Cost of CapitalBangladesh Perspective

Chapter 6

Definition It is the price the firm has to pay to the

suppliers of long term capital for using their money in the business.

Interpretation: The minimum rate of return the firm must generate on every Taka it takes from the suppliers of long term capital to minimally satisfy them

Separation of investment decision from financing decision.

The Rationale for WACC, kw

The Standard WACC Equation kw = WACC = wd(kd)(1-t) + wpr(kpr) +

we(ks)

Ignore Preferred Stock Now

kw = WACC = wd(kd)(1-t) + we(ks)

With 40 % Debt Ratio, kd = 10%, ks = 25%, and a tax rate of 30%, the kw is 17.8%

Rationale - Continued Investment Taka 10,00,000 Minimum return required After tax 1,78,000 Debt Holders’ Share (10% of Taka 4,00,000)

Taka 40,000 Return required by shareholders:.25*6,00,000 = 1,50,000 Before Tax Required Return 2,54,286 Interest on Debt 40,000 Return after Interest 2,14,286 Tax 64,286 Return After Tax 1,50,000 Shareholders’ Required return on their share of Investment 1,50,000 Minimally satisfied Get a better return, everything now belongs to shareholders.

Cost of Long-Term Debt Kd = Yield to Maturity Use and Forms of Long-term Debt in Bangladesh

No Bonds or Debentures in The Market› ACI Zero Coupon Bonds› IBBL Perpetual Bonds

Spread Between Deposit Rate and Lending Rate

Cost of Long-term Debt from Financial Institution

Cost of Callable Bonds A bond paying an annual coupon of 12

percent, maturing in 15 years, callable after 8 years at a call price of Taka 1050. What is the yield to call if current price is Taka 950?

PV = -950, PMT = 120, N = 8, FV = 1050 CPT [I/Y] = 13.44%. This should be used as before tax cost of debt.

Under what circumstances will the company call the callable bond?

Cost of Convertible Bonds A 12 percent annual coupon convertible

bond maturing in 2020 is convertible after 2016 into 50 common shares per Bond. Current price of the bond is Taka 1020. Current share price of the company is taka 16.5. Share price growth historically has been 10 percent. What is the before tax cost of the bonds as a source of LT. Debt Capital?

Value of Convertible Bonds: Conversion Ratio and Conversion Price

Conversion Price = Taka 20 Conversion Ratio = 50 shares per Bond Straight or Pure Bond Value (Assuming

a required return of 13%): Taka 952.01. Known as Floor Value

Market Value of the Bond with the assumptions/information. Assume you will convert it in 2016 (4 years from now).

Value of Convertible Bonds: Conversion Value

Expected stock price in 4 years: 16.5*(1+.10)4 = 24.16

Investors will convert to 50 shares per Bond, in 2016

Value of the stocks in 2016: 50*24.16 = 1,208 Implied Return indicated to Bond Investors:

Current Price 1020, 4 payments of Taka 120 and Taka 1,208 at the end of 2016: 15.43 percent.

Cost of Convertible Bond Capital is greater than coupon rate.

Risk Premium for Long-Term Debt

Inflation Expectation and Real Rate of Return› Inflation : 30 year average: 7.54%› Real Interest Rate: 7-8.6%, at present (Lending Rate)› T-Bond Rates› Availability and Liquidity› Spread between Deposit Rate and Lending Rate: 5-6%› Nominal Lending Rate: 7.5 +7-8.6% = 14.5-16.1%

(Lending)› Nominal Lending rate: 7.5(IP) + 3.5(Real Deposit Rate)

+ 5.5% (Spread between deposit and lending) = 16.5%› kd for average risk L.T. Debt now = 16.5%

Cost of Equity Capital (No new shares issued)

Company with Constant Earnings. No retained earnings, since there is no growth.

Company pays out all earnings as dividend.

Value= Po = D/k = Earnings/k Required Return = k = D/Po = E/Po Cost of Equity = k = 1/PE Ratio

Cost of Equity Capital (No new shares issued)

Company with Growing Earnings. Company retains part of earnings to support growth.

Value = Po = D1/(k-g) + g = Do(1+g)/(k-g)+g

k = D1/P0 + g = Div Yield + Cap Appreciation

How do you determine g?

Growth Rate Choices Retention Growth

› G = ROE*(1-DPO) Sustainable Growth Rate

G* = M(b)(1+D/E)/[(A/S)-M(b)(1+D/E)] M= Margin on sales, b = target retention rate, (A/S)

= ratio of total assets to sales.

The Choices for Growth Rate

1. Historical Growth Rate, Roughly2. Regression Slope (Time Is Predictor)3. GDP Growth (The Business Should

Grow with The Whole Economy)4. Inflation Rate5. Historical ROE Growth6. Asset Growth

Determining Cost of Equity with Gordon Growth Model:Case in Bangladesh

If it pays dividend, › Must recognize total dividend expectation,

includes Cash Dividend Bonus Shares Right Shares

› For Right Shares, We Need Ratio of Issue Issue Price Market Price

On issue date

Cost of Equity Capital (No new shares issued)

Bond Yield + ke = Bond Yield + Premium (Required Return

Reflecting Risk)

Cost of Equity Capital (No new shares issued)

Capital Asset Pricing Model› ke = krf + (km-krf) Betai (Required Return

Reflecting Risk) In Bangladesh, Beta estimates are not

reliable We do not have dependable data on market

returns Stock price fluctuations had been too severe

to produce reliable estimate of beta. Beta values fluctuate too much year to year

Risk Premium for Investment in Stocks

Proxy for Stock Market› DSE All-Share Index› DSE General Index (DGEN)› DSE 30› DSEX

Lack of Long History Representativeness Complexity in deriving dividend yield for DSE

20

Measuring Returns in The Stock Market

Capital Gains Dividend Yield

› Cash Dividend› Bonus Shares

Marginal Cost of Capital

Cost of New Equity Adjust for Floatation cost

ke = [D1/P0(1-f)] + g (No adjustment for tax rebate)

No Adjustment Necessary for New Debt-Capital

Cost of Preferred Stock Capital kpr = Dpr/Net Price per Pr. Share

Weights for WACC Book Value Weights Market Value Weights Target Structure Weights

Recommended WACC Equations

For a firm with no debt, paying constant dividend less than 20%: WACC = ks = D/P0 or 1/PE Ratio For a firm with no debt, paying dividend less than 20% growing at g: WACC: Ks = D1/Po + g. Or required return on stock as indicated by CAPM WACC = Ks = krf + (km-krf)Beta   For a firm with no debt, paying dividend: WACC = Adjusted cost of retained earnings Ks = D1(1+tr)/Po + g. Or required return on stock as indicated by CAPM Ks = krf + (km-krf)Beta For a firm with debt, paying no dividend: WACC = Wd(kd-t)+We(Ks) For a firm with debt, paying dividends: WACC = Wd*kd((1--t)+We(Adjusted Ks)

Tax Rates Tax rate, t = 42.5 percent for banks

and financial institutions, 45 percent of mobile phone

operators 30 percent for public companies other

than banks and financial institutions. 37.5 Percent for private companies

other than banks and financial institutions.

WACC VS Risk-Adjusted Discount Rate

Return ** Risk- Adjusted Discount Rate

*

* * *

* WACC

* * *

Risk

Risk-Adjustment in Capital Budgeting

Risk Adjusted Discount Rate

Risk Use judgment to add 3 to 4 % to previous level of

required return

RADR