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## COST OF CAPITAL

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**COST OF CAPITAL**www.pptmart.com**Concept of Cost of Capital**The cost of capital is the minimum required rate of return, a project must earn in order to cover the cost of raising funds being used by the firm in financing of the proposal. www.pptmart.com**Concept of Cost of Capital**Importance and Significance:(i) if a firm’s actual rate of return exceeds its cost of capital and id this return is earned without of course, increasing the risk characteristics of the firm, then the wealth maximization goal will be achieved. www.pptmart.com**Concept of Cost of Capital**(ii) Moreover, the cost of capital when used as a discount rate in capital budgeting, helps accepting only those proposals whose rate of return is more than the cost of capital of the firm and hence results in increasing the value of the firm. Similarly, the firm’s value is reduced when the rate of return on the proposal falls below the cost of capital. www.pptmart.com**Factors Affecting the Cost of Capital of a Firm**The cost of capital is the minimum expected rate of return of the investors or suppliers of funds to the firm. The expected rate of return depends upon the (1) risk characteristics of the firm, (2) risk perception of the investors and (3) a host of other factors. Following are some of the factors which are relevant for the determination of cost of capital of the firm. www.pptmart.com**Factors Affecting the Cost of Capital of a Firm**1. Risk free Interest Rate: The risk free interest rate, I, is the interest rate on the risk free and default-free securities. (a) Real interest rate: The real interest rate is the interest rate payable to the lender for supplying the funds or in other words, for surrendering the funds for a particular period. www.pptmart.com**Factors Affecting the Cost of Capital of a Firm(Cont..)**(b) Purchasing power risk premium: When a lender lends money, he like to be compensated for the loss in purchasing power over the period of lending or supply of funds. So, over and above the real interest rate, the purchasing power risk premium is added to find out the risk free interest rate. 2. Business Risk: The risk associated with the firm’s promise to pay interest and dividends to its investors. www.pptmart.com**Factors Affecting the Cost of Capital of a Firm(Cont..)**The business risk is related to the response of the firm’s Earnings Before Interest and Taxes, EBIT, to change in sales revenue. 3. Financial Risk: The financial risk is often defined as the likelihood that the firm would not be able to meet its fixed financial charges. It is related to the response of the firm’s earning per share to a variation in EBIT. Higher the proportion of fixed cost securities in the overall capital structure, greater would be the financial risk. www.pptmart.com**Factors Affecting the Cost of Capital of a Firm(Cont..)**The investor in such a case require to be compensated for this increased risk. 4. Other Consideration: Other factors like may be the liquidity or marketability of the investment. Higher the liquidity available with an investment, lower would be the premium demanded by the investor, If the investment is not easily marketable, then the investors may add a premium for this also and consequently demand a higher rate of return. www.pptmart.com**Factors Affecting the Cost of Capital of a Firm**In view of the above, the cost of capital may be defined as k = If + b + f where, k = Cost of capital of different sources. If = Risk free interest rate. b = Business risk premium, and f = Financial risk premium. www.pptmart.com**TYPES OF COST OF CAPITAL**Explicit and Implicit Cost of Capital: The cost of capital of a firm can be analyzed as explicit cost and implicit cost of capital. The explicit cost of capital of a particular source may be defined in terms of the interest or dividend that the firm has to pay to the suppliers of funds. The implicit cost of retained earning is the return which could have been earned by the investor, had the profit been distributed to them. www.pptmart.com**Measurement of Cost of Capital:**The firm should carefully estimate the relevant cash flows associated with a proposal, it should also carefully estimate the cost of capital. If there is a mistake in the