Financial Risk and Relationship Between Cost of Capital

8/13/2019 Financial Risk and Relationship Between Cost of Capital

1/41

Cost of capital andLeverage

Presented By: Suhas Chavan


2/41

Cost of Capital

The cost of capital is the rate of return the company

has to pay to various suppliers of funds in thecompany.

There are variations in the costs of capital due to the

fact that different kinds of investment carry differentlevels of risk, which is compensated for, by different

levels of return on the investment.


3/41

Elements of Cost of Capital

The cost of capital consists of the following elements:

Cost of Equity (KE)

Cost of Retained Earnings (KR)Cost of Preferred capital (KP)

Cost of Debt (KD)


4/41

Cost of Equity

The cost of equity may be defined as theminimum rate of return that a company must

earn on the equity financed portion of an

investment project so that market price of the

shares remain unchanged.

It is a permanent source of funds.

The main objective of the firm is to maximize

the wealth of the equity shareholders.

If the companys business is doing well the

ultimate beneficiaries are the equity

shareholders.


5/41

Computationof Cost of Equity

Dividend Yield MethodThe discount rate that equates the present value of all

expected future dividends per share with the net proceeds

of the sale (or the current market price) of a share.

Dividend Growth Model

An allowance for future growth in dividend is added to the

current dividend yield.

Price Earning MethodThis method takes into consideration the Earnings per share

(EPS) and the market price of share.


6/41

Dividend Yield Method

It is based on the assumption that the market value ofshares is directly related to the future dividends on theshares.

Another assumption is that the future dividend per share

is expected to be constant and the company is expected toearn at least this yield to keep the shareholders content.

Emphasizes future dividends to be constant.

It does not follow any growth rate.

But in reality, a shareholder expects the return from hisinvestment to grow over a time.

This approach has no relevance to the company.


7/41

Dividend Yield Methodcontd.

Where,

KE= Cost of equity

D1 = Annual dividend per share

PE = Ex-dividend per share

E

E

P

DK

1
http://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.doc


8/41

Dividend Growth Model

It is recognized that the current market price

of a share reflects expected future dividends.

Also called as Gordon Dividend Growth

Model.


9/41

Dividend Growth Model contd.

Where,D1 = Current dividend per Equity share

PE = Market price per Equity share

g = Growth in expected dividend

gP

D

KE

E

1
http://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Monica.doc


10/41

Price Earning Method

This method takes into consideration the Earningsper share (EPS) and the market price of share.

Assumption that the investors capitalize the

stream of future earnings of the share need not bein the form of dividend and also it need not bedisbursed to the shareholders.

In calculation of cost of equity share capital, theearnings per share is divided by the currentmarket price.


11/41

Price Earning Method contd.

Where,

E = Current earnings per share

M= Market price per share

M

E

KE


12/41

Cost of Retained Earnings (KR)

The retained earnings is the major sources of Finance.

The equity shareholders of the company are entitled to

these funds.

As long the retained profits are not distributed to theshareholders, the company can use funds within the

company for further profitable investment opportunities.

Retained earnings are a slightly cheaper source of capital

as compared to the cost of equity capital.

Therefore treated separately from the cost of equity

capital.


13/41

Cost of Retained Earnings contd.

Where,

KR = Cost of retained earnings

KE = Cost of equity capital

T = Tax rate of individuals

TKKER 1


14/41

Cost of Preference shares (KP)

The cost of preference share capital is the rate of return

that must be earned on preference capital financed

investments; to keep unchanged the earnings available to

the equity shareholders.Cost of Irredeemable Preference Shares.

Cost of Redeemable Preference Shares.


15/41

Cost of Irredeemable Preference Shares

Where,

KP= cost of irredeemable preference shares

DP= Preference dividend

NP = Net proceeds received from the issue of

Preference shares after meeting the Issue

expenses.

NP

D

K

P

P
http://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Vijaya.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Vijaya.doc


16/41

Cost of Redeemable Preference Shares

Where,

KP = Cost of Preference shares

D = Constant annual dividend payment

N = No. Of years to redemption

RV= Redeemable value of preference shares at the time of redemption

SV = Sale out value of preference shares less discount and floating expenses.

2

VV

VV

PSR

N

SR

DK
http://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Vijaya.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Vijaya.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Vijaya.doc


17/41

Cost of Debt (KP)

The capital structure of a firm normally includes the debtcomponent also.

The debt is carried a fixed rate of interest payable tothem, irrespective of the profitability of the company.

An important point to be remembered that dividendspayable to Equity shareholders and Preferenceshareholders is an appropriation of profit, whereas theinterest payable on Debt is charge against profit.

This phenomenon is called Tax shield
http://localhost/var/www/apps/conversion/tmp/scratch_5/Cost_of_Capital.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Cost_of_Capital.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Cost_of_Capital.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Cost_of_Capital.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Cost_of_Capital.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Cost_of_Capital.doc


18/41

Meaning of Leverage

Leverage refers to the ability of a firm in

employing long term fund having fixed cost to

enhance return to the owner.

