fM-Cost Of Capital

8/14/2019 fM-Cost Of Capital

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COC

Cost of Capital


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COC

The financing decision Cost of capital Leverage

Capital Structure The Dividend Decision

Working Capital


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COC

Liabilities & Equity AssetsCurrent Liabilities Current assets

Long-term debt Fixed AssetsPreferred StockCommon Equity

The financing decisionThe financing decision


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COC

Liabilities & Equity Assets

Current Liabilities Current assets

Long-term debt Fixed AssetsPreferred StockCommon Equity

The financing decisionThe financing decision

Capital Structure


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COC

What is cost of Capital?


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COC

Cost of Capital

Cos cost of capital = Av. Cost of Various componentsemployed by it

Cos cost of Capital =Average rate of return required byby the investors who provide capital

to the company


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For Investors

the rate of return on a security

Cost Of Capital


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For Financial Managers

The rate of return is a cost of raisingfunds that are needed tooperate the firm.

Cost Of Capital


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In other words,

the cost of raising fundsis the firms

cost of capital.

Cost Of Capital


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Cost of Capital

used for evaluating

Investment projectsDetermining Capital structureAssessing leasing proposals


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Bonds Preferred Stock

Common Stock

Each of these offers a rate of returnto investors.

This return is a cost to the firm.

Cost of capital actually refers tothe weighted cost of capital

a weighted average cost of financing

sources.

How can the firm raise capital?


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The Weighted Cost of CapitalThe Weighted Cost of Capital

A companys cost of Capital is the weighted average cost of Various sources of finance used by it

EquityPreference andDebt


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Company uses

Equity 50%Preference 10%Debt 40%

Components costEquity 16%Preference 12%Debt 8%

WACC = (Proportion of Equity)(Cost of Equity)+(Proportion of Preference )(Cost of Pref )+(Proportion of Debt)(Cost of Debt)

= (0.5)(16)+(0.10)(12)+(0.4)(8)

= 12.4%


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Only three types of capital are used

Debt includes short term and long term debt

Non interest bearing liabilities,trade creditors

are not included in WACC


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Rationale behind WACC

if ROR> COC than share holders benefit

A firm employs equity and Debt in equal proportionsAnd whose cost of equity and Debt are 14% and 6%

WACC=(0.5X14 +0.5X6)= 10%

If the firm invest Rs 100 million on a project @12%

Total Return on Project -Interest on DebtEquity Funds100x.12 -50x.6

50

18% IS MORE THAN COST ON EQUITY 14%SHARE HOLDERS WILL BENEFIT

=18%


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Company COC AND Project COC

CCOC is the rate of return expected by existingCapital Providers

PCOC is the rate of return expected by existingcapital providers or investment the companyProposes to undertake


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Cost of Debt


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For the issuing firm, the cost of debt is :

DebentureLoansCommercial Papers

Yield to maturity of that instrument

Cost of Debt

DEBT


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Cost of Debt is Value of R D in the Equation

I + FT=1 (1+r d)t ( 1+r d)n

n

P0 =

Where P O = Current Market Price of DebentureI = Annual interest paymentn = Number of years left to maturityF = Maturity value of debenture

r d = Yield to Maturity


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Yield To Maturity

I+(F-P)/n0.6P o + .4F

R d =

Face Value=Rs 1000Coupon Rate=12%Remaining Period of Mat=4 Yr Current Market Price=Rs1040

120+(1000-1040)/40.6x1040 + .4x1000R d =

=10.7%


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Firm Using different instruments of Debt

Debt Instrument Face Value Mkt Value Coupon Rate Current Rate

Non Convertible Rs 100 mil Rs 104 mil 12% 10.7%DebenturesBank Loan Rs 200mil Rs 200 mil 13% 12%C Papers Rs 50 mil Rs 48.25 NA 7.39

ACD =10.7(104/352.25) +12%(200/352.25+7.39(48.25/352)=10.98%

Post tax cost of Debt =Pre tax cost of Debt(1-taxrate)= 10.98%(1-tax rate)= 10.98%(1-.30)= 7.69%


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with stock with debtEBIT 4,00,000 400,000

- interest expense 0 (50,000 )EBT 400,000 350,000- taxes (34%) (136,000) (119,000)EAT 2,64,000 231,000

Example : Tax effects of financing with debt

Now, suppose the firm pays Rs50,000

in dividends to the stockholders.


