Cost of Capital
- Define
cost of capital. Mention the importance of cost of capital? Cost of
capital computation based on certain assumptions. Discuss.
Ans. Cost of capital is an integral part of
investment decision as it is used to measure the worth of investment proposal
provided by the business concern. It is used as a discount rate in determining
the present value of future cash flows associated with capital projects. Cost
of capital is also called as cut-off rate, target rate, hurdle rate and
required rate of return. When the firms are using different sources of finance,
the finance manager must take careful decision with regard to the cost of
capital; because it is closely associated with the value of the firm and the
earning capacity of the firm.
Cost of capital is the rate of return that a
firm must earn on its project investments to maintain its market value and
attract funds.
Cost of capital is
the required rate of return on its investments which belongs to equity, debt
and retained earnings. If a firm fails to earn return at the expected rate, the
market value of the shares will fall and it will result in the reduction of
overall wealth of the shareholders.
According to the
definition of John J. Hampton “ Cost of capital is the rate of return
the firm required from investment in order to increase the value of the firm in
the market place”.
According to the
definition of Solomon Ezra, “Cost of capital is the minimum required
rate of earnings or the cut-off rate of capital expenditure”.
Assumption
of Cost of Capital
Cost of capital is based on certain
assumptions which are closely associated while calculating and measuring the
cost of capital. It is to be considered that there are three basic concepts:
1. It
is not a cost as such. It is merely a hurdle rate.
2. It
is the minimum rate of return.
3. It
consis of three important risks such as zero risk level, business risk and
financial risk. Cost of capital can be measured with the help of the following
equation.
K =
rj + b + f.
Where,
K =
Cost of capital.
rj = The riskless cost of the
particular type of finance. b = The business risk premium.
f =
The financial risk premium.
IMPORTANCE
OF COST OF CAPITAL
Computation of cost of capital is a very
important part of the financial management to decide the capital structure of
the business concern.
Importance
to Capital Budgeting Decision
Capital budget decision largely depends on
the cost of capital of each source. According to net present value method,
present value of cash inflow must be more than the present value of cash
outflow. Hence, cost of capital is used to capital budgeting decision.
Importance
to Structure Decision
Capital structure is the mix or proportion of
the different kinds of long term securities. A firm uses particular type of
sources if the cost of capital is suitable. Hence, cost of capital helps to
take decision regarding structure.
Importance
to Evolution of Financial Performance
Cost of capital is one of the important
determine which affects the capital budgeting, capital structure and value of
the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance
to Other Financial Decisions
Apart from the above points, cost of capital
is also used in some other areas such as, market value of share, earning
capacity of securities etc. hence, it plays a major part in the financial
management.
Q2. Explain the computation of specific sources of cost
of capital How over all cost of capital is calculated?
Ans. In making
investment decisions, cost of different types of capital is measured and
compared. The source, which is the cheapest, is chosen and capital is raised.
The area to
be focussed on is how to measure the cost of different sources of capital. It
is based largely on forecasts and is subject to various margins of error. While
computing the cost of capital, care should be taken for factors like needs and
requirements of the company, the conditions under which it is raising its
capital, corporate policy constraints, and level of expectations of investors.
A company
raises funds from different sources, and therefore, composite cost of capital
can be determined after specific cost of each type of fund has been obtained.
It is, therefore, necessary to determine the specific cost of each source in
order to determine the minimum obligation of a company,i.e., composite cost of
raising capital
Computation
of cost of capital consists of two important parts:
- Measurement
of specific costs
- Measurement
of overall cost of capital
Measurement
of Cost of Capital
It
refers to the cost of each specific sources of finance like:
• Cost
of equity
• Cost
of debt
• Cost
of preference share
• Cost
of retained earnings
Cost
of Equity
Cost of equity capital is the rate at which
investors discount the expected dividends of the firm to determine its share
value.
Conceptually the cost
of equity capital (Ke) defined as the “Minimum rate of return that a
firm must earn on the equity financed portion of an investment project in order
to leave unchanged the market price of the shares”.
Cost
of equity can be calculated from the following approach:
• Dividend
price (D/P) approach
• Dividend
price plus growth (D/P + g) approach
• Earning
price (E/P) approach
• Realized
yield approach.
Dividend
Price Approach
The cost of equity capital will be that rate
of expected dividend which will maintain the present market price of equity
shares.
Dividend
price approach can be measured with the help of the following formula:
Where,
Ke
= Cost of equity capital
D = Dividend per equity share
Np
= Net proceeds of an equity share
Dividend
Price Plus Growth Approach
The cost of equity is calculated on the basis
of the expected dividend rate per share plus growth in dividend. It can be
measured with the help of the following formula:
Ke= (D/Np ) + g
Where,
Ke
= Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend Np
= Net proceeds of an equity share
Earning
Price Approach
Cost of equity determines the market price of
the shares. It is based on the future earning prospects of the equity. The
formula for calculating the cost of equity according to this approach is as
follows.
Ke = E/NP
Where,
Ke = Cost of equity capital
E = Earning per share
Np = Net proceeds of an equity share
Realized
Yield Approach
It is the easy method for calculating cost of
equity capital. Under this method, cost of equity is calculated on the basis of
return actually realized by the investor in a company on their equity capital.
Ke = PV * D
Where,
Ke = Cost of equity capital.
PVƒ
= Present value of discount factor.
D = Dividend per share.
