; the average beta across firms has to be1.0. Therefore, even though firms cost of capital (and the aggregate risk premium) will decline with improved mandated disclosure, their beta coefficients need not. In the indirect effect category, we show that the quality of accounting information influences a firms cost of capital through its effect on a firms real decisions. First, we demonstrate that if better information reduces the amount of firm cash flow that managers appropriate for themselves, the improvements in disclosure not only increase firm price, but in general also reduce a firms cost of capital. Second, we allow information quality to change a firms real decisions, e.g., with respect to production or investment. In this case, information quality changes decisions, which changes the ratio of expected cash flow to non-diversifiable covariance risk and hence influences a firms cost of capital. We derive conditions under which an increase in information quality results in an unambiguous decrease in a firms cost of capital. Our paper makes several contributions. First, we extend and generalize prior work on estimation risk. We show that information quality directly influences a firms cost of capital and that improvements in information quality by individual firms unambiguously affect their nondiversifiable risks. This finding is important as it suggests that a firms beta factor is a function of its information quality and disclosures. In this sense, our study provides theoretical guidance

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to empirical studies that examine the link between firm s disclosures and/or information quality, and their cost of capital (e.g., Botosan, 1997; Botosan and Plum lee, 2002; Franciset al., 2004; Ashbaugh-Skaifeet al., 2005; Bergeret al., 2005; and Coreet al., 2005). In addition, our study provides an explanation for studies that find that international differences in disclosure regulation explain differences in the equity risk premium, or the average cost of equity capital, across countries (e.g., Hail and Leuz, 2006). It is important to recognize, however, that the information effects of a firms disclosures on its cost of capital are fully captured by an appropriately specified, forward-looking beta. Thus, our model does not provide support for an additional risk factor capturing information risk.One way to justify the inclusion of additional information variables in a cost of capital model would be to note that empirical proxies for beta, which for instance are based on historical data alone, may not capture all information effects In this case, however, it is incumbent on researchers to specify a measurement error model or, at least, provide a careful justification for the inclusion of information variables, and their functional form, in the empirical specification. Based on our results, however, the most natural way to empirically analyze the link between information quality and the cost of capital is via the beta factor. A second contribution of our paper is that it provides a direct link between information quality and the cost of capital, without reference to market liquidity. Prior work suggests an indirect link between disclosure and firms cost of capital based on market liquidity and adverse election in secondary markets (e.g., Diamond and Verrecchia, 1991; Baiman and Verrecchia,1996; Easley and OHara, 2004). These studies, however, analyze settings with a single firm(or settings where cash flows across firms are uncorrelated). Thus, it is unclear whether the effects demonstrated in these studies survive the forces of diversification and extend to more general multi-security settings. We emphasize, however, that we do not dispute the possible role of market liquidity for firms cost of capital, as several empirical studies suggest Our paper focuses on an alternative, and possibly more direct, explanation as to how information quality influences non-diversifiable risks.

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Finally, our paper contributes to the literature by showing that information quality has indirect effects on real decisions, which in turn manifest in firms cost of capital. In this sense, our study relates to work on real effects of accounting information. These studies, however, do not analyze the effects on firms cost of capital or non-diversifiable risks. The remainder of this paper is organized as follows. Section 2 sets up the basic model in a world of homogeneous beliefs, defines terms, and derives the determinants of the cost of capital. Sections 3 and 4 analyze the direct and indirect effects of accounting information on firms cost of capital, respectively. Section 5 summarizes our findings and concludes the paper. Model and Cost of Capital Derivation We define cost of capital to be the expected return on the firms stock. Consistent with standard models of asset pricing, the expected rate of return on a firms stock is the rate, that equates the stock price at the beginning of the period, to the cash flow at the end of the period, We assume there are J securities in the economy whose returns are correlated. The best known model of asset pricing in such a setting is the Capital Asset Pricing Model (CAPM) Therefore, we begin our analysis by presenting the conventional formulation of the CAPM, and then transform this formulation and add an information structure to show how information quality affects expected returns. Assuming that returns are normally distributed or, alternatively, that investors have quadratic utility functions, the CAPM expresses the expected return on a firms stock as a function of the risk-free rate, the expected return on the market. the firms cost of capital is its beta coefficient, or, more specifically, the covariance of its future return with that of the market portfolio. This covariance is a forward-looking parameter, and is based on the information available to market participants Consistent with the conventional formulation of the CAPM, we assume market participants possess homogeneous beliefs regarding the expected end-of-period cash flows and covariance. Because the CAPM is expressed solely in terms of covariance, this formulation might be interpreted as implying that other factors, for example the expected cash flows, do not affect the firms cost of capital. It is important to keep in mind, however, that the covariance term in the CAPM is expressed in terms of returns, not in terms of cash flows. The two are related via the equation . This expression implies that information can affect the expected return on a firms

