Slide 1 : Copyright @ 2011 IILM Institute of Higher Learning. All rights Reserved. Corporate Finance Cost of Capital – session 1
Slide 2 : Contents Lecture Objectives
Concept of Cost of Capital
Usage of cost of capital
Types of cost of capital
Cost of Debt
Cost of Preference shares
Cost of Equity
Models for Calculating Cos of equity. 3 2 1 4 5 6 7 8 2
Slide 3 : Lecture Objectives Explain the meaning of cost of Capital.
Discuss weighted average cost of capital (WACC).
How to find cost of various financing instruments like debt, preference capital and equity.
Introduce various model of measuring cost of equity and their relative advantages and disadvantages.
Slide 4 : Contents Lecture Objectives
Concept of Cost of Capital
Usage of cost of capital
Types of cost of capital
Cost of Debt
Cost of Preference shares
Cost of Equity
Models for Calculating Cos of equity. 3 2 1 4 5 6 7 8 4
Slide 5 : COST OF CAPITAL
The cost of capital of any investment (project, business, or company) is the rate of return the suppliers of capital would expect to receive if the capital were invested elsewhere in an investment (project, business, or company) of comparable risk
The cost of capital reflects expected return
The cost of capital represents an opportunity cost
Slide 6 : Contents Lecture Objectives
Concept of Cost of Capital
Usage of cost of capital
Types of cost of capital
Cost of Debt
Cost of Preference shares
Cost of Equity
Models for Calculating Cos of equity. 3 2 1 4 5 6 7 8 6
Slide 7 : “Importance of Cost of Capital?” An investment can bring gains only when its rate of return is greater than the cut-off rate. It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return.
It is important for capital budgeting decisions (accept & reject criteria).
The wealth of shareholder’s will only be maximized when rate of return on proposal is greater than its cost of capital. Any investment which does not cover the firm’s cost of funds will reduce shareholder wealth.
Just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth.
Slide 8 : Contents Lecture Objectives
Concept of Cost of Capital
Usage of cost of capital
Types of cost of capital
Cost of Debt
Cost of Preference shares
Cost of Equity
Models for Calculating Cos of equity. 3 2 1 4 5 6 7 8 8
Slide 9 : TYPES OF COST OF CAPITAL Explicit cost & implicit cost
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. These payments refer to the explicit cost of capital.
There is one source of funds, which does not involve any payment or flow i.e., the retained earnings of the firm.
Thus, the, implicit cost of retained earning is the return which could have been earned by the investor, had the profit been distributed to them. This is also called opportunity cost of capital.
Slide 10 : Specific cost & overall cost The cost of capital of each, source of capital is known as component or specific cost of capital.
And when we take combined cost of all the components it is called overall cost of capital. The components are assigned certain weights & then the weighted average cost of capital (WACC) is determined.
Slide 11 : Contents Lecture Objectives
Concept of Cost of Capital
Usage of cost of capital
Types of cost of capital
Cost of Debt
Cost of Preference shares
Cost of Equity
Models for Calculating Cos of equity. 3 2 1 4 5 6 7 8 11
Slide 12 : Cost of DEBT Rate of interest payable on debt is treated as its cost but that’s not correct.
This is b’coz interest is a tax deductible expense. Hence the actual cash outflow is less than interest paid to debt holders.
Dividends payable to equity shareholders and preference shareholders is an appropriation of profit, whereas the interest payable on debt is a charge against profit. Therefore, any payment towards interest will reduce the profit and ultimately the company’s tax liability would decrease.
