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CHAPTER The Cost of Capital

CHAPTER The Cost of Capital. Sources of capital Component costs WACC. Cost of Capital. The items on the financing side of the balance sheet are called capital components. The major capital components are equity, preference and debt.

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CHAPTER The Cost of Capital

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  1. CHAPTER The Cost of Capital Sources of capital Component costs WACC

  2. Cost of Capital The items on the financing side of the balance sheet are called capital components. The major capital components are equity, preference and debt. Capital like any other factor of production has a cost. A company’s cost of capital is the average cost of the various capital components or securities employed by it. Put differently, it is the average rate of return required by the investors who provide capital to the company.

  3. Cost of Capital Cost of the capital is the central concept in financial management. It is used for evaluating investment projects, for determining the capital structure, for assessing leasing proposal etc.

  4. What sources of long-term capital do firms use?

  5. Concepts of weighted average cost of capital • A company’s cost of capital is the weighted average cost of various sources of finance used by it. For example, Equity, Preference and Debt. • Suppose that a company uses equity, preference and Debt in the proportion of 50, 10 and 40. If the component costs of equity,preference and debt are 16%, 12% & 8% respectively, Calculate WACC.

  6. Concepts of weighted average cost of capital WACC = (proportion of equity)(cost of equity)+(proportion of preference)(cost of preference)+(proportion of debt)(cost of debt) WACC = (.5)(16)+ (.10)(12)+ (.4)(8) WACC = 12.4% For the shake of the simplicity, we have ignored other forms of capital like convertible or callable preference, convertible or callable debt, bonds with payment linked to stock market index, bonds that are puttable or extendable, warrant so on and so forth.

  7. Cost of Debts conceptually the cost of debt instrument is the yield to maturity of that instrument. Let us apply this concept to different types of debt instruments such as Debentures, Bank Loan and commercial paper. I+(F - Po)/n Formula for rd= 0.6 Po+0.4 F

  8. Cost of Debts where, I = annual interest payment Po = current market price of the debenture F = Face value n = remaining period of maturity. Example, Face Value = 1000 Coupon rate = 12% Remaining period to maturity = 4 years Current market price = 1040

  9. Cost of Debts 120+(1000 - 1040)/4 The Yield to maturity or rd= 0.6 x 1040+0.4 x 1000 • The cost of a bank loan is simply the current interest the bank would charge if the firm were to raise a loan. For example, Multiplex limited has a Tk. 300 million outstanding bank loan on which it is paying an interest of 13%. however, if Multiplex limited were to raise a loan now, the bank would charge 12%. This then represent the cost of the bank loan.

  10. Cost of Debts Commercial paper is a short term debt instrument. Which is issued at a discount and redeemed at par. Hence the cost of commercial paper is simply its implicit interest rate. For example: Multiplex limited has outstanding commercial paper that has a balance maturity of 6 months. The face value of one instrument is Tk. 1,000,000 and it is traded in the market at Tk. 965,000. The implicit interest rate for 6 months is, 1,000,000 - 1 = 0.0363 or 3.63%. 965,000 Annualized interest rate = (1.0363)2- 1= 0.0739 = 7.39%

  11. Cost of Debts When a firm uses different instrument of debt, the average cost of debt has to be calculated. In our example of Multiplex Limited, the following data on the debt employed are reviled.

  12. Cost of Debts The average cost of debt is calculated using the market value proportions and yields/current rate of various debt instruments. The Average Cost of Debts of Multiplex Limited = 10.7% [104/352.25] + 12.0% [200/352.25] + 7.39 [48.25/352.25] = 10.98% • Tax Adjustment Post-Tax Cost of Debt = Pre-tax Cost of Debt (1 – Tax rate)

  13. Cost of Preference Preference capital carries a fixed rate of dividend and is redeemable in nature. Given the fixed nature of preference dividend and principal repayment commitment and the absence of tax deductibility, the cost of preference is simply equal to its yield. Problem: Consider the preference stock of Multiplex Limited for which the following data are given, Face value : Tk. 100 Dividend rate : 11 % Maturity Period : 5 years Market Price : Tk. 95 11 + (100 - 95)/5 The Yield to maturity = 0.6 x 95+0.4 x100 = 12.37%

  14. Cost of Equity Equity Finance may be obtained in two ways (1) Retention of earnings (2) Issue of additional equity The cost of equity or the return required by the equity shareholder is the same in both the cases. Cost of Equity : The SML Approach According to SML Approach, the required return on a company’s equity is, rE= Rf+ β (RM - Rf ) Where, Rf = Risk free rate β = beta of the equity of the company RM = Expected return on the market portfolio. To use the SML Approach, the following inputs are required Rf = the risk free rate β = the beta of the equity stock, (RM - Rf )= the market risk premium.

