Cost of Capital and Capital

Structure Planning
Neetu Singhania
CA,MBA,Mcom

Cost of Capital

Meaning
The cost of capital is the minimum required rate
of earnings or the cut-off rate of capital
expenditure.
It refers to the cost that is incurred in retaining
the funds obtained from various sources and
employed in business.

Components of Cost of Capital

1)Cost of Debt
2)Cost of Equity Share Capital
3)Cost of retained Earnings
4)Cost of Preference Share Capital

Cost of Debt Capital

Cost of debt is the interest rate mentioned in the
instrument subject to the adjustment for taxes .
Cost of debt can be expressed as :
Kd=I(1-T)
Where:
I= the interest rate
T=the tax rate

Cost of Equity Share Capital

Since there is no fixed rate of returns in case of
equity shares, its measurement is very difficult.
The cost of equity can be measured according to
different approaches like
1)Dividend approach,
2)Capital asset pricing model approach,
3)Earning price approach .

Dividend Approach
Dividends can grow at a uniform rate perpetually,
this is called a perpetuity of dividends .
Ke=D1 +g
P0
D1=Dividend per share
P0=Current market price or net proceeds
per share
g=growth in constant dividends

Capital Asset Pricing Model

It measures the risk of the capital i.e systematic risk and
unsystematic risks.
Systematic risk is due to a broad spectrum of
uncontrollable risks. It is measured by which measures
change in market value of equity shares relative to
change in market index.
Unsystematic risk is a unique risk related to the
company like management,staff,losses ,strikes etc.
The market price of a share is influenced by systematic
and unsystematic risks.

Capital Asset Pricing Model

The CAPM model calculates cost of equity
through the following equation:
Ke=Kf+(Km-Kf)
Where Ke=Cost of equity capital
Kf=Cost of risk free asset
=Coefficient of systematic risk
Km=Cost of market portfolio

Earning Price Approach

It takes into consideration dividends and
retained earnings. The cost of capital is
measured through the equation :
Ke=E/NP
E=earnings per share & np is net proceeds .

Cost of Preference Share Capital

It may defined as the dividend expected by the
preference shareholders .
Preference shares may either be redeemable or
irredeemable and the cost of capital has to be
determined accordingly
The formula is :
Kp=
d/Po(1-f)
Where Kp = Cost of preference share capital
D=Annual dividend payment
Po=Expected sale price of preference shares
F=Floatation costs as % of sale price

Cost of retained Earnings

They do not have explicit cost rather have implicit costs .
The cost of retained earnings is in this sense considered
to be having the same cost as that of equity shares but
generally since there is no expense of brokerage
,dividend or tax on retained earnings it is considered to
have a less cost as compared to cost of equity share
capital.
Formula is:
Kr=Ke(1-t)(1-b)
Kr=Cost of retained earnings
T=tax
B=Brokerage cost

Weighted Average cost of Capital

After calculating the specific costs the next step
is to calculate the overall cost of capital i.e
weighted average cost of capital
WACC=wKe+wKd+wKp
Where wKe=weighted cost of capital
wKd=weighed cost of debt
wKp=weighted cost of preference shares.

Basis of Assigning Weights

Weights are of four types:
1)Historical Weights: To base the weights on the
existing proportions of various forms of capital in
the firms Balance sheet.
2)Book Value Weights: To base the weights on the
face value of difference sources of capital .
3)Market Value Weights: Weights are assigned on the
basis of market price of the security.
4)Marginal Weights :Weights are assigned on the
basis on which the current capital budget is to be
financed.

Marginal Cost of Capital

When new projects are taken up then marginal
cost of capital must be calculated.
It is thus used :
1)When there is requirement of additional funds
2)When there is no external financing and only
retained earnings are used for financing new
projects .
3)When external financing is done with the
existing sources of cost of capital in the same
proportion as the existing one.

Capital Structure Planning

Meaning
A mix of debt, preferred stock, and common stock with
which the firm plans to finance its investments.
Objective is to have such a mix of debt, preferred stock,
and common equity which will maximize shareholder
wealth or maximize market price per share.
WACC depends on the mix of different securities in the
capital structure. A change in the mix of different
securities in the capital structure will cause a change in
the WACC. Thus, there will be a mix of different
securities in the capital structure at which WACC will be
the least.
An optimal capital structure means a mix of different
securities which will maximize the stock price share or
minimize WACC.

