Cost of Capital

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CHAPTER VIII

COST OF CAPITAL

Concept of Cost of Capital

            The term cost of capital refers to the minimum rate of return, a firm must earn on its investment so that the market value of the companies equity shares does not fall.

            The cost of capital may be defined, as “the rate of return the firm requires from investment in order to increase the value of the firm in the market place”

            There are three basic aspects of concept of cost;

1. It is not a cost as such: - A firm’s cost of capital is really the rate of return that it requires on the projects available. It is merely a hurdle rate of course; such rate may be calculated on the basis of actual cost of different components of capital.
2. It is the minimum rate of return: - A firm’s cost of capital represents the minimum rate of return that will result in at least maintaining the value of its equity shares.
3. It comprises of three components: - A firms cost of capital comprises of three components.

·         Return at zero risk level: - It refers to the expected rate of return when a project involves no risk whether business or financial.

·         Business risk: - The term business risk refers to the variability in operating profit (EBIT) due to change in sales. It is generally determined by the capital budgeting decisions. In case a firm selects a project having more than the normal or average risk, the suppliers of funds for the project will expect a higher rate of return than the normal rate and thus the cost of capital will go up.

·         Premium for financial risk: - The term financial risk refers to the risk on account of pattern of capital structure. The firms having higher debt content in its capital structure is more risky than the firms having low debt content. This is because firms in the former case require higher operating profit to cover periodic interest payment and repayment of principal at the time of maturity. The suppliers of funds would there fore expect a higher rate of return from such firms as compensation for higher risk.

                               The three components of cost of capital may be put in the form of following equation;

                               K = ro + b + f

           K = Cost of capital

           ro = Return at zero risk level

           b = Premium for business risk

           f = Premium for financial risk

IMPORTANCE OF COST OF CAPITAL

           The determination of the firm’s cost of capital is important from the point of view of both capital budgeting as well as capital structure planning decisions.

I.      Capital budgeting decisions: - In capital budgeting decisions, the cost of capital is often used as a discount rate on the basis of which the firm’s future cash flows are discounted to find out their present values. Thus, the cost of capital is the very basis for financial appraisal of new capital expenditure proposals. The decision of the finance manager will be irrational and wrong in case the cost of capital is not correctly determined. This is because the business must earn atleast at a rate, which equals to the cost of capital in order to make atleast a break even.

II.      Capital structure decisions: - The cost of capital is also an important consideration in capital structure decisions. The finance manager must raise capital from different sources in a way that it optimizes the risk and cost factors. The sources of funds, which have less cost, involve high risk. Rising of loans may, therefore, be cheaper on account of income tax benefits, but it involves heavy risk because a slight fall in the earning capacity of the company may bring the firm near to cash insolvency. It is, therefore, absolutely necessary that cost of each source of funds is carefully considered and compared with the risk involved with it.

Cost of capital may be classified as follows:

        i.          Explicit cost and Implicit cost: - The explicit cost of any source of finance may be defined as the discount rate that equates the present value of the funds received by the firm net of under writing costs, with the present value of expected cash out flows. These out flows may be interest payment, repayment of principal or dividend. This may be calculated by computing value according to the following equation.

                        

                         Io = C1 / (1+K) 1 + C2 / (1+K) 2 + - - - - - - - - - - + Cn / (1+K) n

Where:

           Io = Net amounts of funds received by the firm at time zero

           C = Out flow in the period concerned

           n = Duration for which the funds are provided

           K = Explicit cost of capital

                               Thus the explicit cost of capital may be taken as “the rate of return of the cash flows of financing opportunity”. “The implicit cost may be defined as the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted”. When a company retains the earnings, the implicit cost is the income, which the shareholders could have earned if such earnings would have been distributed and invested by them. As a matter of fact explicit costs arise when the funds are raised, while the implicit costs arise whenever they used.

2. Future cost and Historical cost: - Future cost refers to the expected cost of funds to finance the project, while historical cost is the cost which has already been incurred for financing a particular project. In financial decision making, the relevant costs are future costs and not the historical cost. However, historical costs are useful in projecting the future costs and providing an appraisal of the past performance when compared with standard for pre determined cost.

3. Specific cost and Combined cost: - The cost of each component of capital (i.e. equity shares, preference shares, debentures…etc) is known as specific cost of capital. In order to determine average cost of capital of the firm, it becomes necessary first to consider the cost of specific methods of financing. This concept of cost is useful in those cases where the profitability of a project is judged on the basis of the cost of the specific sources from where the project will be financed.

                   The composite or combined cost of capital is inclusive of all cost of capital from all sources, i.e; equity shares, preference shares, debentures and other loans. In capital investment decisions, the composite cost of capital will be used as basis for accepting or rejecting the proposal, even though, the company may finance one proposal from one source of financing while another proposal from another source of financing.

4. Average cost and Marginal cost: - The average cost of capital is the weighted average of the costs of each component of funds employed by the firm. The weights are in proportion of the share of each component of capital in the total capital structure. The computation of average cost involves the following source of capital.

• It requires assigning of appropriate weights to each components of capital.
• It requires a question whether the average cost of capital is at all affected by changes in the composition of the capital.

