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Corporate Finance

Cost of Capital
Topics Covered ------
• Overview of cost of capital

• Cost of Debt and Preference

• Cost of Equity

• Determining the Proportions

• Weighted AverageCostCost of Capital


of capital_09
------Topics Covered

• Floatation Costs and the WACC

• Divisional and Project Cost of Capital

• Cost of Capital in Practice

Cost of capital_09 2
Cost of Capital--

The cost of capital of any investment (project,


business, or company) is the rate of return the
suppliers of capital would expect to receive if
the capital were invested elsewhere in an
investment (project, business, or company) of
comparable risk.

Cost of capital_09 3
--Cost of Capital

• The cost of capital reflects expected

return.

• The cost of capital represents an

opportunity cost.

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Why Cost of Capital is Important

• We know that the return earned on assets


depends on the risk of those assets. The return
to an investor is the same as the cost to the
company.

• The cost of capital provides us with an indication


of how the market views the risk of our assets.
Knowing the cost of capital can also help us
determine our required return for capital
budgeting projects.
Cost of capital_09 5
Required Return

• The required return is the same as the


appropriate discount rate and is based on the
risk of the cash flows.
• We need to know the required return for an
investment before we can compute the NPV and
make a decision about whether or not to take the
investment.
• We need to earn at least the required return to
compensate our investors for the financing they
have provided.

Cost of capital_09 6
Weighted Average Cost of Capital
(WACC)
WACC = weke + wpkp + wdkd (1 – tc)
we = proportion of equity
ke = cost of equity
wp = proportion of preference
kp = cost of preference
wd = proportion of debt
kd = pre-tax cost of debt
tc = corporate tax rate
Cost of capital_09 7
Company Cost of Capital and Project
Cost of Capital--

The company cost of capital (WACC) is the rate


of return expected by the existing capital
providers. It is the right discount rate for an
investment which is same as that of the
existing firm.

Cost of capital_09 8
--Company Cost of Capital and Project
Cost of Capital

The project cost of capital is the rate of return


expected by capital providers for a new
project the company proposes to undertake.

Cost of capital_09 9
Cost of Debt

• The cost of debt is the required return on our


company’s debt.
• We usually focus on the cost of long-term debt
or bonds.
• The required return is best estimated by
computing the yield to maturity on the existing
debt.
• The cost of debt is not the coupon rate.

Cost of capital_09 10
Cost of Debt
n I F
P0 = ∑ +
t=1 (1 + kd)t (1 + kd)n
P0 = current price of the debenture
I = annual interest payment
n = number of years left to maturity
F = maturity value
kd is computed through trial-and-error. A very
close approximation is:
I + (F – P0)/n
rD =
0.6P0 + 0.4F
Cost of capital_09 11
e.g.:

Face value = Rs. 1,000

Coupon rate = 12%


Period to maturity = 4 years
Current market price = Rs.1040

The approximate yield to maturity of this


debenture is :
120 + (1000 – 1040) / 4
kd = = 10.7 percent
0.6 x 1040 + 0.4 x 1000
Cost of capital_09 12
Cost of Preference

Given the fixed nature of preference dividend


and principal repayment commitment, the cost
of preference is simply equal to its yield.

Cost of capital_09 13
e.g.:

Face value : Rs.100


Dividend rate : 11 percent
Maturity period : 5 years
Market price : Rs. 95

Approximate yield :
11 + (100 – 95) / 5
= 12.37 percent
0.6 x 95 + 0.4 x 100

Cost of capital_09 14
Cost of Equity
The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm.
Equity finance comes by way of
(a) retention of earnings , and
(b) issue of additional equity capital

Cost of capital_09 15
Note:

Irrespective of whether a firm raises equity


finance by retained earnings or issuing
additional equity shares, the cost of equity is
the same. The only difference is in floatation
cost.

Cost of capital_09 16
Approaches to Estimate Cost of Equity

• Security Market Line Approach

• Bond Yield Plus Risk Premium Approach

• Dividend Growth Model Approach

• Earnings-Price Ratio Approach

Cost of capital_09 17
Security Market Line Approach
ke = rf + βe [E(km) – rf ]
Where,
re = required return on the equity of the
company
rf = risk-free rate
βe = beta of the equity of the company
E(km) = expected return on the market
portfolio
Cost of capital_09 18
e.g.:
rf = 7%, βe = 1.2, E(km) = 15%

ke = 7 + 1.2 [15 – 7] = 16.6%

Cost of capital_09 19
Inputs for the SML--

While there is disagreement among finance


practitioners, the following would facilitate as a
guideline:

• The risk-free rate may be estimated as the


yield on long-term bonds that have a
maturity of 10 years or more.

Cost of capital_09 20
-- Inputs for the SML
• The market risk premium may be estimated
as the difference between the average return
on the market portfolio and the average risk-
free rate over the past 10 to 30 years.

• The beta of the stock may be calculated by


regressing the monthly returns on the
market index over the past 60 months or so.