determination of the cost of capital then the investment decision as well as other decisions may be taken wrongly and thus ultimately affecting the profitability and survival of the firm. www.pptmart.com**Underlying AssumptionsThe measurement of cost of capital is**based on the following assumptions: a) The basic assumption of the cost of capital concept is that the business risk of the firm is unaffected by the proposal being evaluated at the cost of capital. www.pptmart.com**Underlying Assumptions**The new proposal accepted by the firm is assumed to possess the same level of risk as of those already held. So, the business risk of the firm remains unchanged and the degree of responsiveness of the EBIT to sales revenue is constant. www.pptmart.com**Underlying Assumptions (Cont..)**b) Another assumption required to be made is that the financial risk of the firm remains unchanged, whether a proposal is accepted or not. Taxes and Costs of Capital: These cash flows are then discounted at the cost of capital to find out their present value. It should be noted that this cost of capital which is used to discount the cash flows (after-tax) should also be after-tax only. www.pptmart.com**Specific and Overall Cost of Capital:**The short terms sources of funds are kept out side the calculation of cost of capital as these short term sources e.g. bank credit, trade credit, bill etc., are generally considered to be temporary in nature and are subject to repayment in the short run. www.pptmart.com**Specific and Overall Cost of Capital:**Therefore, the cost of capital of a firm is calculated as the combined cost of long term sources of funds. The capital expenditures are backed by the long term capital structure of a company, which may include different degree of leverage. www.pptmart.com**Cost of Bonds and Debentures**1.The current level of interest rates. 2. The default risk of the firm. 3.The tax advantages associated with the debt. In order to find out the cost of capital of debts, the following information is required: a) Net proceeds from the issue: This refers to the net cash inflow at the time of issue of debt. This can be calculated as www.pptmart.com**Bo = FV + Pm – D – f**Where, Bo= Net Proceeds FV = Face Value of Debt Pm = Premium Charges on the issue of debt. D = Discount allowed at the time of issue of debt, and F = Flotation cost i.e., the cost of raising funds (including underwriting, brokerage and issue expenses). www.pptmart.com**Periodic Payments of Interest:**Sometimes, the bonds and debentures as well as loans from financial institutions require regular repayments of the principal amount also. This periodic amortization of the principal amount is also considered as a cash outflow together with interest payment for a particular year. www.pptmart.com**Periodic Payments of Interest:**1. The Equation calculates the cost of capital of debt before tax. The tax adjustment will be taken up later. 2. The repayments (periodic amortization or maturity repayment) have not been considered as the debt is taken as perpetual. It may be noted that the concept of perpetual debt is theoretical in nature, otherwise debt, being a type of a loan is always repayable. www.pptmart.com**Tax Adjustment:**The real cost of debt is determined only after considering this tax shield as follows: kd = ki (1-t) where, kd= Cost of capital of debt (after tax) ki= Cost of capital of debt (before tax) t= Tax rate. www.pptmart.com**Tax Adjustment:**It may be noted that the tax benefit of interest deductibility is available only if the firm is a profit making one. For a loss making firm or for a no-tax paying firm, this tax adjustment is not required and in such a case the kd = ki . www.pptmart.com**Cost of Capital of Redeemable Debt:**n B0 = I (1-t) +COPi+COPn i =1 (1+kd)i (1+kd)i (1+kd)n Where, I = Annual Interest Payment Bo = Net Proceeds COPi= Regular Cash Outflow on account of amortization COPn= Cash Outflow on account of repayment at maturity kd = After tax cost of capital of debt. www.pptmart.com**In case, the debt is repayable only at the time of**maturity and there is no annual amortization then the Equation will not contain the second element i.e.,, COPi/(1 + kd)i. In order to avoid the cumbersome procedure of trial and error to find out the value of kd , the following equation may be used to give an approximation of after tax cost of capital of debt. www.pptmart.com**kd = I(1-t) + (RV - Bo) / N**(RV + Bo) / 2 where, RV = Redemption Value of debenture kd = After Tax Cost of Debt t = Tax rate N = Life of debenture www.pptmart.com**Note:**Under the provisions of the Income Tax Act, 1961, the discount on issue of debentures or premium payable on redemption of debentures is deducted out of the taxable income of the company on proportionate basis over the life of the debentures. Hence, this tax deductibility provides a tax shield to the company. www.pptmart.com**Note(Cont..)