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stock through its effect on inferences about the covariance of future cash flows, or through the current period stock price, or both. Clearly the current stock price is a function of the exp ected end-of-period cash flow. In particular, the CAPM can be re-expressed in terms of prices instead of returns. First, we demonstrate that if better information reduces the amount of firm cash flow that managers appropriate for themselves, the improvements in disclosure not only increase firm price, but in general also reduce a firms cost of capital. Second, we allow information quality to change a firms real decisions, e.g., with respect to production or investment. In this case, information quality changes decisions, which changes the ratio of expected cash flow to nondiversifiable covariance risk and hence influences a firms cost of capital. We derive conditions under which an increase in information quality results in an unambiguous decrease in a firms cost of capital. This minimum acceptable return, called the cost of capital, is the price the firm pays for the use of money. Knowing the cost of capital, the manager can then make investment decisions by using the cost of capital as the discount rate in deciding upon whether or not to make a capital investment. The subsequent chapter on capital investment will show in detail how these investment decisions are made. Business Risk Risk has already been defined as the variability of expected returns. Business risk is therefore the variability of expected returns in a specific line of business. In other words, business risk is the risk of being in a particular activity or business. The passenger airline business has a different risk profile from the silicon chip manufacturing business or the wholesale food distribution business. The return that investors expect is a function of the variability of the expected Returns in other words, the investors have different expectations of return from the different businesses they invest in. Since the reason for calculating the cost of capital is to establish a discount rate which can be used in evaluating investments, the obvious first question which must be addressed is what is the business risk of the investment under consideration? If a passenger airline is considering an investment in the wholesale food distribution business, the business risk that

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matters is that of the wholesale food distribution business and not the passenger airline business. It would be unrealistic to expect the two businesses to have the same business risk. It would likewise be foolish for the financial manager to impose the cost of capital of the airline or silicon chip business onto a decision for investment in the wholesale food distribution business. This concept of business risk is often overlooked or misunderstood. It is clear that two potential investors in, for example, the fertilizer manufacturing business should use the same cost of capital for evaluating their investment in that business. If one investor uses a higher cost of capital than the next, it is possible for both investors to expect exactly the same returns from the fertilizer manufacturer under consideration but come to different financial conclusions about the investment. (It must be remembered that the final investment decision will be based not just upon financial considerations. Strategic planning and personal preferences, as discussed more fully in the next chapter, also play significant roles.) Thus, the financial manager should not use the cost of capital established in one business in the evaluation of a different business. If parent companies impose one cost of capital on all of their subsidiaries, regardless of the differences in the business risk of their subsidiaries, then they are not demanding enough return from the businesses with high business risk and are demanding too much return from those with less business risk, when compared with the average for the parent company.

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CHAPTER 2 ANYLISES I

Significance And Components Of Cost Of Capital

Cost of capital is considered as a standard of comparison for making different business decisions. Such importance of cost of capital has been presented below. 1. Making Investment Decision Cost of capital is used as discount factor in determining the net present value. Similarly, the actual rate of return of a project is compared with the cost of capital of the firm. Thus, the cost of capital has a significant role in making investment decisions. 2. Designing Capital structure The proportion of debt and equity is called capital structure. The proportion which can minimize the cost of capital and maximize the value of the firm is called optimal capital structure. Cost of capital helps to design the capital structure considering the cost of each sources of financing, investor's expectation, effect of tax and potentiality of growth. 3. Evaluating The Performance Cost of capital is the benchmark of evaluating the performance of different departments. The department is considered the best which can provide the highest positive net present value to the firm. The activities of different departments are expanded or dropped out on the basis of their 4. Formulating Dividend Policy Out of the total profit of the firm, a certain portion is paid to shareholders as dividend. However, the firm can retain all the profit in the business if it has the opportunity of investing in such projects which can provide higher rate of return in comparison of cost of capital. On the other hand, all the profit can be distributed as dividend if the firm has no opportunity investing the profit. Therefore, cost of capital plays a key role formulating the dividend policy.

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Importance of Cost of Capital

The concept of cost of capital is a very important concept in financial management decision making. The concept, is however, a recent development and has relevance in almost every financial decision making but prior to that development, the problem was ignored or by-passed. The progressive management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions. (1) Capital Budgeting Decision. Cost of capital may be used as the measuring road for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing. In various methods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management. It measures the financial performance and determines the acceptability of all investment opportunities. The cost of capital is used for discounting cash flows under Net Present Value method for investment proposals. So, it is very useful in capital budgeting decisions. (2) Designing the Corporate Financial Structure. An optimal capital is that structure at which the value of the firm is Value of the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing optimal capital structure. The cost of capital is significant in designing the firm's capital structure. The cost of capital is influenced by the chances in capital structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. He may try to substitute the various methods of finance in an attempt to minimise the cost of capital so as to increase the market price and the earning per share.

(3) Deciding about the Method of Financing.

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A capable financial executive must have knowledge of the fluctuations in the capital market and should analyse the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, he may ave a better choice of the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the considerations of relating control and of avoiding risk. (4) Performance of Top Management. The cost of capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitabilitys of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. Cost of capital is used to evaluate the financial performance of top management. The actual profitably is compared to the expected and actual cost of capital of funds and if profit is greater than the cast of capital the performance nay be said to be satisfactory. (5) Other Areas. The concept of cost of capital is also important in many others areas of decision making, such as dividend decisions, working capital policy capitalization of profits, making the rights issue, etc.

