Cost of Capital

1.Cost of capital and multinational financial environment 2. How to cost various sources of Funds : 1.Cost of capital and multinational financial environment 2. How to cost various sources of Funds Ramanadh Kasturi For Amity Business School

Cost of Capital : Cost of Capital Refers to the cost of funds raised by a firm to finance the assets. Serves as the hurdle required rate of return on investments. The overall cost of capital is a weighted average of the individual required rates of returns(costs)

Understanding Cost of Capital : Understanding Cost of Capital

Significance of Cost of Capital : Significance of Cost of Capital It forms the basis for investment decisions of a firm. A firm must earn at least a rate of return equivalent to its cost of capital

Multinational Environment : Multinational Environment MNCs operate in different economies Differences in the consumption, savings, investment and growth patterns Regulatory influences Investment avenues

Cost of Individual Sources : Cost of Individual Sources Cost of Debt Long term loans and Debentures are called as debt. Debentures bear a stipulated rate of interest which is a cost to the firm. Debentures are mainly of two types redeemable or irredeemable

Slide 7 : Redeemable debentures are repaid on maturity i.e., after stipulated period. Irredeemable debentures form permanent source of borrowed capital of the firm.

Cost of Irredeemable debt : Cost of Irredeemable debt As the principal sum will never be repaid, irredeemable debenture holders receive interest on the principal. Cost of Irredeemable debt Kd= I P0 Where Kd is the cost of Debt I is the Annual Interest payable on debenture P0 is the Sale proceeds of Debenture

Slide 9 : Interest on debentures is an admissible deduction and hence a firm saves tax on the interest paid on debentures. Tax adjusted Cost of Debenture capital is Kd = I(1-t)/P0

Cost of Redeemable Debentures : Cost of Redeemable Debentures Firm need to repay the principal at the maturity apart from annual interest on the debentures. Cost of Redeemable debt is the discount rate that equates future annual interest and the principal repayment. P0 = ?n It (1-t) + Pt t=1 (1+Kd)t (1+Kd)t Where It is the annual interest on debenture Pt is the principal repayable on maturity Kd is the cost of debenture capital t is the tax rate applicable to the company

Issue of Debentures-Redemption : Issue of Debentures-Redemption

Example : Example A firm issued 8% debentures of face value Rs 100 each at a discount of 10% and are redeemable after 10 years at face value. Calculate the cost of debt.

Slide 13 : Alternative formula Kd = I(1-t) + (RV – SV) /Nm RV +SV 2 Where RV = Redeemable Value SV= Sale proceeds Nm = Number of years to maturity

Example 2 : Example 2 CATS Ltd issues 1,00,000 14% debentures of face Value 100 each, redeemable after 5 years at Rs 110 each. The commission payable to underwriters and brokers is 10%. Company’s Tax rate is 45%. Calculate the cost of debt.

Slide 15 : Ans: 11.7%

Example 3 : Example 3 Titan Limited issues 8% debentures of face value 100 each and paid Rs 5 per debenture as brokerage . The debentures are redeemable after 12 years at a premium of 10% on face value. Tax rate applicable to the company is 45%. Calculate cost of debt.

Cost of Preferred Capital : Cost of Preferred Capital Preference shares bare a fixed rate of dividend and the dividends are not an obligation to the company. Cost of irredeemable preferred capital KP = DP P0

Cost of Redeemable Preferred Capital : Cost of Redeemable Preferred Capital P0 = ?n Dt + Pt t=1 (1+Kp)t (1+Kp)t Where Dt is constant annual dividend Pt is the redeemable value of the preference shares

Example : Example TCS limited has 12% redeemable preference shares of Face Value 100 each, redeemable at par after 10 years. The underwriting expenses are 4%. Calculate cost of Preferred capital.