Leverage is using fixed costs to magnify the

potential return to a firm


19/41

Types of fixed costs

Fixed operating cost: - e.g. Rent, deprecation

Fixed Financial: - e.g. interest cost from debt


20/41

Types of Leverage

Operating LeverageOperating Leverage is concerned with theoperation of any firm. The cost structure

of any firm gives rise to operating

leverage because of the existence offixed nature costs. This leverage relatesto the Sales & Profit variations, sometime

a small fluctuation in Sales would havegreat impact on profitability. This is

because of the existence of fixed costelements in the cost structure of a

product.


21/41

Degree of operatingleverage

Degree of operating leverage (DOL): -It measures the EBIT's percentagechange as a result of a change of onepercent in the level of output. - It helps

in measuring the business risk.


22/41

Operating Leverage

Operating Leverage measures the sensitivity of a

firms operating income to change in Sales.

Degree of operating leverage =

% change in EBI

% Change in Sales

A change in Sales -------------A large change

in EBIT


23/41

Operating Leverage (DOL)

How efficiently is the fixed cost used in firms

operations

Is it optimal?

DOL or Degree of Operating Leverage

measures how the fixed cost is deployed in

operations. Should the firm decrease or

increase it in its operations?


24/41

Financial Leverage

How efficiently is the fixed charge capital

used in firms finances

Is it optimal?

DFL or Degree of Financial Leverage

measures how the interest, lease and other

such fixed charges are deployed.


25/41

Degree of financialleverageThe degree of financial leverage

(DFL) is defined as the percentage

change in earnings per share [EPS] that

results from a given percentage changein earnings before interest and taxes

(EBIT):

DFL = Percentage change in EPS

divided by Percentage change in EBIT


26/41

Computation of Financial

Leverage

FL = EBIT

EBT

DFL = % change in EPS

% change in EBIT


27/41

Degree of combinedleverage

The degree of combined leverage is

also known as degree of total leverage

(DTL). To compute it use the following

formula:

DCL = DOL * DFL


28/41

Combined Leverage

(DCL)

How efficiently are all the fixed charges used in thefirm

Is the business risk optimal?

DCL or Degree of Combined Leverage measures

how all fixed charges are deployed by the firm.


29/41

Computation of Combined

Leverage

DCL = (NI / NI) / (S / S)


30/41

Capital Structure Theories

Weighted Average Cost of Capital.

Net Income Approach.

Net Operating Income Approach.

Modigliani & Miller Theory.

A ti i C it l St t


31/41

Assumptions in Capital Structure

Theories

Company distributes all its earnings as dividends to its

shareholders.

Taxation & its effect on cost of capital is ignored.

Business risk is treated constant at different capitalstructure of company.

No transaction costs & a company can alter its capital

structure.


32/41

Weighted Average Cost of Capital

WACC is defined as the weighted average cost ofvarious sources of finance.

WACC is considered as the minimum rate of return

required from project to pay-off the expected return of

investors.The combined cost of Equity capital and Debt capital

is the WACC for a company as whole.

WACC = (Cost of Equity * %Equity) + (Cost of

Debt * % Debt)


33/41

Net Income Approach

This approach is given by Durant David.

According to this approach capital structure decision is

relevant to the valuation approach.

As such a change in the capital structure causes an overall

change in the cost of capital & also in the total value of thefirm.

There are usually 3 basic assumptions of the approach

- Corporate taxes do not exist.

- Debt content does not change the risk perception of theinvestors.

- Cost of debt is less than cost of equity.


34/41

Net IncomeApproach

Value of Firm (V)Where,

S = Market value of Equity.

B = Market value of Debt.

Market value of Equity (S)

Where,

NI = Net income available for Equity

shareholdersKe = Equity capitalization rate

eK

NIS

BSV
http://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Satish.dochttp://localhost/var/www/apps/conversion/tmp/scratch_5/Examples%20Satish.doc


35/41

Net Operating Income Approach

Value of the firm is independent on its Capitalstructure.

It assumes that the Weighted average cost of capital, is

unchanged irrespective of the level of gearing.

NOI approach is opposite to the NI approach.Market value of the firm depends upon the net

operating profit or EBIT.


36/41

Net Operating Income Approach contd

The NOI approach is based on the following assumptions:

The cost of debt is constant.

There is no tax.

Overall cost of the capital of the firm is constant.


37/41


Value of the Firm (V)

Where,

EBIT : Earnings before interest andtax

KO : Overall cost of capital.

Value of Equity (S)

Where,

S = Market value of Equity.B = Market value of Debt.

OK

EBITV

BVS


38/41


Cost of Cost of Equity

Capital

WACC

Cost of Debt

0


39/41

MM THEORY

Cost of capital is independent of Capital structure.

It closely resembles Net operating income approach.

It argues the overall cost of capital is the weighted

average of cost of debt and cost of equity capital.

Investors are rational

There are no taxes or transaction cost.


40/41

Conclusion

Under the net income and net operating

approach cost of capital increases if the

leverage decreases and vice-versa.

Under the traditional and MM theory the cost

of capital decreases if the leverage also

decreases and vice-versa.


41/41

Documents

Financial Risk and Relationship Between Cost of Capital