                               Marginal cost of capital is the weighted average cost of new funds raised by the firm. For capital budgeting and financing decisions, the marginal cost of capital is the most important factor to be considered.

DETERMINATION OF COST OF CAPITAL

Problems in Determination

               It has already been stated that the cost of capital is one of the most crucial factors in most financial management decisions. However the determination of cost of capital of a firm is not an easy task. The finance manager faces a number of problems, both conceptual and practical, while determining the cost of capital of a firm. Some of these problems are as follows….

1. Controversy regarding the dependence of cost of capital up on the method and level of financing: -

                     There is a major controversy whether or not the cost of capital of dependent upon the method and level of financing by the company. According to traditional theorists, a firm can change its overall cost of capital by changing its debt equity mix. On the other hand modern theorists such as Modigliani & Miller argue that the change in the debt equity ratio does not affect the total cost of capital.

2.      Computation of cost of equity: -

                     The determination of cost of equity capital is another problem. The cost of capital is the rate of return with the equity shareholders expect from the shares of the company and which will maintain the present market price of the equity shares of the company. This means that determination of the cost of equity capital will require quantifications of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares of a company on the basis of a large number of factors, financial as well as psychological.

3.      Computation of cost of retained earnings and depreciation fund: -

                     The cost of capital raised through these sources will depend upon the approach adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager has to face a difficult task in subscribing and selecting an appropriate approach.

4.      Future costs v/s Historical costs: -

                     It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider marginal cost of capital i.e. cost of additional funds or the average cost of capital, i.e. the cost of total funds.

5.      Problem of weights: -

                     The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the book value of each source of funds and the market value of each source of funds. The results would be different in each case.

                     Computation of cost of capital involves; i) Computation of cost of each specific source of finance termed as computation of specific costs and ii) Computation of composite cost termed as weighted average cost.

Computation of Specific costs

                     Cost of each specific source of finance, viz; debt, preference capital and equity capital can be determined as follows.

             I.      Cost of Debt:

a.          Debt issued at par: - It is the explicit interest rate adjusted further for the tax liability of the company. It may be computed according to the following formula:

                    

                     Kd = (1-T) R               Where: Kd = Cost of debt, T = Marginal tax rate,

                                                          R = Debenture interest.

   b.      Debt issued at premium or discount: - In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realized on issue of such debentures or bonds.

                    

      i) After Tax: -Kd = I / NP (1-T)

Where;        Kd = cost of debt,      T = Tax rate,     I = Annual interest payment

                     NP = net proceeds of loans or debentures

ii) Before Tax: - I / NP

b.      Cost of redeemable debt: - If the debentures are redeemable after the expiry of fixed period the effective cost of debt can be calculated by using the following formula:

i) Before tax cost when debt is redeemed at par

        

                  Kd = I + (P - NP) 1/n

                           ----------------------

                           ½ (P + NP)

Where;     I = Annual interest payment,     P = Par value of debentures,

                  NP = Net proceeds of debentures,         n = Number of years to maturity

·   After tax: - Kd = I + (P-NP) 1/n

                              ---------------------------        (1-t)

                              ½ (P + NP)

ii) When debt is redeemed at a premium

         Kd (before tax) = I + (RV – NP) 1/n

                                       -----------------------

                                       ½ (RV + NP)

         Kd (After tax) = I + (RV – NP) 1/n

                                     ------------------------     (1-t)

                                       ½ (RV + NP)

When RV= Redemption value

         II.Cost of preference share capital

a.Cost of irredeemable preference share capital: -

                  i. When shares issued at par

                                    Kp = D/P        Where D = Preference dividend

                                          P = Par value of shares

                  ii. When shares issued at discount or premium

                                    Kp = D/ NP

                                    Kp = D + 1/n (MV – NP)

                                              ------------------------

                                              ½ (MV + NP)  

                MV=MATURITY VALUE

     III.Cost of equity capital

                  In order to determine the cost of equity capital, it may be divided in to the following two categories;

1.The external equity or new issue of equity shares

                  The following are some of the approaches according to which the cost of equity capital can be worked out.

      a. Dividend yield method (Dividend price ratio method)

                                    Ke = D/ NP or D / MP

         Where; D = dividend per equity shares

                     NP = net proceeds of an equity share

                     MP = market price of an equity share

b. Dividend yield + growth method

                                    Ke = D / NP or MP + G

                  Where; G = growth in expected dividend.

                                    OR

                  Ke = Do (1 + G)

                           --------------    + G

                           NP or MP

c.           Earnings yield method

                 

                           Ke = EPS / NP or MP                    EPS = Total earnings

                                                                                                -------------------

                                                                                                No. Of shares

         d. Capital Asset Pricing Model (CAPM)

                           Ke = Risk free rate of return + Risk premium

                                    OR

                           Ke = Rf + β1 (Rm – Rf)

            Where; Rf = Risk free return

                         Rm = Return on market risk

2.Cost retained earnings

                                    Kr = D / NP or MP   (1-t) (1-b)

                  Where b = brokerage

Computation of weighted average cost of capital

         Kw = ЄXW/ ЄW

         Where;     X = Specified cost of capital

                           W = Weight allotted to each source of capital

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