Cost of Capital

Cost of Capital : Cost of Capital By Dr. Gurendra Nath BhardwajAssociate ProfessorIILM Graduate School of Management,16 Knowledge Park - II, Greater Noida - 201 306,Tel: 0120 - 3374335 (O), Mobile - 9910634497Email: gurendra.bhardwaj@iilmgsm.ac.in, gurendrabhardwaj@gmail.com

Rationale of Cost of Capital : Rationale of Cost of Capital Capital budgeting (long term investment decision) has a major impact on the firm, and proper investment decision procedures require an estimate of the cost of capital. Thus, the average cost capital used as discount rate for investment proposals. In general, firm’s financing decision, is closely based on cost of capital.

Slide 3 : It helps in fixing debt equity ratio of the firm. It indicates the payment that the firm has to make to the supplier of the capital according to their expectations. The expected retunes depends on the degree of risk assumed by the investors. The greater the risk, the higher is the cost of that source.

Cost of Capital : Dr. Gurendra Nath Bhardwaj 4 Cost of Capital Every resource has some price or that has its cost. Fund also has a price. Supplier of Funds wants some compensation like interest. If one pays the appropriate interest the supplier will release the funds, otherwise not. So the “Cost of Capital is the return that is enough to motivate him (Lender) to provide his funds.”

Types of funds : Dr. Gurendra Nath Bhardwaj 5 Types of funds

Debt : Dr. Gurendra Nath Bhardwaj 6 Debt In this type of fund the supplier (lender) wants fixed return. So, in general we can say the interest paid to the lender is cost of capital. However, in some cases this may be different. The rate of interest is expressed in percentage term. In a simple case of lending & borrowing Cost of Capital = Rate of Interest

Contd. : Dr. Gurendra Nath Bhardwaj 7 Contd. But many times the rate of interest received by the lender is not same as cost paid by the borrower. It has prospective difference, like from the view point of lender it is an interest or return while from the view point of borrower it is a cost of capital.

Contd. : Dr. Gurendra Nath Bhardwaj 8 Contd. In a simple situation it will remain same. However, in the process of lending & borrowing some incidental charges and other expenses are involved that creates difference in between the rate of interest & cost of capital. So in case of debt, the cost of capital-

Contd. : Dr. Gurendra Nath Bhardwaj 9 Contd. In the process of borrowing some exp. Like bank charges, processing fees, transport, and documentation expenses etc. may be incurred. So the net receipt of the borrower would become less than the amount lent by lender.

Example: : Dr. Gurendra Nath Bhardwaj 10 Example: Let us assume that in order to borrow Rs. 1,00,000 the borrower has to spend Rs. 5,000 on the transport, documentations or as processing fees. Calculate the rate of return and cost of capital if the rate of interest is 12% p.a.

Solution : Dr. Gurendra Nath Bhardwaj 11 Solution = 12%

Cost of Capital : Dr. Gurendra Nath Bhardwaj 12 Cost of Capital The Net receipt of borrower = Borrowed amount – Incidental charges = 1,00,000 – 5,000 = 95,000 = 12.63%

Important Note : Dr. Gurendra Nath Bhardwaj 13 Important Note This calculation of cost of capital will be correct in perpetual debt. It means that the borrowed amount (Principal amount) will not repaid for an infinite period. It may not happen in the real life.

Slide 14 : When issue bonds / debentures take place, borrower (Company) has to pay many exp. like underwriting commission, discount on issue etc. So, all these expenses have to be accounted for in calculating the cost of capital.

Types of Cost of Capital : Dr. Gurendra Nath Bhardwaj 15 Types of Cost of Capital Before Tax Cost & After Tax Cost Average Cost & Incremental Cost / Marginal Cost Weighted Average Cost of Capital

Before Tax Cost & After Tax Cost : Dr. Gurendra Nath Bhardwaj 16 Before Tax Cost & After Tax Cost If the rate of interest is 10% the cost of capital before tax will be 10%. but if the tax rate is 30% then the cost of capital after tax will be- = Before Tax Cost X 1- t t = Tax Rate So, in the above case cost of capital after tax will be = 10% X 1- .3 = 10% X .7 = 7%.