Cost of capital_09 21
Bond yield plus Risk Premium Approach

Yield on the Risk


Cost of equity = long-term bonds + premium
of the firm

Should the risk premium be 2%, 4% or n% ?

There seems to be no objective way of doing it.

Cost of capital_09 22
Dividend Growth Model Approach--

If the dividend per share grows at a constant


rate of g percent.
D1
P0 =
ke – g
D1
So, ke = + g
P0

Cost of capital_09 23
-- Dividend Growth Model Approach

Thus, the expected return of equity


shareholders, which in equilibrium is
also the required return, is equal to the
dividend yield plus the expected growth
rate.

Cost of capital_09 24
e.g.:
Suppose that a company is expected to pay a
dividend of Rs. 1.50 per share next year. There
has been a steady growth in dividends of 5.1%
per year and the market expects that to
continue. The current price is Rs. 25.
Compute the cost of the equity.

Cost of capital_09 25
e.g.:Suppose that a company is expected
to pay a dividend of Rs. 1.50 per share
next year. There has been a steady
growth in dividends of 5.1% per year and
the market expects that to continue. The
current price is Rs. 25. Compute the cost
of equity.
Solution: 1 .50
ke = + .051 = .111
25
Cost of capital_09 26
Getting a handle over g

• Analysts’ forecasts of growth rate.

• Average annual growth rate in the preceding


5 –10 years.

• (Retention rate) (Return on equity)

Cost of capital_09 27
Advantages and Disadvantages of
Dividend Growth Model
Advantage
– easy to understand and use
Disadvantages
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth
rate (an increase in g of 1% increases the
cost of equity by 1%)

Cost of capital_09 28
e.g.:
Suppose the company has a beta of 1.5. The
market risk premium is expected to be 9% and
the current risk-free rate is 6%. We have used
analysts’ estimates to determine that the market
believes our dividends will grow at 6% per year
and our last dividend was Rs. 2. Our stock is
currently selling for Rs. 15.65. What is the cost of
equity?

Cost of capital_09 29
Solution:

Using SML: ke = 6% + 1.5(9%) = 19.5%

Using DGM: ke = [2(1.06) / 15.65] + .06


= 19.55%

Cost of capital_09 30
Earnings-Price Ratio Approach--
Cost of equity = E1 / PO
where,
E1 = the expected EPS for the next year
PO = the current market price

Cost of capital_09 31
--Earnings-Price Ratio Approach—
This approach provides an accurate measure
in the following two cases:
• When the EPS is constant and the dividend
payout ratio is 100 percent.
• When retained earnings earn a rate of
return equal to the cost of equity.

Cost of capital_09 32
Weighted Average Cost of Capital
• We can use the individual costs of capital
that we have computed to get our “average”
cost of capital for the firm.
• This “average” is the required return on the
firm’s assets, based on the market’s
perception of the risk of those assets.
• The weights are determined by how much
of each type of financing is used.

Cost of capital_09 33
Determining the Proportions or Weights--

• The appropriate weights are the target capital


structure weights stated in market value terms.
The primary reason for using the target capital
structure is that the current capital structure may
not reflect the capital structure expected in future.

Cost of capital_09 34
--Determining the Proportions or Weights
• Market values are superior to book values
because in order to justify its valuation the
firm must earn competitive returns for
shareholders and debt holders on the
current (market) value of their investments.

Cost of capital_09 35
e.g.:
Suppose you have a market value of equity equal to Rs.
500 million and a market value of debt Rs. 475 million.
What are the capital structure weights?

Solution:
V = Rs. 500 million + Rs. 475 million = Rs. 975 million
we = E/V = 500 / 975 = .5128 = 51.28%
wd = D/V = 475 / 975 = .4872 = 48.72%

Cost of capital_09 36
e.g.:

Source of Capital Proportion Cost Weighted Cost


(A) (B) [AxB]
Equity 0.60 16.0% 9.60%
Preference 0.05 14.0% 0.70%
Debt 0.35 8.4% 2.94%
Note: Assuming tax rate @ 30%. WACC = 13.24%

Cost of capital_09 37
Weighted Marginal Cost of Capital Schedule--

The procedure for determining the weighted


Marginal cost of capital involves the
following steps:
1. Estimate the cost of each source of
financing for various levels of its use
through an analysis of current market
conditions and an assessment of the
expectations of investors and lenders.
Cost of capital_09 38
--Weighted Marginal Cost of Capital Schedule--

2. Identify the levels of total new financing


at which the cost of the new components
would change, given the capital structure
policy of the firm. These levels, called
breaking points, can be established using
the following relationship:

Cost of capital_09 39
--Weighted Marginal Cost of Capital Schedule--
TFj
BPj =
wj

where, BPj is the breaking point on account of


financing source j, TFj is the total new financing from
source j at the breaking point, and wj is the
proportion of financing source j in the capital
structure.

Cost of capital_09 40
--Weighted Marginal Cost of Capital Schedule

3. Calculate the WACC for various ranges of total


financing between the breaking points.

4. Prepare the weighted marginal cost of capital


schedule which reflects the WACC for each level
of total new financing.

