Chapter 14 the Cost of Capital

Chapter 14

THE COST OF CAPITAL

Centre for Financial Management , Bangalore

OUTLINE

• Some Preliminaries

• Cost of Debt and Preference

• Cost of Equity

• Determining the Proportions

• Weighted Average Cost of Capital

• Weighted Marginal Cost of Capital

• Floatation Costs and the WACC

• Divisional and Project Cost of Capital

• Cost of Capital in Practice


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


WEIGHTED AVERAGE

COST OF CAPITAL (WACC)

WACC = wErE + wprp + wDrD (1 – tc)

wE = proportion of equity

rE = cost of equity

wp = proportion of preference

rp = cost of preference

wD = proportion of debt

rD = pre-tax cost of debt

tc = corporate tax rate


KEY POINTS

• Only three types of capital (equity; nonconvertible,

noncallable preference; and nonconvertible, noncallable

debt) are considered.

• Debt includes long-term debt as well as short-term debt.

• Non-interest bearing liabilities, such as trade creditors,

are not included in the calculation of WACC.


COMPANY COST OF CAPITAL AND

PROJECT COST OF CAPITAL

• The company cost of capital is the rate of return

expected by the existing capital providers.

• The project cost of capital is the rate of return expected

by capital providers for a new project the company

proposes to undertake

• The company cost of capital (WACC) is the right

discount rate for an investment which is a carbon copy

of the existing firm.


COST OF DEBT

n I F

P0 = + t = 1 (1 + rD)t (1 + rD)n

P0 = current price of the debenture

I = annual interest payment

n = number of years left to maturity

F = maturity value

rD is computed through trial-and-error. A very close

approximation is:

I + (F – P0)/n

0.6P0 + 0.4F rD =


ILLUSTRATION

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


COST OF PREFERENCE

Given the fixed nature of preference dividend and

principal repayment commitment and the absence of tax

deductibility, the cost of preference is simply equal to its

yield.


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


COST OF EQUITY

• Equity finance comes by way of (a) retention of earnings

and (b) issue of additional equity capital.

• Irrespective of whether a firm raises equity finance by

retaining earnings or issuing additional equity shares,

the cost of equity is the same. The only difference is in

floatation cost.

• Floatation costs will be discussed separately.


APPROACHES TO ESTIMATE

COST OF EQUITY

• Security Market Line Approach

• Bond Yield Plus Risk Premium Approach

• Dividend Growth Model Approach


SECURITY MARKET LINE

APPROACH

rE = Rf + E [E(RM) – Rf ]

rE = required return on the equity of the company

Rf = risk-free rate

E = beta of the equity of the company

E(RM) = expected return on the market portfolio

Illustration

Rf = 7%, E = 1.2, E(RM) = 15%

rE = 7 + 1.2 [15 – 7] = 16.6%


INPUTS FOR THE SML

While there is disagreement among finance practitioners, the

following would serve.

• The risk-free rate may be estimated as the yield on long-

term bonds that have a maturity of 10 years or more.

• The market risk premium may be estimated as the

difference between the average return on the market

portfolio and the average risk-free rate over the past 10

to 30 years.

• The beta of the stock may be calculated by regressing the

monthly returns on the market index over the past 60

months or so.


BOND YIELD PLUS RISK

PREMIUM APPROACH

Yield on the

long-term bonds

of the firm

Should the risk premium be 2 percent, 4 percent, or n

percent ? There seems to be no objective way of

determining it.

Cost of =

equity

+ Risk

premium


DIVIDEND GROWTH MODEL APPROACH

If the dividend per share grows at a constant rate of g

percent.

D1

P0 = rE – g

D1

So, rE = + g

P0

Thus, the expected return of equity shareholders, which in

equilibrium is also the required return, is equal to the

dividend yield plus the expected growth rate


GETTING A HANDLE OVER g

• Analysts’ forecasts of growth rate.

• Average annual growth rate in the preceding 5 - 10

years.

• (Retention rate) (Return on equity)


DETERMINING THE

PROPORTIONS OR WEIGHTS

• The appropriate weights are the target capital structure

weights stated in market value terms.

• The primary reason for using the target capital structure

is that the current capital structure may not reflect the

capital structure expected in future.

• Market values are superior to book values because in

order to justify its valuation the firm must earn

competitive returns for shareholders and debtholders on

the current (market) value of their investments.


WACC

Source of Capital Proportion Cost Weighted Cost

(1) (2) [(1) x (2)]

Debt 0.60 16.0% 9.60%

Preference 0.05 14.0% 0.70%

Equity 0.35 8.4% 2.94%

WACC = 13.24%


DETERMINING THE OPTIMAL

CAPITAL BUDGET

10 20 30 40 50 60 70 80 90 100 110 120 130 140

10

11

12

13

14

15

16

17

18

A

B

C

D

E

Marginal Cost of Capital Curve

Optimal Capital Budget

Amount (in million rupees)

14.6%

14.0% 13.2%

Return,

Cost (%)

Investment Opportunity Curve


DIVISIONAL AND PROJECT COST

OF CAPITAL

• Using WACC for evaluating investments whose risks are

different from those of the overall firm leads to poor decisions. In such cases, the expected return must be compared with the risk-adjusted required return, as calculated by the security market line.

• Multidivisional firms that have divisions characterised

by differing risks may calculate separate divisional costs of capital. Two approaches are commonly employed for this purpose:

• The pure play approach

• The subjective approach


FLOATATION COSTS

• Floatation or issue costs consist of items like

underwriting costs, brokerage expenses, fees of

merchant bankers, underpricing cost, and so on.

• One approach to deal with floatation costs is to adjust

the WACC to reflect the floatation costs:

WACC

Revised WACC = 1 – Floatation costs

• A better approach is to leave the WACC unchanged but

to consider floatation costs as part of the project cost.


SOME MISCONCEPTIONS

Several misconceptions characterise the calculation and

application of cost of capital in practice.

• The concept of cost of capital is too academic or

impractical.

• The cost of equity is equal to the dividend rate or return

on equity.

• Retained earnings are either cost free or cost

significantly less that the external equity.

• Share premium has no cost


SOME MISCONCEPTIONS

• Depreciation has no cost

• The cost of capital can be defined in terms of an

accounting-based measure.

• A company must apply the same cost of capital to all

projects.

• If a project is financed heavily by debt, its WACC is low.


SUMMING UP

• A company’s cost of capital is the weighted average cost of the various sources of finance used by it, viz., equity, preference and debt.

• Since debt and preference entail more or less fixed payments, estimating their cost is relatively easy.

• Three approaches are commonly used to estimate the cost of equity : security market line approach, bond yield plus risk premium approach, and dividend growth model approach.

• The appropriate weights in the WACC calculation are the target capital structure weights stated in market value terms

• In multidivisional firms, it is advisable to calculate divisional costs of capital.

• Floatation costs may be considered as part of project cost.

• Several misconceptions characterise cost of capital in practice.


Chapter 14 the Cost of Capital

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Transcript of Chapter 14 the Cost of Capital