Slide 20 : Alternative Formula KP = D + (RV – SV) /Nm RV +SV 2

Cost of Equity : Cost of Equity Valuation of Equity Value of any financial security is the present value of cash flows generated by it. Investment in equity fetches dividends and appreciation in price. P0 = D1+P1__ (1+Ke)

Slide 22 : Investment in equity over a period of time P0 = D1 + D2 + D3 ………. Dn + Pn (1+Ke)1 (1+Ke)2 (1+Ke)3 (1+Ke)n (1+Ke)n

Constant Growth Rate in Dividends : Constant Growth Rate in Dividends Let D0 be the dividend for current year D1 is the expected dividend at the end of the year. Dividends grow at a rate of ‘g’ per annum D1 = D0(1+g) D2 = D1(1+g) = D0(1+g)(1+g) = D0(1+g)2 D3 = D2(1+g)= D0(1+g)3

Slide 24 : P0 = D0(1+g) + D1(1+g) + D2(1+g) ………. Dn(1+g) (1+Ke)1 (1+Ke)2 (1+Ke)3 (1+Ke)n = D0(1+g) + D0(1+g)2 + D0(1+g)3 …………. D0(1+g)n (1+Ke)1 (1+Ke)2 (1+Ke)3 (1+Ke)n Equation reduces to P0 = D1 Ke – g Ke = D1 + g P0

Slide 25 : Ke = D1 + g P0 Where D1 is the expected dividend , P0 is the current market price and ‘g’ is the growth rate.

Multiple Growth rates : Multiple Growth rates Imagine………?????????

Example : Example Market price of equity shares of X limited is Rs 225 and the company paid a dividend of Rs 15 per share in the current year. The dividends are expected to grow at a constant rate of 4% per annum. Calculate the cost of Equity capital.

Slide 28 : Ke = D1/P0 + g = 15/225 + 0.04 = 10.67%

Example 2 : Example 2 A company pays a constant dividend of Rs 12 per share. Current price of equity share is Rs 160 and after 3 years the price is likely to rise up to Rs 240. Calculate the cost of equity.

Slide 30 : 160 = PVIFA(Ke, 3)*12 + PVIF(Ke, 3)* 240 At 15% RHS= 2.283* 12 + 0.658*240 = 185.26 AT 20% RHS = 2.106 * 12 + 0.579 * 240 = 164.23 AT 19% RHS = 2.14 * 12 + 0.593 * 240 = 168 By interpolating RHS = 19.20

Example 3 : Example 3 The expected growth of dividends of a company for 3 years is 4% and are likely to raise to 6% for the next 3 years. Current dividend of the company is Rs 15 and the market price is Rs 125. Price of equity at the end of 6th year is expected to be Rs 500. Calculate the cost of equity.

Slide 32 : P0 = D0(1+g)t + D3(1+g)t + P6 (1+Ke)t (1+ Ke)6 (1+ Ke)6 6 ? t=4 3 ? t=1 P0 = 15(1+0.04)t + D31+0.06)t + 500 (1+Ke)t (1+ Ke)t (1+ Ke)6 3 ? t=1 6 ? t=4 125 = 15(1.04)1 + 15(1.04)2 + 15 ( 1.04)3 + D3(1.06)1 + D4 (1.06)2 + D4 ( 1.06)3 (1+Ke)1 (1+Ke)2 (1+Ke)3 (1+Ke)4 (1+Ke)5 (1+Ke)6 500 (1+Ke)6 = 15.6*PVIF(Ke, 1) + 16.22*PVIF(Ke, 2) + 16.87*PVIF(Ke, 3) + 17.88*PVIF(Ke, 4) + 18.96 *PVIF(Ke, 5) + 20.10*PVIF(Ke, 6) + 500*PVIF(Ke, 6)

Cost of New Equity : Cost of New Equity When a company issues new equity shares, it involves certain costs like brokerage, underwriting commission etc., commonly referred to flotation costs. In such cases, cost of new equity = D1/ P0(1-f) Where f stands for flotation cost.

Cost of Retained Earnings : Cost of Retained Earnings As retained earnings are part of owners’ equity, cost of retained earnings is same as cost of equity. However, retained earnings are not traded, they do not have a market value.