Cost of capital_09 41
e.g.:
ABC Ltd. Wishes to use equity, preference and debt capital in the
following proportions:
Equity: 0.45 , Preference: 0.05, Debt: 0.50
As per the estimates of ABC Ltd., the cost of each of its three
sources of financing for various levels of usage are as follows:

Source Target proportions Range of new financing(Rs. in cr.) Cost (%)


Equity 45% 0 - 10 15.00
10 – 30 16.50
30 & above 18.00
Preference 5% 0–1 14.50
1 & above 15.00
Debt 50% 0 - 15 7.50
15 – 40 8.00
40 & above 8.40
Compute the breaking points for each source of finance and corresponding
ranges of new financing.

Cost of capital_09 42
Solution--
We have,

Source Cost (%) Range of new Breaking Points Range of total new
financing (in cr.) (Rs. in cr.) financing (in cr.)

Equity 15.00 0 - 10 10/0.45= 22.22 0 – 22.22


16.50 10 – 30 30/0.45 = 66.67 22.22 – 66.67
18.00 30 & above ---------- 66.67 & above

Preference 14.50 0–1 1/0.05 = 20.00 0 – 20.00


15.00 1 & above ---------- 20.00 & above

Debt 7.50 0 – 15 15/0.50 = 30.00 0 – 30.00


8.00 15 – 40 40/0.50= 80.00 30.00 – 80.00
8.40 40 & above ----------- 80.00 & above

Cost of capital_09 43
--Solution--
Range of total new Source Proportions Cost (%) Weighted Cost (%)
financing (Rs. In cr.)

0 – 20.00 Equity 0.45 15.00 6.750


Preference 0.05 14.50 0.725
Debt 0.50 7.50 3.750
WACC = 11.225

20.00 – 22.22 Equity 0.45 15.00 6.750


Preference 0.05 15.00 0.750
Debt 0.50 7.50 3.750
WACC = 11.250

22.22 – 30.00 Equity 0.45 16.50 7.425


Preference 0.05 15.00 0.750
Debt 0.50 7.50 3.750
WACC = 11.925

Cost of capital_09 44
--Solution--
Range of total new Source Proportions Cost (%) Weighted Cost (%)
financing (Rs. In cr.)

30.00 – 66.67 Equity 0.45 16.50 7.425


Preference 0.05 15.00 0.750
Debt 0.50 8.00 4.000
WACC = 12.175

66.67 – 80.00 Equity 0.45 18.00 8.100


Preference 0.05 15.00 0.750
Debt 0.50 8.00 4.000
WACC = 12.850

80.00 & above Equity 0.45 18.00 8.100


Preference 0.05 15.00 0.750
Debt 0.50 8.40 4.200
WACC = 13.050

Cost of capital_09 45
--Solution
---

Thus, the weighted marginal cost of capital schedule will


be as follows:
Range of Total New Financing (Rs. In cr.) Weighted Cost (%)

0.00 -- 20.00 11.225

20.00 – 22.22 11.250

22.22 - 30.00 11.925

30.00 – 66.67 12.175

66.67 – 80.00 12.850

80.00 & above 13.050


Cost of capital_09 46
Divisional and Project Cost of Capital --

• Using WACC for evaluating investments


whose risks are different from those of the
overall firm leads to poor decisions. In such
cases, the expected return must be
compared with the risk-adjusted required
return, as calculated by the security market
line.

Cost of capital_09 47
--Divisional and Project Cost of Capital

• Multidivisional firms that have divisions


characterised by differing risks may calculate
separate divisional costs of capital. Two
approaches are commonly employed for this
purpose:
• The pure play approach
• The subjective approach

Cost of capital_09 48
Pure Play Approach
• Find one or more companies that specialize
in the product or service (that we are
considering)
• Compute the beta for each company and
take an average
• Use that beta along with the CAPM to find
the appropriate return for a project of that
risk
• Often difficult to find pure play companies

Cost of capital_09 49
Subjective Approach
• Consider the project’s risk relative to the firm
overall.
• If the project is riskier than the firm, use a
discount rate greater than the WACC.
• If the project is less risky than the firm, use a
discount rate less than the WACC.
• One may still accept projects that one
shouldn’t and reject projects one should
accept, but one’s error rate should be lower
than not considering differential risk at all.

Cost of capital_09 50
Divisional and Project Costs of Capital

• Using the WACC as our discount rate is only


appropriate for projects that are the same risk
as the firm’s current operations
• If we are looking at a project that is NOT of the
same risk as the firm, then we need to
determine the appropriate discount rate for
that project
• Divisions also often require separate
discount rates

Cost of capital_09 51
Floatation Costs--
• Floatation or issue costs consist of items
like underwriting costs, brokerage
expenses, fees of merchant bankers etc.

• One approach to deal with floatation costs


is to adjust the WACC to reflect the
floatation costs:

Cost of capital_09 52
--Floatation Costs
WACC
Revised WACC =
1 – Floatation costs

Note: A better approach is to leave the WACC


unchanged but to consider floatation costs
as part of the project cost.

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