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COC

with stock with debtEBIT 4,00,000 400,000

- interest expense 0 (50,000 )EBT 400,000 350,000- taxes (34%) (136,000) (119,000)EAT 2,64,000 231,000Dividend 50.000 -

Example : Tax effects of financing with debt

Retained earnings 214,000 231,000


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COC

Post-taxCost of

Debt

Before-taxCost of

Debt

Tax= _

33,000 = 50,000 - 17,000OR 33,000 = 50,000 ( 1 - .34 )

Or ,if we want to look at percentage costs :


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COC

After-tax%Cost of

Debt

Before-tax%Cost of

Debt

marginalTax Rate=

_

1-

Rd = Rd (1 - T)Rd = Rd (1 - T)

.066 = .10 (1 - .34).066 = .10 (1 - .34)


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COC

A Company issues a Rs1,000 par,20 year bond paying the market rateof 10%. Coupons are annual. The

bond will sell for par since it paysthe market rate, but flotation costsamount to Rs50 per bond.

What is the pre-tax and after-taxcost of debt for the Corporation?

Example: Cost of Debt


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COC

Pre-tax cost of debt:950 = 100(PVIFA 20, k d ) +

1000(PVIF 20, k d ) using the calculator,

Rd = 10.61%.

After-tax cost of debt: rd = Rd (1 - T)

Rd = .1061 (1 - .34)

Rd = .07 = 7%

So 10 % cost of Bond Costs theFirm only 7%(With floatationCosts) sinceThe interest isTax deductible


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COC

Cost of Preference Stock


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COC

Cost of Preference

1 carries a fixed rate of dividend

2 it is redeemable in nature

3 preference dividend at regular interval

3 not tax- deductible expense

4 does not produce any tax saving

5 COP is = to its yield


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COC

Cost of Capital of Preference Shares

PD +(P n- P o)/n(P n + p o)/2

Kp =

WhereKp is Cost of capital of preference capital

Pd is annual preference dividend at fixed rate Pn is amount payable at the time of redemption Po is net proceed on issue of preference shares n is number of years


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COC

Cost of Preference

Face Value :Rs 100Dividend Rate :11%Maturity Period :5 Yr Market Price Rs 95

11+(100-95)/n0.4x100+.6x95=12.37%

yieldEXP

If more than one issue of preference stock outstanding thanWe apply average yield of preference like debt


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COC

There are 2 sources of Equity:

3) Internal equity

(retained earnings),&

2) External equity

(new issues)

Do these 2 sources have the same cost?

Cost of EquityCost of Equity


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COC

Since the stockholders own the firms retainedearnings, the cost is simply the stockholdersrequired rate of return.

Why? If managers are investing stockholders

funds, stockholders will expect to earn anacceptable rate of return.

Cost of Internal Equity


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COC

Cost of External Equity

Far more difficult to measure than other sources

No Coupon rate in equity capital

Value comprises

EarningsDividendMarket Value

Dividend decisions Depends upon Board

Market value depends upon lot of factors


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COC

Cost Of External Equity

D1 + D 2 ----------+ D n + P n( 1+k e)1 ( 1+ke)2 ( 1+ke)n ( 1+ke)n

P O =

Where

Po is Current Market Price of Equity SharesPn is share Market Price after n year

D1 is dividend receivable over different yearsKe Req rate of return of share holders


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The weighted cost of capital isjust the weighted average costof all of the financing sources.

Weighted Cost of CapitalWeighted Cost of Capital


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COC


WACC = r e. w1 + rp.w2+ rd.w 3(1-t c)

WhereWACC is cost of Weighted Av. Cost of Capitalre is cost of equity capitalrd is after tax cost of debtW1 Proportion of Equity capital in capital Structure

W3 Proportion of Debt CapitalW2 Proportion of Pref.Capitaltc is corporate tax rate


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COC

Cost of specific sources of capital in a company are

R e =16%

R p =14%

R d =12%

Market Value proportion of Equity,Preference and Debt

We =0.60Wp =0.05Wd =0.35

Tax rate is 30%

Sources Proportions Cost WCost

1 2 3Debt .60 16.0% 9.60Preference .05 14.0% 0.70Equity .35 8.4% 2.94

WACC= 13.24%


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COC

Capital

Source Cost Structure

debt 6% 20%

preferred 10% 10%

common 16% 70%



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COC

Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16)

= 13.4%

Weighted Cost of Capital


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COC

The Concept of COC is too Academic

The cost of Equity is Equal to dividend rate or ROE

Retained Earnings are either Cost free or cheaper than External Equity

Share Premium has no Cost

Depreciation has no cost

The COC can be defined in terms of Accounting Based

Measures

Co. can apply same COC to all Projects

Project heavily financed by debt has low WACC

SomeMisconceptions


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COC

Few Responses about Cost of Capital

We look at the profitability of InvestmentProposals from point of view of equityCapital.Our dividend rate is 10percentSo our cost of Capital is 10%

* Electrical


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COC


We dont calculate COC- it is tooAcademic and impractical

*Chemical


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Our rate of return is too high andThus it is not necessary

*Chemical

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fM-Cost Of Capital