Slide 13 : Cost of Perpetual Debt The cost of perpetual debt, rD is simply equal to the coupon payments (interest) divided by price of debt/debenture. rD = I / P0
Slide 14 :
Slide 15 : Example
Face value = 1,000
Coupon rate = 12 percent
Period to maturity = 4 years
Current market price = Rs.1040
The approximate yield to maturity of this debenture is :
120 + (1000 – 1040) / 4
rD = = 10.7 percent
0.6 x 1040 + 0.4 x 1000
Slide 16 : Tax adjustment: After-tax cost of debt = rD(1- t) where t is the tax rate Suppose EBIT = Rs.10,000, Debt capital =Rs.50,000, kd = 6%,
Tax rate (t) = 40%. EAIT with and without debt can be calculated as follows
With debt Without debt
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EBIT 10,000 10,000
Interest 6% 3,000
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7,000 10,000
Tax 40% 2,800 4,000
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EAIT 4,200 6,000
Slide 17 : Cal cost of debt ABC Ltd. issues 15% debentures of face value of Rs.100 each, redeemable at the end of 7 years. The debentures are issued at a discount of 2.25% & redeemable at 5% premium. Find out the cost of capital of debentures given that the firm has 35% tax rate. Ans. = 10.4%
Slide 18 : Contents Lecture Objectives
Concept of Cost of Capital
Usage of cost of capital
Types of cost of capital
Cost of Debt
Cost of Preference shares
Cost of Equity
Models for Calculating Cos of equity. 3 2 1 4 5 6 7 8 18
Cost of Preference shares : Cost of Preference shares It may be dividend expected by preference shareholders.
Like interest Preference Dividend is not a charge on earnings but appropriation of earnings since it is paid out of after tax profits.
Hence no adjustment for tax is required.
Slide 20 : Cost of Preference Capital Irredeemable Preference Share
The preference share may be treated as a perpetual security if it is irredeemable. Thus, its cost is given by the following equation:
rP =Dp / P
where rp is the cost of preference share, Dp represents the fixed dividend per preference share and P is the price per preference share.
Slide 21 : Redeemable Preference Share P0 = D / (1+rP)t + F / (1+rP)n
The cost of preference capital is not adjusted for taxes, because dividends on preference capital are paid after taxes as it is not tax deductible. rD =
Slide 22 : COST OF Redeemable Preference shares
n I F
P0 = +
t = 1 (1 + rP)t (1 + rP)n
P0 = current price of the Preference share
D = Annual Dividend
n = number of years left to maturity
F = maturity value
rP is computed through trial-and-error. A very close approximation is:
D + (F – P0)/n
0.6P0 + 0.4F
Slide 23 : ILLUSTRATION
Face value : Rs.100
Dividend rate : 11 percent
Maturity period : 5 years
Market price : Rs.95
Approximate yield :
11 + (100 – 95) / 5
= 12.37 percent
0.6 x 95 + 0.4 x 100
Slide 24 : Contents Lecture Objectives
Concept of Cost of Capital
Usage of cost of capital
Types of cost of capital
Cost of Debt
Cost of Preference shares
Cost of Equity
Models for Calculating Cost of equity. 3 2 1 4 5 6 7 8 24
Cost of equity : Cost of equity Most difficult cost to measure.
The return on debt & preference shares is fixed.
Moreover in case of repayment of capital, equity capital is last in priority list.
It seems that they do not carry cost. But equity shares like others also carry a cost. It carries a cost in terms of dividends expected by the shareholders.
The cost of equity is the highest among all, b’coz the shareholders bear the highest degree of financial risk, since they are paid after all other payments are made. Hence with higher risk, the return expected is higher & cost of capital is more.
Slide 26 : APPROACHES TO ESTIMATE COST OF EQUITY
Dividend Growth Model Approach
Capital Asset Pricing Model (CAPM)
Slide 27 : Acknowledgments We wish to acknowledge the people who actively contributed to the writing and delivery of the learning material
Author
Prof. Rajiv Srivastava
Presenter
Dr. Anubha Gupta
A special thanks to the technical support team who were instrumental in the design and implementation of this presentation.
Slide 28 : Contact Details For further information, please contact:
IILM Institute for Higher Education
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Lodhi Road, New Delhi- 110003
Email: learning@iilm.edu
Web : www.iilm.edu