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CHAPTER 3 ANYLISES II
CLASSIFICATION OF COST OF CAPITAL: Cost of capital can be classified as follows: i) Historical Cost and future Cost: Historical costs are book costs relating to the past, while future costs are estimated costs act as guide for estimation of future costs. ii) Specific Costs and Composite Costs: Specific accost is the cost if a specific source of capital, while composite cost is combined cost of various sources of capital. Composite cost, also known as the weighted average cost of capital, should be considered in capital and capital budgeting decisions. iii) Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which equates the present value of cash inflows with the present value of cash outflows. It is the internal rate of return and is calculated with the following formula; IO=C1/(I+ K)1+ C2/(I+ K)2+..+Cn/ (I+ K)n I= Net cash inflow received at zero of time C = Cash outflows in the period concerned K = Explicit cost of capital N = Duration of time period Implicit cost also known as the opportunity cost is the of the opportunity foregone in order to take up a particular project. For example, the implicit cast of retained earings is the rate of return available to shareholders by investing the funds elsewhere. iv) Average Cost and Marginal Cost: An average cost is the combined cost or weighted average cost of various sources of capital. Marginal cost of refers to the average cost of capital of new or additional funds required by a firm. It is the marginal cost which should be taken into consideration in investment decisions.

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COMPUTATION OF COST OF CAPITAL: Computation of cost capital of a firm involves the following steps: Computation of cost of specific sources of a capital, viz., debt, preference capital, quity and retained earnings, and

Cost of Debt
When issuing debt, the firm agrees to a coupon rate and a face value payable at maturity. As discussed in the chapter on valuation of bonds, the present value of the future income stream is the market value of the bond. The market value will be the amount the lender (purchaser) of the bond is willing to pay for the future income. The discount rate used to discount the future cash flows so that these add up to the market value of the bond, is the rate of return for the bond. This rate of return is arrived at iteratively (by trial and error). The cost of debt is the cost associated with raising one more dollar by issuing debt. Suppose you borrow one dollar and promise to repay it in one year, plus pay $0.10 to compensate the lender for the use of her money. Since Congress allows you to deduct from you income the interest you paid, how much does this dollar of debt really cost you? It depends on your marginal tax rate -the tax rate on your next dollar of taxable income. Why the marginal tax rate? Because we are interested in seeing how the interest deduction changes your tax bill. We compare taxes with and without the interest deduction to demonstrate this. Suppose that before considering interest expense you have $2 of taxable income subject to a tax rate of 40 percent. Your taxes are $0.80. Now suppose your interest expense reduces your taxable income by $0.10, reducing your taxes from $2.00 x 40 percent = $0.80 to $1.90 x 40 percent = $0.76. By deducting the $0.10 interest expense, you have reduced your tax bill by $0.04. You pay out the $0.10 and get a benefit of $0.04. In effect, the cost of your debt is not $0.10, but $0.06 -- $0.04 is the government's subsidy of your debt financing. We can generalize this benefit from the tax deductibility of interest. Let rdrepresent the cost of debt per year before considering the tax deductibility of interest, rd represent the cost of debt after considering tax deductibility of interest, and t be the marginal tax rate. Creditors receive 10 percent, but it only costs the company 6 percent. In our example, the required rate of return is easy to figure out: we borrow $1, repay $1.10, so your lender's required

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rate of return of 10 percent per year. But your cost of debt capital is 6 percent per year, less than the required rate of return, thanks to Congress. Most debt financing is not as straight-forward, requiring us to figure out the yield on the debt -- the lender's required rate of return -- given information about interest payments and maturity value. Example ABC Company debt consists of bonds with an annual coupon rate of 9% on a $1,000 face value over 14 years. If the present market value of the bonds is $860.36, what is the rate of return of the bonds? In other words, what discount rate must be used in order that the sum of the discounted cash stream for the bonds equals $860.36, or find such that: 860.36 = Annuity Factor14 yrs at r%x 90+ Discount Factor14 yrs at r%x 1,000 By substituting different values for r, the equation is solved for r of 11%, which is therefore the rate of return for these bonds. Hence, 11% would be the prevailing interest rate for bonds of the particular risk class under consideration. However, when ABC Company wishes to issue new debt it will have to pay for the service of having the debt issued. Accountants fees, legal fees and underwriting fees must all be deducted from the amount which is finally issued to the company. The net amount the company receives will be reduced, thus increasing the effective cost of issuing debt. Computation of weighted average cost of capital. Cost of Debt (kd) Debt may be perpetual or redeemable debt. Moreover, it may be issued at par,at premium or discount. The computation of cost debt in each is explained below. Perpetual / irredeemable debt:a At par: Kd = Cost of debt before tax =I/Po Kd= Cost of debt; I= interest; Po= net proceeds Kd (after-tax) = i/P(I-t) Where T = tax rate Example