**In the strict sense, this tax shield should be treated as a cash inflow for different years and be incorporated in the process of calculation of cost of capital of debentures. However, the present value of the annual tax shield of discount on issue and premium on redemption has been ignored for the sake of simplicity. As the investors demand a higher return for the debt security, they will be willing to pay a lesser price for the security for any given set of interest and repayment terms. www.pptmart.com**Cost of Capital of Convertible Debentures:**In case, the company issues convertible debenture (CD) then the face value of these CD are fully or partially converted into equity shares as per the terms of issue of CD. In case of partial CD, the company will be required to pay interest on the residual amount and this residual amount is redeemed at the end of the given period. www.pptmart.com**Cost of Capital of Convertible Debentures:**The cost of capital of CD may be defined as the discount rate which equates the present value of cash outflows with the inflows. The value of kd in the following equation is the cost of CD: n B0 = I (1-t) +mPcb + RV i =1 (1+kd)i (1+kd)c (1+kd)n www.pptmart.com**where, I = Interest Amount per annum**t = Tax Rate m = Number of shares issued at the time of conversion Pc= Price per share at conversion time b = Promotion of market price, that could be realized net, if the fresh share were issued. c = Conversion time RV = Redemption Value. www.pptmart.com**Cost of Preference Share Capital:**The company has no legal obligation to pay preference dividend, but the investors, when they invest the funds in preference shares, must have an expectation of getting returns from the company. If the investor’s expectations are belied by the company then it may face two consequences www.pptmart.com**Cost of Preference Share Capital:**i.e., (i) in case of non payment of preference dividend, the preference shareholders will get voting right as per section 87 of the Companies Act, 1956, and (ii) the position of the company in the capital market will be affected and it may not be in a position to raise additional funds from the market at a later stage. www.pptmart.com**Cost of Capital of Redeemable Preference Share:**If the preference shares are redeemable at the end of a specific period, then the cost of capital of preference shares can be calculated by Equation n P0 = PDi+ Pn i =1 (1+kp)i (1+kp)n www.pptmart.com**Cost of Capital of Redeemable Preference Share:**where, Po = Net Proceeds on issue of preference shares PD = Annual preference dividend at fixed rate of dividend Pn = Amount payable at the time of redemption kp= Cost of preference share capital, and n = Redemption period of preference shares. www.pptmart.com**Cost of Capital of Irredeemable Preference Share:**kp = PD Po where, PD = Annual preference dividend Po = Net Proceeds on issue of preference shares kp = Cost of capital of preference shares. It may be noted that no company in India can issue irredeemable preference shares after 1988 (Section 80 of the Companies Act, 1956). www.pptmart.com**Approximation to kp :**An approximation to kp can be quickly obtained by using the following formulations: kp = PD + (Pn - Po) / N (Pn + Po) / 2 Note: The calculation of kp as presented in Equation is a standard model in financial management. This, however, may be adjusted in the light of the relevant tax provisions. www.pptmart.com**Approximation to kp (Cont..):**Note:In India, the company paying preference dividend, has to pay a Corporate Dividend of Tax. Say, a company declares preference dividend of Rs.2 per share and the rate of Corporate Dividend Tax is 20%, then the company has to pay 40 paise tax to the government, and therefore the total cash outflow of the company would be Rs.2.40. So; the