Average Cost & Incremental Cost / Marginal Cost : Dr. Gurendra Nath Bhardwaj 17 Average Cost & Incremental Cost / Marginal Cost Average cost of capital refers the average of historical cost and incremental cost of capital. Historical cost means is the cost incurred in the past. While incremental cost is the cost of additional funds.

Cost of Debt : Dr. Gurendra Nath Bhardwaj 18 Cost of Debt Debt includes mainly two types of financial instruments. Long Term Debt (Term Loan) Debenture / Bonds

Long Term Debt (Term Loan) : Dr. Gurendra Nath Bhardwaj 19 Long Term Debt (Term Loan) Debts, which are borrowed for a long term period i.e. which are not paid with in an accounting year. The amounts are released in the lump sum form. The unique feature of long term debt is that the principal amount (Issue & maturity price)of loan will be same. Therefore, change in principal amount will not lead to change in cost of debt.

Debenture / Bonds : Dr. Gurendra Nath Bhardwaj 20 Debenture / Bonds These types of financial instruments are issued by the company in small financial units. Like of Rs. 10, Rs.100 & Rs. 1,000 in some cases it may be Rs. 1,00,000. LIC Housing Finance issued bonds of Rs. 1,00,000 each.

Contd. : Dr. Gurendra Nath Bhardwaj 21 Contd. In case of long term debt (Term Loan) there is no need to make any adjustment except incidental charges at the time of borrowing. But in case of issue of debentures / bonds, some adjustments are need to be done for following transactions. Discount on issue Premium on issue Premium on redemption Floating Cost

Contd. : Dr. Gurendra Nath Bhardwaj 22 Contd. From the view point of a company discount on issue & floating cost will increase the cost of capital at the time of issue. While the premium on redemption will increase the cost of capital, not at this time but in the future. Premium on issue will reduce the cost of capital.

Contd. : Dr. Gurendra Nath Bhardwaj 23 Contd. When we make all these adjustments then we get real cost of capital for any bond or debentures. A formula which gives an appropriate value is as follows.

Abbreviations of Notations : Dr. Gurendra Nath Bhardwaj 24 Abbreviations of Notations I = Interest t = Tax Rate F = Flotation Cost or Issue Exp. D = Discount on Issue Pr = Premium on redemption Pi = Premium on issue n = No. of year Rv= Net redemption value Sv = Net Sale Value (Net receipt of Loan)

Example : Dr. Gurendra Nath Bhardwaj 25 Example A company makes an issue of 12% coupon bonds for Rs. 1,00,000. The issue exp. Rs. 6,000 while the issue is made at discount of 2%. The bond will be redeemed after 5 year at a premium of 5%. Find out the after tax cost of Capital if the rate of tax is 30%. Take the assumption of annual compounding.

Solution : Dr. Gurendra Nath Bhardwaj 26 Solution = .1117or 11.17 %

Cost of Preference Share : Dr. Gurendra Nath Bhardwaj 27 Cost of Preference Share Preference Share: Preference shares are those shares, which have preference in payment over equity shares in respect of following two- Regarding payment of dividend Regarding payment of principal amount at the time of winding up of a company.

Contd. : Dr. Gurendra Nath Bhardwaj 28 Contd. However, when the preference share holders get above two privileges, then they have to forego the voting right in the company’s management and they are not entitled to receive excess dividend over the predetermined rate of dividend. They get only fixed return on their capital contribution.

Contd. : Dr. Gurendra Nath Bhardwaj 29 Contd. On the basis of payment, the preference shares can be divided in to two parts.