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Y Ltd issued Rs. 2,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2% . The tax rate is 50%. Compute the after tax cost of debt. Answer: Kd (after-tax)= I/NP (i-t) RS 18,000/Rs 2,15,600 (I-5)=4.17% [net proceeds = Rs. 2,00,000 + 20,000 (2/100x2,20,000)] Redeemable debt The debt repayable after a certain period is known ad redeemable debt. Its cost computed by using the following formula: Before tax cost of debt = I+1/n (P-NP)/ (P+NP) i) ii) iii) Example A company issued Rs. 1,00,000 10% redeemble debentures at a discount of 50%. The cost of floatation amount to Rs. 3,000. The debentures are redeemable after 5 years. Compute before tax and after tax Cost of debt. The rate is 50%.Solution : i) Before tax cost of debt = I+1/n (P-NP)/ (P+NP) =10,000+1/5(1,00,000-92,000)/ (1,00,000+92,000) =10,000-16000/96,000 =11,000/96,000 9 = 12.08% [NP=1,00,000 5,000 3,000=92,000] After tax cost of debt = Before tax cost x (1-t)=12.08X(1-.5)=6.04% I = interest: P= proceeds at par; NP = net proceeds; n = No. of years in which debt is to be redeemed ii) After tax of debt = Before tax cost of debt x(1-t)

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The cost of Preference Capital

Cost of preference Capital (kP) In case of preference share dividend are payable at a fixed rate. However, the dividends are not allowed to be deducted for computation of tax. So no adjustment for tax is required just like debentures, preference share may be perpetual or redeemable. Future, they may be issued at par, premium or discount. Perpetual preference Capital i) If issued at par ; Kp= D/P Kp= Cost of preference capital D = Annual preference dividend P = Proceeds at par value ii) If issued at premium or discount Kp= D/NP Where NP = net proceeds. Example: A company issued 10,000, 10% preference share of Rs. 10 each, Cost of issue is Rs. 2 per share. Calculate cost of capital, of these shares are not issued (a) at par , (b) at 10% premium, and (c) at 5% discount. Solutions : Cost of preference capital, (Kp) = D/NP a) When issued at par: Kp Rs. 10,000/1,00,000-20,000 x100 = 10,000/ 80,000 x 100 = 12.5% [ Cost of issued = 10,000xRs. 2= Rs. 20,000] b) When issued at 10% premium: Kp =Rs. 10,000/1,00,000 + 10,000-20,000 x100 =10,000/90,000x100 =11.11% c) When issued at 5% discount:

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Kp = Rs. 10,000/1,00,000- 5,000-20,000x100 =10,000/75,000x100 =13.3%

The cost of equity Capital

Cost of Equity is the expected rate of return by the equity shareholders. Some argue that, as there is no legal for payment, equity capital does not involve any cost. But it is not correct. Equity shareholders normally expect some dividend from the company while making investment in shares. Thus, the rate of return expected by them becomes the cost of equity. Conceptually, cost of equity share capital may be defined as the minimum rate of return that a firm must earn on the equity part of total investment in a project in order to leave unchanged the market price of such shares. For the determination of cost equity capital it may be divided into two categories: External equity or new issue of equity shares. Retained earnings. The cost of common equity is the cost of raising one more dollar of common equity capital, either internally -- from earnings retained in the company or externally by issuing new shares of common stock. There are costs associated with both internally and externally generated capital. How does internally generated capital have a cost? As a company generates funds, some portion is used to pay off creditors and preferred shareholders. The remaining funds are owned by the common shareholders. The company may either retain these funds (investing in assets) or pay them out to the shareholders in the form of cash dividends. Shareholders will require their company to use retained earnings to generate a return that is at least as large as the return they could have generated for themselves if they had received as dividends the amount of funds represented in the retained earnings. Retained funds are not a free source of capital. There is a cost. The cost of internal equity funds (i.e.,retained earnings) is the opportunity cost of funds of the company's shareholders. This opportunity cost is what shareholders could earn on these funds for the same level of risk. The only difference between the costs of internally and externally generated funds is the cost of issuing ne w common stock. The cost of internally generated funds is the opportunity cost of

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those funds -- what shareholders could have earned on these funds. But the cost of externally generated funds (that is, funds from selling new shares of stock) includes both the sum of the opportunity cost and cost of issuing the new stock. The cost of issuing common stock is difficult to estimate because of the nature of the cash flow streams to common shareholders. Common shareholders receive their return (on their investment in the stock) in the form of dividends and the change in the price of the shares they own. The dividend stream is not fixed, as in the case of preferred stock. How often and how much is paid as dividends is at the discretion of the board of directors. Therefore, this stream is unknown so it is difficult to determine its value. The change in the price of shares is also difficult to estimate; the price of the stock at any future point in time is influenced by investors' expectations of cash flows farther into the future beyond that point. Nevertheless, there are two methods commonly used to estimate the cost of common stock: the dividend valuation model and the capital asset pricing model . Each method relies on different assumptions regarding the cost of equity; each pr oduces different estimates of the cost of common equity.