term PD may be replaced by PD (1+t) where ‘t’ is the Corporate Dividend Tax Rate. www.pptmart.com**Cost of Equity Share Capital:**Equity share capital just like other sources, also has a cost. The potential investors of equity share capital must estimate the expected stream of dividend from the firm. This stream of dividends may then be discounted to get the present value of such stream. The rate of discount at which the expected dividends are discounted to determine their present value is known as the cost of equity share capital. www.pptmart.com**Cost of Equity Share Capital:**Po = D1+D2+ ----- Dn+ Pn (1+ke)1 (1+ke)2(1+ke)n(1+ke)n where, Po = Current Market Price of Equity Share Pn = Share market price after year n Di = Dividends receivable over different years ke= Required rate of return of the shareholder or cost of equity share capital. www.pptmart.com**Cost of Equity Share Capital:**The Equation does not seem to be practical one as it required to ascertain the market price at the end of year n, when the share is eventually sold. However, the share price at year n is itself the present value of all the future expected dividends plus the subsequent sale proceeds. www.pptmart.com**Cost of Equity Share Capital:**The sale of a share and the selling price thereof can be seen as merely transferring the right of future dividends for a price. The share price, therefore at any time can be taken as the present value of all the future expected dividends infinitely. Po = D1+D2+ ----- Dn (1+ke)1 (1+ke)2(1+ke)n www.pptmart.com**Zero-Growth Dividends: It may be assumed that dividends will**remain constant and pegged at the current level for the assumed perpetual life of the firm. In such a case, the dividend stream is treated as a perpetuity of dividends and the cost of equity share capital, ke can be ascertained with the help of Equation. ke = D1 Po where, ke = Cost of equity share capital D1 = Expected dividend at the end of year 1 Po = Current market price of the share. www.pptmart.com**Zero-Growth Dividends:**Impliedly, zero growth dividend means that the firm is following policy of 100% dividend pay out ratio and no profits are retained by the firm. Under such a situation, the D1 will be equal to EPS1 of the firm. In other words, when earnings are constant and the dividend pay out ratio is 100%, then www.pptmart.com**Zero-Growth Dividends:**E1 = E2 = E3 ---------- E, and D1 = D2 = D3 ---------- D, and therefore, E = D. On the basis of Equation, ke = E1 Po It may be noted on the basis of this equation that ke = 1/ (Po/ E1 ) and therefore, ke may also be defined as inverse of the PE ratio. www.pptmart.com**Constant-Growth Dividends:**Constant Growth Rate in Dividends perpetually: Dividends may be assumed to grow at a constant rate, say, ‘g’ per cent per annum. In such a case, the dividend payment in year n can be expressed as: Dn = Do (1 + g)n www.pptmart.com**Constant-Growth Dividends:**Po=D0(1+g)1+D0(1+g)2+ ----- +D0(1+g)n (1+ke)1 (1+ke)2(1+ke)n The only condition before applying the Equation is that ke>g. The dividend amount will get larger and larger as the time passes because of the growth factor, g. This is clearly different from the debts, preference share capital and the zero growth dividend streams. www.pptmart.com**Constant-Growth Dividends:**Mathematically, Previous Equation can be further simplified and written as Equation. Po = Do (1 + g) ke – g = D1 ke – g Or, ke = D1 + g Po www.pptmart.com**Constant-Growth Dividends:**The formulations given in Equations are subject to the following assumptions: 1. That the current market price of the share is a function of future expected dividends. 2. Do is > 0, i.e., the present dividend is positive. 3. The dividend pay out ratio is constant. Growth in dividend can be extremely volatile and sensitive depending upon the market, economic and company factors. It may be estimated as follows: a) Past growth in dividends. b) Current Retained earnings. www.pptmart.com**Varying-Growth Dividends:**5 10 n Po=D0(1+g1)i+ D5(1+g2)i-5 + ----+ D10(1+g3)i-10 i=1 (1+ke)ii=6 (1+ke)ii=11 (1+ke)i where, Po = Current marker price of the equity share Do = Dividend just paid by the company D5 = Dividend payable at the end of year 5 D10= Dividend payable at the end of year 10 g1 ,g2 and g3 = Different growth rates, and ke= Cost of equity share capital. www.pptmart.com