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8/8/2019 Prof P. Krishna
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Financial Management
Topic 4
Cost of Capital
8/8/2019 Prof P. Krishna
http://slidepdf.com/reader/full/prof-p-krishna 2/26
Introduction
Introduction
Opportunity Cost of Capital
WACC Preview
Cost of Debt
* Cost of Redeemable Debt
* Cost of Perpetual Debt
* Post Tax Cost of Debt
* Historical Yields and Current Yields
8/8/2019 Prof P. Krishna
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* Treating Floatation Cost and Issue at Premium/Discount
* Which Debts to Consider
Cost of Capital
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CONTENTS
Cost of Preferred Capital
Cost of Equity
*Dividend Capitalization Approach
* Earning Based Approach
* CAPM Based Approach
* Cost of External Equity
Assigning Weights
* al
Contents
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Marginal Proportions
* Book Value Vs. Market Value Proportions
Marginal Cost of Capit
Contents
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WACC as Discount Rate & Risk
Pure Play Approach-
* Unlevering & Relevering Beta
* Factors Affecting Cost of Capital
Optimal Capital Budget
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Cost of capital is an extremely important input requirement for capital budgeting
decision.
Without knowing the cost of capital no firm can evaluate the desirability of the
implementation of new projects.
Cost of capital serves as a benchmark for evaluation.
Introduction
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The basic determinant of cost of capital is the expectations of the suppliers of capital.
The expectations of the suppliers of capital are dependent upon the returns that
could be available to them by investing in the alternatives.
The returns provided by the next best alternative investment is called opportunity
cost of capital. This could serve as basis for cost of capital.
Opportunity Cost of Capital
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Besides opportunity cost the cost of capital must also consider
1. Business risk 2.Financial risk
There are be many suppliers of capital; predominantly two
1.Debt 2.Equity
WACC is a composite figure reflecting cost of each component multiplied by the
weight of each component.
WACC = wex re+ wpx rp+ wdx rdwe= Proportions of equityre= Cost of equity
wp= Proportion of pref capitalrp= Cost of preference capital
wd= Proportion of Debt rd= Cost of debt
WACC
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Cost of redeemable debt is determined by equating the cash flows of the instrument
to its market price
Cost of perpetual debt, rd is Po=Ct or rd= Ct
r d Po
Cost of redeemable debt is Post tax cost of debt is
N
Po = Ct + R___ Post tax cost of debt = rd (1-T)
t=1 (1+ r d ) t ( 1+ r d ) N
For a bond paying 11% coupon annually and redeemable after three years at Rs 105
that sells for Rs 95 the cost of debt is 10.12% given by
95= 11 X 0.6 + 11 X 0.6 + 11 X 0.6 + 105
1 + rd (1+rd)2
(1+rd)3
( 1+rd)4
Cost of Debit
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To mobilize debt one has to incur floatation cost which increase the cost of debt
While computing the cost of debt the claims of the suppliers of long-term debt are
only considered.
Cost of Debit
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Preference capital is in between pure debt and equity that explicitly states a fixed
dividend.
The dividend has claim prior to that of equity holders.
But unlike interest on the debt the dividend on preference capital is not tax
deductible
Cost of preference capital , rp is determined by equating its cash flows to market
price. There is no adjustment of tax.
Introduction
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Cost of equity capital is most difficult to determine because
* It is not directly observable
* There is no legal binding to pay any compensation and
* It is not explicitly mentioned
This does not mean that cost of equity is zero
Equity capital is classified as
1) Internal: the profits that are not distributed but retained by the firm in funding
the growth, is referred as internal equity and
2) External: equity capital raised afresh to fund, is called external equity
Cost of Equity Capital
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Cost of equity is determined by
* Dividend Capitalization approach
* CAPM based approach.
Both approaches are driven by market conditions and measure the cost of equity in
an indirect manner
The price to be used in any of the model is the market determined
Approaches Cost of Equity
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Dividend capitalization approach determines the cost of equity by equating the
stream of expected dividends to its market price. For constant dividend cost of equity
is equal to dividend yield
Dividend Capitalization Approach
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Earnings based approach, as manifested by Dividend Capitalization Approach
equates the value
Under the special case when the firm uses the earnings at the same rate as
expected by shareholders earnings based approach measures the cost of equity
Cost of Equity PE Approach
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CAPM based determination of cost of equity considers the risk characteristics that
dividend capitalization approach ignores.
Determinants of cost of equity under CAPM based approach include three
parameters;
* the risk free rate, rf
* the market return, rmand
* , as measure of risk
Cost of Equity CAPM Approach
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, the primary determinant of risk governs the cost of equity.
re= rf+ x (rmrf)
Cost of Equity CAPM Approach
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CAPM based determination of cost of equity is regarded superior as
* it relies on the market information and
* incorporates risk
* it need not know the dividend policy.
Dividend capitalization approach
* does not consider risk of the dividend
* has assumption of constant pay out ratio.
Cost of Equity DDM Vs CAPM Approach
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There are three major differences in the INTERNAL and EXTERNAL equity Existence
of flotation costUnder utilization of external equityUnder pricing of fresh capital If
floatation cost is 5% of the issue price and cost of internal equity determined either
through DDM or CAP-M is 16% then the cost of fresh equity shall be 16.84%
(16/0.95).
Cost of Internal and External Equity
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After cost of each component is determined they need to be multiplied by the
respective proportions to arrive at WACC.
The proportions may be based on
1) marginal
2) book value or
3) market value
The weights based on the target capital structure are most appropriate though the
current capital structure may not conform.
Assigning Weights
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The weights for computation of WACC can either be based on book values or market
values
Though book value weights appear convenient and practical it lacks conviction
ignoring current trends.
Use of market value based weights is technically superior reflecting the current
expectations of investors.
Book Values Vs Market Values
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WACC as discount rate, implies that acceptance of projects do not alter the existing
capital structure.
When project is large compared to the existing operations, the capital structure as
well as the cost of each component would more likely increase.
Lenders tend to raise cost with the quantum, so could be the case with equity
suppliers.
In such cases WACC is inappropriate as hurdle rate. Marginal (incremental) cost of
capital is more appropriate.
Marginal Cost of Capital
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In practice Marginal Cost of Capital must be used in determination of the optimal
capital budget.
Marginal cost of capital governs the value addition.
Incremental benefits must exceed incremental cost.
The capital expenditure level at which incremental benefits are equal to the
incremental cost is Optimal capital budget.
Optimal Capital Budget
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The discount rate for the project must be appropriate to its risk.
In most cases WACC adequately represents the risk since most projects selected by
the firms belong to the line of activity.
Where project has substantially different risk profile blind use of WACC as discount
rate may cause
1.erroneous acceptance of riskier project due to lower discount rate or
2.erroneous rejection of less risky project due to higher discount rate.
WACC and RISK
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Risk-adjusted WACC must be used as discount rate for the cash flow.
Most popular method to incorporate such risk is called a pure-play approach,
* identifying a firm that most resembles the risk profile of the new project.
* beta of the firm is adjusted for its leverage to find an all equity beta, called
unleveringand then
* re-adjusting for the proposed capital structure of the project, called relevering.
* The value of so arrived is used in calculating the WACC
Pure Play Approach (Adjusting for Risk)