Cost of common equity using the capital asset pricing model

The investor's required rate of return is compensate on for both the time value of money and risk. To figure out how much compensation there should be for risk, we first have to understand what risk we are talking about. The capital asset pricing model (CAPM) assumes an investor holds a diversified portfolio -- a collection of investments whose returns are not in synch with one another. The returns on the assets in a diversified portfolio do not move in the same direction at the same time by the same amount. The result is that the only risk left in the portfolio is the risk related to movements in the market as a whole (i.e., market risk). If investors hold diversified portfolios, the only risk they have is market risk. Investors are risk averse, meaning they don't like risk, so if they are going to take on risk they want to be compensated for it. Investors who only bear market risk need only be compensated for market risk. If we assume all shareholders' hold diversified portfolios, the risk that is relevant in the

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valuing a particular investment is the market risk of that investment. It is this mark et risk that determines the investment's price. The greater the market risk, the greater the compensation -meaning a higher yield -- for bearing this risk. And the greater the yield, the lower the present value of the asset because expected future cash flows are discounted at a higher rate that reflects the higher risk. The cost of common equity, estimated using the CAPM, is the sum of the investor's compensation for the time value of money and the investor's compensation for the market risk of the stock: Cost of common equity = Compensation for the Compensation for + time value of money market risk Let's represent the compensation for the time value of money as the expected risk-free rate of interest, rf. If a particular common stock has market risk that is the same as the risk of the market as a whole, then the compensation for that stock's market risk is the market risk premium. The market's risk premium is the difference between the expected return on the market, rm, and the expected risk-free rate, rf where rf is the expected risk free rate of interest, is a measure of the company's stock return to changes in the market's return (beta), and r is the expected return on the market. The CAPM is based on two ideas that make sense: investors are risk averse and they hold diversified portfolios. But the CAPM is not without its drawbacks. First, the estimates rely heavily on historical values -- returns on the stock and returns on the market. These historical values may not be representative of the future, which is what we are trying to gauge. Also, the sensitivity of a company's stock returns may change over time; for example, when the company changes its capital structure. Second, if the company's stock is not publicly-traded, there is no source for even historical values. The cost of external equity can be computed as per the following approaches: Dividend Yield / Dividend Price Approach According to this approach, the cost of equity will be that rate of expected dividends which will maintain the present market price of equity shares. It is calculated with the following formula: Ke = D/NP (for new equity shares)

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Or Ke = D/MP (for existing shares) Where, Ke = Cost of equity D = Expected dividend per share NP = Net proceeds per share Mp = Market price per share This approach rightly recognizes the importance of dividends. However, it ignores the importance of retained earnings on the market price of equity shares. This method is suitable only when the company has stable earnings and stable dividend policy over a period of time. Example A company issues, 10,000 equity shares of Rs. 100 each at a premium of 10%. The company has been paying 20% dividend to equity shareholders for the past five years and expected to maintain the same in the future also. Compute cost of equity capital. Will it make any difference if the market price of equity share is Rs. 150 ? Ke = D/NP = Rs 20./Rs 110 x 100 =18.18% If the market price per share =Rs.150 Ke = D/MP =Rs20/Rs150x100 =13.33% Dividend yield plus Growth in dividend methods According to this method, the cost of equity is determined on the basis if the expected dividend rate plus the rate of growth in dividend. This method is used when dividends are expected to grow at a constant rate. Ke = D1/NP +g (for new equity issue) Where

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D1= expected dividend per share at the end of the year. [D1= Do(1+g)] Np = net proceeds per share g = growth in dividend for existing share is calculated as: D1/ MP + g Where, MP = market price per share. Where, MP = market price per share. Example: ABC Ltd plans to issued 1,00,000 new equity share of Rs. 10 each at par. The floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs. 1 per share and the growth rate in dividend is expected to be 5%. Compute the cost of new issue share. If the current the cost of new issue of shares. Solution :Cost of new equity shares = (Ke) = D/NP +g Ke= 1 / (10-5-) + 0.05 = 1 / 9.5 + 0.05 = 0.01053 + 0.05 = 0.1553 or 15.53% Cost of existing equity share: ke= D / MP + g Ke= 1/ Rs. 15 = 0.05 = 0.0667 or 11.67

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Earnings Yield Method According to this approach, the cost of equity is the discount rate that capitalizes a stream of future earnings to evaluate the shareholdings. It is called by taking earnings per share (EPS) into consideration. It is calculated as: Ke= Earnings per share / Net proceeds = EPS / NP [For new share] Ke= EPS / MP [ For existing equity] Example XYZ Ltd is planning for an expenditure of Rs. 120 lakhs for its expansion programme. Number of existing equity shares are 20 lakhs and the market value of equity shares is Rs. 60. It has net earnings of Rs. 180 lakhs. Compute the cost of existing equity share and the cost of equity capital assuming that new share will be issued at a price of Rs. 52 per share and the costs of new issue will be Rs. 2 per share. Solutions Cost of existing equity =MP/EPS Earnings per share (EPS) =1,80,000/20,00,000 =Rs 9 Ke=9/60=0.15 or 15% Cost of new equity capital (Ke)=ESP/NP=9/52-2=9/50=0.18 or 18% Cost of Retained Earnings (Kr) Retained earnings refer to undistributed profits of a firm. Out of the total earnings, firms generally distribute only past of them in the form of dividends and the rest will be retained within the firms. Since no dividend is required to paid on retained earnings, it is stated that retained earnings carry no cost. But this approach is not appropriate. Retained earnings has the