Capital
asset pricing model approach
This model
establishes a relationship between the required rate of return of a security
and its systematic risks expressed as ―β‖. According to this model,
Ke = Rf + β
(Rm – Rf)
Where Ke is
the rate of return on share
Rf is the
risk free rate of return
β is the
beta of security
Rm is rate
of return on market portfolio
Beta (β) of
a security is a measure of a stock's volatility in relation to the market. By
definition, the market has a beta of 1.0, and individual stocks are ranked
according to how much they deviate from the market. A stock that swings more
than the market over time has a beta above 1.0. If a stock moves less than the
market, the stock's beta is less than 1.0. High-beta stocks are supposed to be
riskier but provide a potential for higher returns.Low-beta stocks pose less
risk but also lower returns.
Beta is a
key component for the Capital Asset Pricing Model (CAPM), which is used to
calculate cost of equity. We know that the cost of capital represents the
discount rate used to arrive at the present value of a company's future cash flows.
All things being equal, the higher a company's beta, the higher its cost of
capital discount rate. The higher the discount rate, the lower the present
value placed on the company's future cash flows.
In short,
beta can impact a company's share valuation.The CAPM model is based on some
assumptions, some of which are:
Investors
are risk-averse.
Investors
make their investment decisions on a single-period horizon.
Transaction costs are low and therefore can be ignored. This translates to assets
being bought and sold in any quantity desired. The only considerations that
matter are the price and amount of money at the investor‘s disposal.
All
investors agree on the nature of return and risk associated with each
investment.
Cost
of Debt
Cost of debt is the after tax cost of
long-term funds through borrowing. Debt may be issued at par, at premium or at
discount and also it may be perpetual or redeemable.
Debt
Issued at Par
Debt issued at par means, debt is issued at
the face value of the debt. It may be calculated with the help of the following
formula.
Kd
= (1 – t) R
Where,
Kd = Cost of debt capital t = Tax
rate
R =
Debenture interest rate
Debt
Issued at Premium or Discount
If the debt is issued at premium or discount,
the cost of debt is calculated with the help of the following formula.
Kd = I (1-t) / NP
Where,
Kd
= Cost of debt capital
I = Annual interest payable Np =
Net proceeds of debenture
t =
Tax rate
Cost
of Perpetual Debt and Redeemable Debt
It
is the rate of return which the lenders expect. The debt carries a certain rate
of interest.
Kdb =
|
I +
1 / n(P − N p )n
|
|
1
/ n(P +
N p ) / 2
|
||
Where,
I =
Annual interest payable P = Par value of debt
Np = Net proceeds of the debenture
n = Number of years to maturity
Kdb
= Cost of debt before tax.
Cost
of debt after tax can be calculated with the help of the following formula:
K d
a= K d b× (1–t)
Where,
Kda
= Cost of debt after tax
Kdb
= Cost of debt before tax
t = Tax rate
Cost
of Preference Share Capital
Cost of preference share capital is the
annual preference share dividend by the net proceeds from the sale of
preference share.
There are two types
of preference shares irredeemable and redeemable. Cost of redeemable preference
share capital is calculated with the help of the following formula:
K p = Dp
N
p
Where,
Kp
= Cost of preference share
Dp
= Fixed preference dividend
Np
= Net proceeds of an equity share
Cost of irredeemable preference share is calculated with
the help of the following formula:
Kp
|
=
|
D p
(P −
N p )/n
|
||||||
(P
N p )/2
|
||||||||
Where,
|
||||||||
Kp
=
|
Cost
of preference share
|
|||||||
Dp
=
|
Fixed
preference share
|
|||||||
P
=
|
Par
value of debt
|
|||||||
Np
=
|
Net
proceeds of the preference share
|
|||||||
n
=
|
Number
of maturity period.
|
|||||||
Cost
of Retained Earnings
Retained earnings is one of the sources of
finance for investment proposal; it is different from other sources like debt,
equity and preference shares. Cost of retained earnings is the same as the cost
of an equivalent fully subscripted issue of additional shares, which is
measured by the cost of equity capital. Cost of retained earnings can be
calculated with the help of the following formula:
Kr=Ke (1 – t) (1 – b)
Where,
Kr
= Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b = Brokerage cost
Measurement
of Overall Cost of Capital
It is also called as weighted average cost of
capital and composite cost of capital. Weighted average cost of capital is the
expected average future cost of funds over the long run found by weighting the
cost of each specific type of capital by its proportion in the firms capital
structure.
The
computation of the overall cost of capital (Ko) involves the
following steps.
(a) Assigning
weights to specific costs.
(b) Multiplying
the cost of each of the sources by the appropriate weights.
(c) Dividing
the total weighted cost by the total weights.
The overall cost of capital can be calculated
with the help of the following formula; Ko = Kd Wd
+ Kp Wp + Ke We + Kr Wr
Where,
Ko
= Overall cost of capital Kd = Cost of debt
Kp
= Cost of preference share Ke = Cost of equity
Kr
= Cost of retained earnings
Wd=
Percentage of debt of total capital
Wp = Percentage of preference share
to total capital We = Percentage of equity to total capital
Wr
= Percentage of retained earnings
Weighted
average cost of capital is calculated in the following formula also:
Σ XW Kw ΣW
Where,
Kw
= Weighted average cost of capital
X =
Cost of specific sources of finance
W =
Weight, proportion of specific sources of finance.
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