  15. Cost of Equity The Dividend Growth Model Approach Financial analyst who do not have faith in the SML approach often prefer Dividend Growth Model to estimate the cost of equity. D1 D2 P0 = + + ……………………. (1+rE)1 (1+rE)2 Where, P0 = current price of the stock Dt=dividend expected to be paid at the end of year t rE = Equity shareholders required rate of return If dividend are expected to grow at a constant rate of “g” percent per year, then Equation becomes,

  16. Cost of Equity D1 D1(1+g) D1(1+g)2 P0 = + + + ……………. (1+rE)1 (1+rE)2 (1+rE)3 This simplifies to, D1 P0 = rE – g Solving the above equations for rE we get, D1 rE= + g P0 D0(1+g) = + g P0

  17. Calculating the weighted average cost of capital WACC = wErE+ wprp + wdrd(1-T) Where, wE = Proportion of Equity rE = Cost of Equity Wp = Proportion of Preference rp = Cost of Preference Wd = Proportion of Debt rd = Cost of Debt

  18. Calculating the weighted average cost of capital The cost of specific sources of capital for “X” company limited are: rE = 16% wE = 0.60 rp = 14% Wp = 0.05 rd = 12% Wd = 0.35 The Tax Rate for “X” company limited is 30% Required: Calculate the WACC

  19. Calculating the weighted average cost of capital

  20. Calculating the weighted Marginal cost of capital The relationship between additional financing and WACC can be estimated by the WMCC. The procedure for determining WMCC involves • Estimate the cost of each source of financing for various level of its use. • Identify the level of total new financing at which the cost of new components would change. These level is called breaking points, can be established using the following relationship TFj BPj = Wj

  21. Calculating the weighted Marginal cost of capital BPj = breaking point on account of financing source j TFj = Total new financing from source j at the breaking point Wj = proportion of financing source j in the capital structure • Calculate the WACC • Prepare the WMCC schedule

  22. Calculating the weighted Marginal cost of capital Assume “Y” Company Limited plans to use equity and Debt in the following proportion Equity : 40 Debt : 60 “Y” Company Limited estimates the cost of its sources of finance for various levels of usage as follows, Source of Finance Range of New Financing Cost (Taka in Million) Equity 0 - 30 18% More than 30 20% Debt 0 – 50 10% More than 50 11%

  23. Calculating the weighted Marginal cost of capital: Determination of Breaking Point

  24. Calculating the WACC for various ranges of Total financing for “Y” Company Limited.

  25. Calculating the WACC for various ranges of Total financing for “Y” Company Limited.

  26. Calculating the WMCC

  27. Calculating the weighted Marginal cost of capital Assume “Z” Company Limited plans to use equity,preference and Debt in the following proportion Equity : 0.45, Preference: 0.05, Debt : 0.50 “Z” Company Limited estimates the cost of its sources of finance for various levels of usage as follows, Source of Finance Range of New Financing Cost (Taka in Million) Equity 0 - 10 15% 10 – 30 16.50% More than 30 18.00% Preference 0 – 1 14.50% More than 1 15.00% Debt 0 – 15 7.50% 15 – 40 8.00% More than 40 8.40%

  28. Problem Assume “Z” Company Limited plans to use equity, preference and Debt in the following proportion Equity : 0.45, Preference: 0.05, Debt : 0.50 “Z” Company Limited estimates the cost of its sources of finance for various levels of usage as follows,

  29. Problem Source of Finance Range of Cost New Financing Equity 0 - 10 15% 10 – 30 16.50% More than 30 18.00% Preference 0 – 1 14.50% More than 1 15.00% Debt 0 – 15 7.50% 15 – 40 8.00% More than 40 8.40%

  30. Step 1: Determining the Breaking points and the Resulting ranges of Total new financing

  31. Step 2: WACC for various range of total new financing Range of Total Source of Proportion Cost Weighted Cost(%) New Financing Capital (Tk. In Million) [1] [2] [3] [(2) x (3)] 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 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

  32. Step 2: WACC for various range of total new financing Range of Total Source of Proportion Cost Weighted Cost(%) New Financing Capital (Tk. In Million) [1] [2] [3] [(2) x (3)] 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 Above 80.00 Equity 0.45 18.00 8.100 Preference 0.05 15.00 0.750 Debt 0.50 8.40 4.200 WACC 13.050

  33. Step 3:Weighted Marginal Cost of Capital Schedule Range of Total Financing Weighted Marginal Cost of Capital (Tk. In Million) (%) 0 – 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 Above 80.00 13.050

  34. Finding a divisional cost of capital:Using similar stand-alone firms to estimate a project’s cost of capital • Comparison firms have the following characteristics: • Target capital structure consists of 40% debt and 60% equity. • kd = 12% • kRF = 7% • RPM = 6% • βDIV = 1.7 • Tax rate = 40%

  35. Calculating a divisional cost of capital • Division’s required return on equity • ks = kRF + (kM – kRF)β = 7% + (6%)1.7 = 17.2% • Division’s weighted average cost of capital • WACC = wd kd ( 1 – T ) + wc ks = 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2% • Typical projects in this division are acceptable if their returns exceed 13.2%.

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