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opportunity cost of dividends in alternative investment becomes cost if retained earnings. Hence, shareholders expect a return on retained earnings at least equity. Kr= Ke= D/NP+g However, while calculating cost of retained earnings, two adjustments should be made: a) Income-tax adjustment as the shareholders are to pay some income tax out of dividends, and b) adjustment for brokerage cost as the shareholders should incur some brokerage cost while investment dividend income. Therefore, after these adjustments, cost of retained earnings is calculated as: Kr= Ke(1-t)(1-b) Where, Kr= cost of retained earnings Ke= Cost of equity t = rate of tax b = cost of purchasing new securities or brokerage cost. Example A firm s cost of equity (Ke) is 18%, the average income tax rate of shareholders is 30% and brokerage cost of 2% is excepted to be incurred while investing their dividends in alternative securities. Compute the cost of retained earnings. Solution : Cost of retained earnings = (Kr) = Ke(1-t)(1-b)=18(1-.30)(1-.02) =18x.7x.98=12.35% Cost of Rights Issue

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Rights issue is an invitation to the existing shareholders to subscribe for further shares to be issued by a company. A right simply means an option to buy certain shares at a privileged price which is considerably below the market price. It is generally felt that the cost of issue would be different from the cost of direct issue. But for two reasons, the real cost of rights issue would be the same as the cost of direct issue of share to the public. i) The shareholder who is not interested in the rights issue, sells his rights and obtain cash. Then he has the old share plus the money obtained from selling the rights. ii) Otherwise, the shareholder exercise his rights and acquires the share the new share,in addition to the old shares. Thus, the present wealth of the shareholders in both the cases remains the same. Cost of Convertible Securities Convertible securities or debentures are another type of instruments for mobilization of debt capital. In this case the debenture holder is entitled to gull pr a part of the value of the debenture being converted into equity shares. The price at whch the debenture is convertible into share is known as conversion price. This conversion price is declares at the time of the issue of debentures itself. When the bondholder exercises his option of conversion, he enjoys two benefits-interest on bonds till the date of conversion and increased market value share a at the time of conversion. Hence, the cost of convertible securities is taken to be that rate of discount swhich equates the after-tax interest and the expected market value of the share at the end option period, with the current market value of bond. This is calculated with the help of following formula: Po= Where Po= Current market value of debenture I = Interest

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t = tax rate Ko= Rate of discount or cost of convertible security. n = no. of years at the end of which conversion takes place. CR = conversion or the no. of share the bond holder gets on conversion

WEIGHTED AVERAGE COST OF CAPITAL : It is common for the financial manager to seek funding for projects which have the same business risk as the ongoing operations; in other words, to expand existing operations. For example, a jewellery business which expands by opening additional retail shops in new locations using the same business strategy and capital structure. The weighted average cost of capital (WACC) is a commonly used approach for determining the cost of capital assuming that business risk, financial risk and dividend policy all remain constant. Capital invested in the firm in the form of debt and equity can take many forms. The forms of debt and equity typically consist of bonds, ordinary shares, and preferred shares. The weighted average cost of capital approach takes the weighted average of the costs of the capital being used in the firm. For simplicity, this chapter examines this process using just these three sources of financing. The procedure is to first determine the present weighting of debt, ordinary shares and preferred shares. Then the cost of each of these sources of funding is determined. Finally a weighted average of the costs is calculated. It is the average of the costs of various sources of financing. It is also known as composite or overall or average cost of capital. After computing the cost of individual sources of finance, the weighted average cost of capital is calculated by putting weights in the proportion of the various sources of funds to the total funds. Weighted average cost of capital is computed by using either of the following two types of weights:

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1) Market value 2) Book Value Market value weights are sometimes preferred to the book value weights as the market value represents the true value of the investors. However, market value weights suffer from the following limitations: i) Market value are subject to frequent fluctuations. ii) Equity capital gets more importance, with the use of market value weights. Moreover, book values are readily available. Average cost of capital is computed as followings: Kw = KW/W Where, Kw = weighted average cost of capital X = cost of specific sources of finance W = weights (proportions of specific sources of finance in the total) The following steps are involved in the computation of weighted average cost of capital : i) Multiply the cost of each sources with the corresponding weight. ii) Add all these weighted costs so that weighted average cost of capital is obtained. Examination of the market value weightings of ABC Company reveals that the following sources of financing are being used: Debt Ordinary Shares Preferred Shares $12,000,000 $10,000,000 $3,000,000

What are the percentage weightings of each financing source? Using the formula:

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Assets Total Assets

= = =

Debt + Equity, 12,000,000 + 10,000,000 + 3,000,000 $25,000,000

To find the percentage of total assets being financed by each source, divide the amount being used by the total assets: Debt Ordinary Shares Preferred Shares 12/25 = 48% 10/25 = 40% 3/25 = 12%

Calculating the weighted average cost of capital The cost of capital is the average of the cost of each source, weighted by its proportion of the total capital it represents. Hence, it is also referred to as the weighted average cost of capital(WACC) or the weighted cost of capital (WCC ). The weighted average cost of capital is: As you raise more and more money, the cost of each additional dollar of new capital may increase. This may be due to a couple of factors: the flotation costs and the demand for the security representing the capital to be raised. As you raise more and more money, the cost of each additional dollar of new capital may increase. This may be due to a couple of factors: the flotation costs and the demand for the security representing the capital to be raised. For example, the cost of internal funds from retained earnings will differ from the cost of funds from issuing common stock due to flotation costs. If a company expects to generate $1,000,000 entirely from what's available in internal funds retained earnings -- there are no flotation costs. But if the company needs $1,000,001, that $1 above $1,000,000 will have to be raised externally, requiring flotation costs. Additional capital may be more costly since the company must offer higher yields to entice investors to purchase ever larger issues of securities. Considering the effects of flotation costs and the additional yield necessary to entice investors, we most likely face a schedule of marginal