Perpetual Preference Share: : Dr. Gurendra Nath Bhardwaj 30 Perpetual Preference Share: In case of perpetual Preference share the cost of capital can be calculated as follows. d = Amount of dividend F= Flotation Exp. D = Discount on Issue Pi = Premium on Issue

Redeemable Preference share : Dr. Gurendra Nath Bhardwaj 31 Redeemable Preference share In case of redeemable preference share the cost of capital can be calculate through the following formula-

Abbreviations of Notations : Dr. Gurendra Nath Bhardwaj 32 Abbreviations of Notations d = Dividend F = Flotation Cost or Issue Exp. D = Discount on Issue Pr = Premium on redemption Pi = Premium on issue N = No. of years. Rv= Net redemption value Sv = Net Sale Value (Net receipt of Capital)

Important Note : Dr. Gurendra Nath Bhardwaj 33 Important Note The difference between cost of debenture or bonds & redeemable preference share is that in case of cost of preference share, we will not consider tax impact (1 - t). Because interest is tax deductible item, whereas the dividend is not deductible from profit & Loss A/c as an expenditure while calculating taxable business income.

Slide 34 : Dr. Gurendra Nath Bhardwaj 34 The simple reason behind this is that the Interest paid to the lender is an expenditure. The debenture holders are not owner of the company. Whereas preference share holders are owner of the company and They do not form risk capital (debt)like lenders.

Contd. : Dr. Gurendra Nath Bhardwaj 35 Contd. Therefore, It is obvious that how we can deduct the owner’s return from Profit & Loss A/c. While computing dividend which is to paid to them after deduction of corporate tax. The Company has to show the dividend part in the Profit & Loss Appropriation A/c.

Equity Share : Dr. Gurendra Nath Bhardwaj 36 Equity Share Equity share holders are real owner of the company because – They have voting right in the company’s management. They are risk bearer i.e. they get dividend after making all the payments like payment of interest to the debenture holders and other lenders, corporate tax and payment of dividend to the preference share holders.

Important Tips : Dr. Gurendra Nath Bhardwaj 37 Important Tips Although, it is not mandatory for a company to pay dividend on equity, but still the company is required to pay the return to the shareholders which they expect. Otherwise the shareholders will start selling their shares even on the low price to recover their capital. Which will bring down the market price of the share and Ultimately it will reduce the level of the wealth of the shareholders.

Slide 38 : Therefore company is required to pay the return to the shareholders as per their expectation. i.e. Cost of Equity. Shareholders expect two things form their investment in share- Current Return (Dividend) Growth in Return (Capital Gain)

Slide 39 : Current return (Dividend) can be achieved by way of following two ways. By increase in dividend rate By increase in dividend amount through bonus shares. Capital gain means difference between share prices over a specific period. If shares are sold then, it will be realized capital gain, otherwise it will be unrealized capital gain.

Cost of Equity Share Capital : Cost of Equity Share Capital The cost of equity capital is the most difficult component to calculate. Conceptually, it is the expected return on the firm’s equity share capital, which, if earned, will leave the market value of the share unchanged.

Slide 41 :

Earning Price Model : Earning Price Model Assumptions: The market price of shares is influenced only by fluctuation in the earning of the firm & Future earning, which can be will expressed as average, will grow at a constant rate. Cost of equity (ke) can be calculated as follows – E= Earning per share P= Current market price per share

Example : Example The share capital of a company represented by 20,000 shares of Rs. 10 each, fully paid. The current market price of the share is Rs. 40. The earning available to the shareholders amount to Rs. 1,00,000 at the end of the period. Calculate the cost of equity.

Solution : Solution

Limitations : Limitations Earnings/ price ratio matches earnings (EPS)based on historical experiences with a market price (P) based on investor’s perception of the present value of the future cash flows.