Components of Capital structure

Owned Funds being share capital,free reserves
and surplus.
Borrowed Funds being debentures,bonds,long
term loans and term lending institutions.

Essentials of an Optimum capital

structure

Flexibility
Economy
Solvency
Efficiency
Simplicity
Safety
Control

Indifference Point
The indifference between the two alternative methods is calculated
using the formulae:
EPS Plan 1
= EPS Plan 2
(EBIT-I1)(1- t)-Pd1
= (EBIT-I2)(1-t)-PD2
E1
E2
Where ,
EBIT=Earning before interest & tax
I1=Interest charges in plan 1
I2=Interest charges in plan 2
t=Rate of tax
Pd1=Preference dividend in Plan 1
Pd2=Preference Dividend in Plan 2
E1=Number of equity shares in Plan 1
E2=Number of equity shares in Plan 2

Financial Break Even

At financial break even level of EBIT the firms
EPS is just equal to zero.
If EBIT is more than the financial break even
point then EPS is positive.
If EBIT is less than the financial break even
point then EPS is negative.

Earning per share

Y

Debt
Equity

Indifference
point

EBIT (Rs)

The capital Structure may be any

of the following patterns:
1)Capital Structure with equity shares only.
2)Capital structure with both equity shares and
preference shares .
3)Capital structure with equity shares and
debentures .
4)Capital structure with equity shares ,
debentures & preference shares .

Theories of Capital Structure

Net Income Approach
Net Operating Income Approach
The traditional Approach
Modigliani Miller Approach

Net Income Approach

Net Income approach proposes that there is a

definite relationship between capital structure
and value of the firm.
The capital structure of a firm influences its cost
of capital (WACC), and thus directly affects the
value of the firm.
NI approach assumptions

o NI

approach assumes that a continuous

increase in debt does not affect the risk
perception of investors.
o Cost of debt (Kd) is less than cost of equity
(Ke) [i.e. Kd < Ke ]
o Corporate

income taxes do not exist.

Net Operating Income Approach

Net Operating Income (NOI) approach is the

exact opposite of the Net Income (NI) approach.
As per NOI approach, value of a firm is not
dependent upon its capital structure.
Assumptions
WACC is always constant, and it depends on
the business risk.
o Value of the firm is calculated using the
overall cost of capital i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.
o

Traditional Approach

The NI approach and NOI approach hold extreme

views on the relationship between capital
structure, cost of capital and the value of a firm.
Traditional approach (intermediate approach) is
a compromise between these two extreme
approaches.
Traditional approach confirms the existence of an
optimal capital structure; where WACC is
minimum and value is the firm is maximum.
As per this approach, a best possible mix of debt
and equity will maximize the value of the firm.

Traditional Approach

The approach works in 3 stages

1) Value of the firm increases with an increase in
borrowings (since Kd < Ke). As a result, the
WACC reduces gradually. This phenomenon is
up to a certain point.
2) At the end of this phenomenon, reduction in
WACC ceases and it tends to stabilize. Further
increase in borrowings will not affect WACC
and the value of firm will also stagnate.
3) Increase in debt beyond this point increases
shareholders risk (financial risk) and hence Ke
increases. Kd also rises due to higher debt,

Modigliani-Miller Approach
It states that there is no correlation between cost
of capital and debt equity ratio.
The average cost of any firm is independent of its
capital structure and equal to capitalization rate
of pure equity stream of its class.

Assumptions:
Perfect Capital Markets
Given the assumption of perfect information and
rationality ,all investors have the same expectation
of firms net operating income (EBIT) with which to
evaluate the value of a firm.
There does not exist any transaction costs .
The dividend payout ratio is 100%
There are no taxes.
Business risk is equal among all firms within similar
operating environment.

MM Model proposition
o Value

of a firm is independent of the capital

structure.

o Value

of firm is equal to the capitalized value

of operating income (i.e. EBIT) by the
appropriate rate (i.e. WACC).

o Value

of Firm = Mkt. Value of Equity + Mkt.

Value of Debt

= Expected EBIT
Expected WACC

MM
Model
proposition
o As per
MM, identical
firms (except capital
structure) will have the same level of earnings.
o As

per MM approach, if market values of

identical firms are different, arbitrage
process will take place.

o In

this process, investors will switch their

securities between identical firms (from
levered firms to un-levered firms) and receive
the same returns from both firms.