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COST OF CAPITAL AND CAPITAL STRUCTURE THEORIES CHAPTER OVERVIEW (1) (3) Cost of Capital Indifference & Financial

BEP Capita l Structure 1. Cost of Capital 1. EBIT EPS Indifference Point 1. Meaning, Considerations & Factors 2. Cost of Debt Capital - Kd 2. Financial Break-Even Point 2. Theories & common Assumptions 3. Cost of preference Capital - Kp 3. Net Income Appro ach 4. Cost of Equity Capital - Ke 4. Net Operating In come Approach 5. Cost of Reserves - Kr 5. Traditional Approach 6. Overall Cost of Capital - Ko 6. Modigliani & Mil ler Approach 7. Marginal Cost of Capital 7. Pecking Order Th eory 1. COST OF CAPITAL 1. What do you understand by the term Cost of Capital? (2)

1. Cost of Capital: For financing its operations, a Firm can raise long-ter m funds through a combination of - (a) Debt, Preference Capital, and (c) Equity Capital. The Company has to service the above funds by paying Interest, Preferen ce Dividend and Equity Dividend respectively. The payment made by the Company co nstitutes the cost of obtaining / utilizing that source of finance. 2. Aspect: Cost of Capital has the following two aspects - (a) Explicit, an d (b) Implicit, described as under Explicit Cost of Capital Implicit Cost of Capital Meaning It is the Discount Rate that equals the Present It is the rate of return associated with the best Value of Cash Inflows, t hat are incremental to Investment opportunity for the Firm and its shareholders , the taking of financing opportunity, with the that will be foregone, i f the project presently under Present Value of its incremental Cash Outflows. Consideration by the Fir m were accepted. Arises It arises when the funds are raised. It arises when the funds are use d. Measure It can be measured on a comparatively realistic It is based on the oppor tunity cost concept, and arises and quantifiable basis. only when there are alternatives. Decision Useful for making Capital Budgeting Decisions. Generally not co nsidered in making Capital Budgeting Making decisions. 2. How will you compute the cost of Debt Capital ? Debt has two types of costs (1) Explicit or Direct Costs, and (2 Implici t or Indirect Costs. 1. Explicit or Direct Costs refer to the interest rate adjusted for tax sav ings and the cost of raising funds. 2. Implicit or Indirect Costs refer to the risk associated with debt, refle cted in the increase in expectations of Equity Shareholders and the rise in cost of Equity Capital.

Explicit Cost of Debt Capital denoted as Kd Cost of Irredeemable Debt Cost of Redeemable Debt Kd = Kd = Avg. Premium on Redemption = Avg Liability = 3. How will you compute the value of a Bond? 1. Present Value of a Bond or Debenture = Total Discounted Value of all its Cash Flows. So, PV of a Bond = [Note : Refer Chapter 19 Time Value of Money for a discussion on Present Value.] 2. Cash Flows (denoted as CF above) consist of (a) annual Interest Payments , & (b) repayment of Principal. If there is no risk of default, then there will not be much difficulty in calculating the Cash Flows associated with a bond, sin ce interest rate and schedule of repayment is known in advance. 3. Discount Rate (denoted as R above) (also called Capitalisation Rate or E xpectation Rate), Depends on the extent of risk associated with the Bond, e.g. G overnment Bonds have a lower risk and lower discount rate, when compared to Debe ntures of a Company. (Note : Coupon Rate is the 4. Repayment / Amortisation of Bond : Where the Principal Amount of the Bon d / Debenture is repaid at maturity, the annual Cash Flows consist of Interest P ayment only. However, if the Bond is amortised every year, i.e. principal is rep aid every year, the principal will go down with annual payments and interest wil l be computed on the outstanding amount. in such case, the Cash Flows of the Bon ds will be uneven. 4. A Company sell a 4-year Bond of `10,000 at 12.5% interest per annum. The Bond will be amortised equally over its life. What will be the Present Value of the Bond for an investor who expects a minimum rate of return of 12%? Particulars Year 1 Year 2 Year 3 Year 4 1. Principal Outstanding 10,000 7,500 5,000 2,500 2. Principal repaid 2,500 2,500 2,500 2,500 3. Interest at 12.5% p.a. on (1) = Coupon Payment 1,250 938 625 313 4. Total Cash Flows p.a. (2+3) 3,750 3,438 3,125 2,813 5. (1 + 0.12)n where n = nth year 1.1200 1.2544 1.4049 1.5735 6. PV of Cash Flows (45) 3,348 2,741 2,224 1,788 7. Hence, Present Value of Bond = Total of (6) = `10,101 5. as Kp) Cost of Irredeemable PSC Cost of Redeemable PSC Kp = Kp = Avg. Premium on Redemption = Avg Liability = Note : 1. Preference Dividend is not taxdeductible, and hence tax rate is not relev ant in computation of Kp. 2. Value of a Preference Share may also be computed in the same way as that of a Bond, i.e. Present Value of Cash Flows associated with that Preference Sha re. 6. How will you compute the cost of Equity Share Capital? How do you determine cost of equity capital in growth Companies? Cost of Equity Capital (denoted by Ke) represents the expectations of Equity Sha reholders from a Company. Based on Investors behaviour and expectations, the Cost of Equity Capital can be determined by any of the following approaches Approach Assumptions Formula Ke = Other Points 1. Dividend Investor is interested in Cash Suitable for ble Price Dividends, i.e. Distributed Profits How will you compute the cost of Preference Share Capital? Cost of Preference Share Capital (PSC) can be computed as under (denoted

Income and Stable Approach (N 06) s. d &

only. Dividend Policy Dividends are paid at a constant

Companie

rate till winding-up of the DPS1 = Next Year Dividen Tax effect is not Company MPS0 = Current MPS considered 2. Earnings Investor is interested in EPS and Suitable for Companies Price Market price of shares, whether or with sta ble income and Approach not such EPS is fully paid out as if income accrues in a (N 06) dividend. business cycle. Note: This Ke is the inverse of PE EPS1 = Next Year EPS and Ignores the effect of Ratio. So, Ke = MPS0 = Current MPS Capital Appreciation. 3. Dividend Investor is interested in present Suitable for growth Price + dividends, and also future Companies with f ocus on Growth prospects of growth in EPS and dividend and int ernal Approach EPS, DPS and MPS all grow at g = expected future grow th rate financing. the same rate. in Dividends. 4. Earnings Investor is interested in future Suitable for Companies Price + prospects of growth in EPS and enjoying a stead y growth Growth dividends. rate of steady rate of Approach EPS and MPS grow at the same g = expected future grow th rate earnings. rate. in EPS. 5. Realised Investor is interested in (a) Current Suitable for Companies with Yield Dividend, & (b) Capital Appreciation proven track rec ord and Approach (increase in Share Price) over a Numerator = Next Year Dividend enjoying a steady rate of specified time-frame. + Increase in MPS in one year. growth r ate, rate of Denominator = Next Year MPS. dividend & Incre ase in MPS 6. Capital Investors should be remunerated in Recoginses the e ntire Asset two ways (a) for time value of where Rf = Risk free Return, market expectations, and Pricing money by means of Risk-Free Rate, Rm=Overall Marke d Return, = does not depend upon the Model and (b) for bearing risk, by way of a Beta Co-efficient, i.e. a measure EPS of DPS of the (CAPM) Risk Premium. of non-diversifiable risk. Company. Approach