Divided Growth Model : Dr. Gurendra Nath Bhardwaj 46 Divided Growth Model In this model, cost of equity is the dividend yield plus the expected dividend growth rate. It assumes constant growth at a compound rate. D = Current Dividend Amount P = Market Price of the Share g = Growth rate of dividend

Example : Dr. Gurendra Nath Bhardwaj 47 Example Suppose a company makes an issue of equity share of Rs. 10 at premium of Rs. 40. The current dividend rate is 40%. This dividend expected to grow10% p.a. Calculate the cost of equity.

Solution : Solution Dr. Gurendra Nath Bhardwaj 48

Limitations : Limitations The dividend growth rate may not remain constant over a time. So, estimating the value of g becomes difficult in such cases.

Earning Growth Model : Earning Growth Model This model replaces dividend by earnings in it, and the cost of equity (ke) is measured by the following equation- E = Current Dividend Amount P = Market Price of the Share g = Growth rate of earnings

Example : Example If earning per share is Rs. 5 and the growth rate in earnings 10% per annum. The market price of the share is Rs. 40. Calculate Cost of Equity (ke).

Solution : Solution

Important note : Important note The principal reason for preferring the earning model is that the cost of capital’s primary purpose is to provide a discount rate of long term investment proposals. So, it should be more focused on earning rather than on dividend only. Estimating the growth rate is very crucial factor in this model.

Methods of Growth Rates Estimation : Methods of Growth Rates Estimation

Average past rate of growth rate of dividends : Average past rate of growth rate of dividends

Derivation of future growth : Derivation of future growth It is based on Rate of investment which partly determine the rate of dividend growth. Rate of return yielded by these projects Assumptions: The firm is an all equity firm. Retained earnings are the only sources of additional investment. A constant proportion of earnings is retained each year for reinvestment. Projects financed through retained earnings produce a constant annual return.

Contd. : Contd. g=br g = Future dividend growth rate b = Constant proportion of net profits retained each year r = Average rate of return of the projects of the firm

Gordon’s approach : Gordon’s approach According to Gordon model, the b & r will be estimated as follows.

Adjustment of Floatation Costs : Adjustment of Floatation Costs Floatation cost includes brokerage, underwriting commission and other issue exp. relevant for issue of Initial Public Offering (IPO)/ Follow Public Offering (FPO)/Right Issues. Thus, the market price of share should be adjusted by (1-f), where f stands for rate of floatation costs.

Adjustment of Floatation Costs : Adjustment of Floatation Costs

Example : Example A company plans to issue new shares of Rs. 10 each to raise additional capital of Rs. 10,00,000. The floatation cost is expected to be 2%. The current market price of share is Rs. 50. Earning per share is Rs. 15. Assume growth in earning is 5%. Calculate cost of equity (ke).

Solution : Solution

Capital Asset Pricing Model(CAPM) : Capital Asset Pricing Model(CAPM) The CAPM is based on the premises that the required rate of return on any security equals to the risk free return plus risk premium. Assumptions: The capital market is efficient. All investors have the same expectations about risk and return. All investor’s decisions are based on a single time period. All investors lend or borrow at a risk free rate of interest.

CAPM equation : CAPM equation Rj= Return on security βj= Beta of security Rm= Return in the market Rf = Risk free return

Example : Example For given period of time- If the T bills rate is 7.5%, As per sensex, the return in the Bombay Stock Exchange is 30%. The β of TCS equity share is 1.5 Calculate the Cost of Equity (ke) of TCS equity share.

Solution : Solution Rj= to be find out βj= 1.5 Rm= 30% Rf = 7.5%

Retained Earning : Dr. Gurendra Nath Bhardwaj 67 Retained Earning The cost of retained earnings determined by this dividend growth model implies that if the firm would have distributed earning to the shareholders, they could have invested it in the shares of the firm or in the shares of other firms of similar risk at the same market price to earn equal rate of return. So, the cost of capital of retained earning will be equal to the cost of capital to the equity shares.