Cost of Equity-Capital Asset Pricing Model : Cost of Equity-Capital Asset Pricing Model Risks associated with business can be classified into two types Systematic Risks Unsystematic risk

Cost of Equity under CAPM : Cost of Equity under CAPM Re = Rf+(Rm-Rf)ß where Re = Cost of Equity Capital Rf = Risk free rate of return Rm= Market return ß = systematic risk factor(regression coefficient of particular scrip)

Example : Example Treasury bills earn 6% per annum at prevailing interest rates and a company X has a beta value of 1.20. Average return on market portfolio is 14%. Calculate the cost of equity.

Slide 38 : Ans: 15.6%

Weighted Average Cost of Capital(WACC) : Weighted Average Cost of Capital(WACC) n WACC= ? Wx * Kx x=1 Where Wx = Weights of individual capital sources Kx = cost of individual capital sources

Example : Example The Manx company was recently formed to manufacture a new product. It has the following capital structure in the market value terms. Debentures $ 6,000,000 Preferred Stock $ 2,000,000 Common Stock $ 8,000,000 $16,000,000 The company has a marginal tax rate of 40%. A study of publicly held companies in this line of business suggests that the required rate of return on equity is about 17%. ( The CAPM approach was used to determine the required rate of return). The company’s debt is currently yielding 13 percent and its preferred stock is yielding 12 percent. Compute the firm’s present weighted average cost of capital. (Adapted From Fundamentals of Financial Management, Twelfth Edition, James C. van Horne, John M. Wachowicz JR.)

Illustration : Illustration Evan Soft Limited has assets of Rs 2,80,000 which have been financed with Rs 64,000 of debt and Rs 1,10,000 of equity and a general reserve of Rs 18,000. The firm’s total profit after interest and taxes for the year ended 31 March 2004 was Rs 25,700. It pays 13% interest on borrowed funds and is in 60% tax bracket. It has 1,000 equity shares of Rs 100 each selling at a market price of Rs 125 per share. The firm pays 60% of earnings as dividends.

: EPS= 25.7 DPS = 15.42 Cost of Debt = 5.2% Cost of Equity = 12.34% WACC = 9.96%

Exercise : Exercise The sprouts N-steel company has two divisions: health foods and specialty metals. Each division employs debt equal to 30 percent and preferred stock equals to 10 percent of its total requirements, with equity capital used for the reminder. The current borrowing rate is 15%, and the company’s tax rate is 40 percent. At present, preferred stock can be sold yielding 13 percent. Sprouts N-steel wishes to establish a minimum return standard for each division based on the risk of that division. This standard would then serve as the transfer price of capital to the division. The company thought about using the capital asset pricing model in this regard. It has identified two samples of companies, with modal value of betas of 0.90 for health foods and 1.30 for specialty metals.(Assume that the sample companies had similar capital structures to that of Sprouts N-steel. The risk free rate is currently 12 percent and the expected return on the market portfolio 17 percent. Using the CAPM approach, what weighted average required returns on investment would you recommend for these two divisions?

Exercise 2 : Exercise 2 ABC company has the following capital structure. Book Value(Rs) Market Value(Rs) 8% Debentures( FV Rs 100) 10,00,000 12,00,000 13% preference shares(FV Rs 100) 4,00,000 4,00,000 Equity shares (FV Rs 100 each) 16,00,000 19,00,000 Retained Earnings 2,00,000 - The Company is in a tax bracket of 40%. Debentures were issued a discount of 5% and are redeemable at par after 5 years. Preference shares are issued at par and are irredeemable . Company incurred a flotation cost of 10% on the issue of preference shares. Equity shares of the company are sold at Rs 172 per share and the company declared a dividend of Rs 12 per share in the current year. The company’s dividends are expected to grow at a constant rate of 6%. Calculate Cost of debt Cost of Equity Cost of preferred Capital Weighted average cost of capital using book value and market value weights.