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costs of debt capital and a schedule of marginal costs of equity capital. Hence, we need to determine at what level of raising funds the marginal cost of capital for the company changes. The maximizing shareholder wealth means in terms of making investment and financing decisions. To maximize owners wealth we must invest in a project until the marginal cost of capital is equal to its marginal benefit. What is the benefit from an investment? It is the internal rate of return -- also known as the marginal efficiency of capital. If we begin by investing in the best projects (those with highest returns), and then proceed by investing in the next best projects, and so on, the marginal benefit from investing in more and more projects declines. Also, as we keep on raising funds and investing them, the marginal cost of funds increases. To maximize shareholders' wealth, we should invest in projects to the point where the increasing marginal cost of funds is equal to the marginal benefit from our investment. Relation between the marginal cost of capital(MCC) and the marginal return on investment (IRR) is shown in Exhibit 2. The point at which the marginal cost and marginal benefit intersect is the optimal capital budget. This is the point at which the value of the company is maximized. Capital Asset Pricing Model and Financial Leverage The amount of debt used to finance the assets of the company determines the amount of financial leverage. The return on debt to the debt holders is fixed by agreement between the company and the lenders. Equity holders finance the remainder of the assets of a company. The return on equity varies not only with the amount of business risk, but also with the amount of financial leverage being used by the company. Using the CAPM to determine cost of capital has a difficulty not mentioned in the previous chapter. When looking into the share market to determine the returns of a share, it must be remembered that it is the return on equity that is being examined not return on assets. But it is the return on assets that determines the business risk. When attempting to determine the cost of capital, the first step is to determine the return on assets for a business similar to the investment under consideration. Business risk is measured by a Beta coefficient in the CAPM. The Beta coefficient for assets is calculated according to the following formula:

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ABC Company is considering an investment in the oil exploration business. In order to evaluate the potential of the investment, it is first necessary to determine the cost of capital, or the cost of using money for oil exploration. In examining the share market, the financial manager of ABC notices that XYZ Company is in exactly the type of oil exploration business that is under consideration. By doing a regression analysis of the returns on XYZ shares against the returns of the market, it is determined that: Beta equity XYZ = 1.7 By examining the Balance Sheet of XYZ Company, it is determined that 40% of the assets of XYZ are financed by debt and 60% are financed by equity. Discussions with XYZs bankers about the perceived risk of lending to XYZ indicate that XYZ does not borrow risk free, and thus it can be assumed that: Beta debt XYZ = 0.2 What is the cost of capital that ABC should use in their project evaluation if the risk free rate is 12%, the excess return on the market is 8%, and ABC will use 30% debt and 70% equity? From the above formula: Beta assets XYZ = 1.7 x .60 + .2 x .40 = 1.1 By using the CAPM, the expected return on assets for an oil exploration project is: E(r)= .12 + (1.1 x .08) = .208 or 20.8% This is the cost of capital in the oil exploration business. This is a measure of the business risk of this type of business.

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A further question could be: what is the expected return that ABC equity holders will require? Because ABC plans on using less debt (30% compared with 40% for XYZ), then Beta equity for ABCs project can be solved from the above equation by using 1.1 for a measure of the business risk and by using the debt and equity percentages under consideration. (Discussions with bankers lead to an assumption that the level of riskiness of the debt of ABC is slightly higher than the debt risk for XYZ. Thus, it is assumed that Beta debt of ABC is .3.) Knowing that 1.1 is Beta assets of this line of business, it is possible to solve for Beta equity of ABC given their preferred capital structure. 1.1 = Beta equity ABC x .70 + (.3 x .30) Therefore: Beta equity ABC = (1.1 - .09)/.7 =1.443 Using this beta in the CAPM to determine the cost of equity capital to ABC for the project gives: E(r)=.12 + (1.443 x .08) =.235 or 23.5% Comparing this cost of equity capital to the cost of equity capital for XYZ, we find that for XYZ, E (r) = 25.6% (E(r) = .12+ (1.7 x .08)), where E(r) is the expected return from equity capital. It is not surprising that ABC s cost of equity capital at 23.5% is lower than XYZ s at 25.6% since ABC is considering using less financial leverage - in spite of the fact that the assumed level of debt risk for ABC was higher than the assumed level of debt risk for XYZ. Yet both companies have the same cost of capital at 20.8% since they both have the same business risk, as defined by beta of the assets, since they are in the same kind of business. Determining the Beta Debt coefficient for a company requires sensitivity analysis. It may be possible to examine the Balance Sheet and determine the interest rate being paid on the debt carried. By knowing that the prime lending rate of banks is the risk free lending rate, that is,