Weighted Average Cost of Capital : Dr. Gurendra Nath Bhardwaj 68 Weighted Average Cost of Capital In the Weighted Average Cost of Capital (WACC), one has to find out the average cost of capital from different sources of finance like debt & equity. As we know that WACC is nothing but it is sum total of all the average costs of different sources of capital after considering their individual ratio the total capital. These individual ratios are termed as weight.

Contd. : Dr. Gurendra Nath Bhardwaj 69 Contd. It is an average of various cost of capitals on the basis of given proportion of different sources of finance. It accommodates the individual cost of capital particular component & its respective weight in total capital. WACC= (kd1 X wd1 )+ (kd2 X wd2 ) + (kp X wp) + (ke X we) +(kr X wr)

Abbreviations of Notations : Abbreviations of Notations kd1 = Cost of Capital of Debt or Term Loan kd2 = Cost of Debenture/ Bonds kp= Cost of Preference Share ke = Cost of Equity Share kr=Cost of Retained Earning wd1 = Weight of Debt or Term Loan wd2 = Weight of Debenture/ Bonds wp= Weight of Preference Share we = Weight of Equity Share wr= Weight of Retained Earning

Slide 71 : Thus, to measure the overall cost of capital (WACC), it is necessary to determine; The cost of each of the components, and Respective weights in the capital structure of the firm.

Selection of Weights : Selection of Weights

Example : Dr. Gurendra Nath Bhardwaj 73 Example Like in a capital structure if 10% debentures of Rs. 1,00,000 are issued out of total Capital of say 8,00,000. The ratio of debt to total capital will be 1,00,000 / 8,00,000 = 1/8 or .125, While calculating WACC we will consider this weight also. In this case, average cost of debt will not be 10% but it will be .125 X 10% = 1.25 and sum total of these type of average cost of capital calculated on the basis of their respective weight will be WACC. It represents the amount which is to be paid or payable by the company to obtain overall funds.

Contd. : Dr. Gurendra Nath Bhardwaj 74 Contd. The concept of WACC is such a important factor for the company that it has to design various strategies to reduce this rate. In the different sources of funds one has to decide which is the cheapest source of finance. What should be its ratio in the total capital.

Example : Dr. Gurendra Nath Bhardwaj 75 Example Let us assume that Company X has to raise Rs. 5,00,000 for its new project. The company has decided to raise it in the following manner- Rs. 1,00,000 by a term loan from IDBI & rate of interest is 14%. Issue of bonds of Rs. 1000 each at coupon rate of 12% p.a. at discount of 3%. The issue exp. comes to Rs. 8,000. The bond are redeemable at par after 6 years. Total amount is Rs. 2,00,000. Perpetual preference shares @ 14% p.a. & the issue exp. are 5%. The total amount is Rs. 50,000. Equity Rs. 10 each. The current market price is Rs. 40 current dividend rate is 40% & growth is 12%. The amount is Rs. 1,00.000 Internal Sources Rs. 50,000. The tax rate is. 40%. Calculate Weighted Average Cost of Capital (WACC) of the X Company.

Solution : Dr. Gurendra Nath Bhardwaj 76 Solution

Self Assessment : Self Assessment 1. Which of the following is not an assumption of capital asset pricing model for determination of cost of equity? The capital market is efficient Investors lend or borrow at a risk free rate of return Investors do not have the same expectations about the risk & return Investors decisions are based on a single- time period

Slide 78 : 2. If risk-free rate of return = 5%, market return = 10%, cost of equity = 13%, then value of beta (β) is : 1.2 1.5 1.6 1.8

Slide 79 : 3. Which of the following statements is not true in the context of marginal cost of capital? It is the cost of additional amount financed by a firm. It is the specific cost of capital when capital is raised from one particular source. It is generally higher than the average cost of capital of the firm. It is equivalent to marginal revenue.

Slide 80 : 4. Given ko = 11.88%; ke = 15% and weights used in favour of equity, retained earnings and debts are respectively, 40%, 20% and 40%, the after tax cost of debt is, 7.5% 7.2% 8.5% 8.2%

Answers : Answers