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Beta debt = 0, it is possible to measure the amount above The prime rate being paid by the firm. The difference between the prime rate and the cost of borrowing only provides a measure of lending risk. It is important not to assume a linear relationship between Beta debt and increased cost of borrowing. When undertaking cost of capital calculations, it is helpful to try several Beta Debt levels, for instance from 0 to .5, in order to see the effect it has on the cost of equity capital. A Beta debt of 1 would mean that the variability of the expected returns ofdebt is equal to the variability of the marke- which would imply that debt has variable returns and this would not be acceptable to lenders (with the possible exception of junk bond/high risk holders). Using this approach, it is possible to see how sensitive the cost of capital, and therefore the investment decision, is to the various risk levels of debt. If minor levels of debt are being considered (less than 35%) in an extremely sound investment, it is reasonable to assume that Beta debt equals zero. Attempts to refine the relationship between geared and ungeared Beta and to measure the components of the cost of geared equity capital have been criticised for making unreliable approximations which significantly distort the resulting values. While formulae have been proposed for ungearing Beta many of them are overly simplistic (Buckley, 1989).

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CHAPTER 4 SUMMARY AND CONCLUSION

When making investment decisions, the financial manager must know the cost of capital to be used in the investments. The cost of capital is the discount rate (sometimes called a hurdle rate) which will be used in the capital investment process to determine if projects are financially acceptable. The cost of capital is a function of the business risk, financial risk, and the total amount of funding necessary. Business risk can be observed in the market place by observing companies in the same line of business. Financial risk, which is a function of the debt to asset ratio of the company, can be taken into account by using the Capital Asset Pricing Model. Assuming a fixed financial structure and the same business risk, it is possible to calculate the weighted average cost of capital. These weightings enable the analyst or decision maker to determine the levels of funding at which the cost of capital. changes. By adding the lowest possible profitable discount rate for each project to a graph of these breaks in the cost of capital, it becomes clear which projects are financially feasible. The cost of capital is the marginal cost of raising additional funds. This cost is important in our investment decision making because we ultimately want to compare the cost of funds with the benefits from investing these funds. The cost of capital is determined in three steps: (1) determine what proportions of each source of capital we intend to use; (2) calculate the cost of each source of capital,and (3) put the cost and the proportions together to determine the weighted average cost of capital. The required rate of return on debt is the yield de manded by investors to compensate them for the time value of money and the risk they bear in lending their money. The cost of debt to the company differs from this required rate of return due to flotation costs and the tax benefit from the deductibility of interest expense. The required rate of return on preferred stock is the yield

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demanded by investors and differs from the company's cost of preferred equity be cause of the costs of issuing additional shares (the flotation costs). The cost pf common equity is more difficult to estimate than the cost of debt or preferred stock because of the nature of the return on stock: Dividends are not guaranteed nor fixed in amount, and part of the return is from the change in the value of the stock. The dividend valuation model and the capital asset pricing model are two methods commonly used to estimate the required rate of return on common equity. The DVM deals with the expected dividend yield and is based on an assumption that dividends grow at some constant rate into the future. The CAPM assumes that investors hold diversified portfolios, so they require compensation for the time value of money and the market risk they bear by owning the stock. The proportion of each source of capital that we use in calculating the cost of capital is based on what proportions we expect the company to raise new capital. If the company already has a capital structure a mix of debt and equity it feels appropriate then that same proportion of each source of capital, in market value terms, is a good estimate of the proportions of new capital. The cost of capital is the cost of raising new capital. The weighted average cost of capital is the cost of all new capital for a given level of financing. The cost of capital is a marginal cost the cost of an additional dollar of new capital at a given level of financing. In determining the optimal amount to spend on investments, the relevant cost is the marginal cost, since we are interested in investing until the marginal cost of the funds is equal to the marginal benefit from our investment. The point where marginal cost = marginal benefit results in the optimal capital budget. The actual estimation of the cost of capital for a company requires a bit of educated guesswork, and lots of reasonable assumptions. Using readily available financial data, we can, at least, arrive at a good enough estimate of the cost of capital.

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BIBLIOGRAPHY

Black, F., Jensen, M.C. & Scholes, M., The Capital Asset Pricing Model: Some Empirical Tests in Jensen, M.C. (ed) Studies in the Theory of Capital Markets Praeger, New York, 1971. Brealey R. & Myers, S., Principles of Corporate Finance , McGraw -Hill, New York, 1981. Brigham, E.F. and Gardenski, L.C., Financial Management Theory and Practice, Fifth Edition, The Dryden Press, 1988. Buckley, A.Beta Geared and Ungeared British Readings in Financial Management, 1989, pp 199-207. Francis, J.C.,Investments: Analysis and Management, 4th Edition, McGraw-Hill, New York, 1986. Keown, A.J., Scott, D.F., Martin, J.D., and Petty, J.W., Basic Financial Management, Third Edition, Prentice-Hall, 1985. Peirson, G., and Bird, R., Business Finance, Third Edition, McGraw Hill, Sydney,1983. Pringle, J.J. and Harris, R.S.,Essentials of Managerial Finance, Scott Foresman & Co, Glenview, Illinois, 1984. Reilly, F.K.,Investment Analysis and Portfolio Management, Second Edition, The Dryden Press, 1985.

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