Cost of Capital Cost of Capital By Prof. Manish B By Prof. Manish B Tardeja Tardeja
Cost of CapitalCost of Capital
By Prof. Manish B TardejaBy Prof. Manish B Tardeja
Liabilities & Equity Liabilities & Equity AssetsAssets
Equity SharesEquity Shares Current assets Current assets
Preference SharesPreference Shares
Long-term debtLong-term debt
Fixed assetsFixed assets
Current Liabilities Current Liabilities
Liabilities & Equity Liabilities & Equity AssetsAssets
Equity SharesEquity Shares Current assets Current assets
Preference SharesPreference Shares
Long-term debtLong-term debt
Fixed assetsFixed assets
Current Liabilities Current Liabilities
The investment decisionThe investment decision
IngredientsIngredients
Cost of capitalCost of capital
LeverageLeverage
Capital StructureCapital Structure
The Dividend DecisionThe Dividend Decision
Working CapitalWorking Capital
The financing decisionThe financing decision......
Liabilities & Equity Liabilities & Equity AssetsAssets
Equity SharesEquity Shares Current assets Current assets
Preference SharesPreference Shares
Long-term debtLong-term debt
Fixed assetsFixed assets
Current Liabilities Current Liabilities
Liabilities & Equity Liabilities & Equity AssetsAssets
Equity SharesEquity Shares Current assets Current assets
Preference SharesPreference Shares
Long-term debtLong-term debt
Fixed assetsFixed assets
Current Liabilities Current Liabilities
The financing decisionThe financing decision
Liabilities & Equity Liabilities & Equity AssetsAssets
Equity SharesEquity Shares Current assets Current assets
Preference SharesPreference Shares
Long-term debtLong-term debt
Current Liabilities Current Liabilities Fixed assetsFixed assets
Long-term debtLong-term debtPreference SharesPreference Shares Capital StructureCapital StructureCommon EquityCommon Equity
Cost of CapitalCost of Capital
For InvestorsFor Investors the rate of return on the rate of return on a security is a benefit of investing.a security is a benefit of investing.
For Financial ManagersFor Financial Managers that same that same rate of return is a cost of raising rate of return is a cost of raising funds that are needed to operate funds that are needed to operate the firm.the firm.
In other words, the cost of raising In other words, the cost of raising funds is the firm’s funds is the firm’s cost of capitalcost of capital..
How can the firm raise How can the firm raise capital?capital?
Debenture and Long term LoansDebenture and Long term Loans Equity SharesEquity Shares Preference SharesPreference Shares Each of these offers a Each of these offers a rate of returnrate of return to to
investors.investors. This return is a This return is a costcost to the firm. to the firm. ““Cost of capitalCost of capital” actually refers to the ” actually refers to the
weighted cost of capitalweighted cost of capital - a weighted - a weighted average cost of financing sources. average cost of financing sources.
The Weighted Cost of CapitalThe Weighted Cost of Capital
To calculate the firm’s weighted To calculate the firm’s weighted cost of capital, we must first cost of capital, we must first calculate the costs of the individual calculate the costs of the individual financing sources:financing sources:
Cost of DebtCost of Debt Cost of Preference SharesCost of Preference Shares Cost of Equity SharesCost of Equity Shares
Cost of Cost of DebtDebt
Cost of DebtCost of Debt
For the issuing firm, the For the issuing firm, the cost of debtcost of debt is: is: the the rate of returnrate of return required by required by
investors,investors, adjusted for adjusted for flotation costsflotation costs (any costs (any costs
associated with issuing new Debt), associated with issuing new Debt), and and
adjusted for adjusted for taxes.taxes.
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 4,00,000 4,00,000 4,00,000 4,00,000
- interest expense- interest expense 0 0 (50,000)(50,000)
EBTEBT 4,00,000 4,00,000 3,50,000 3,50,000
- taxes (34%)- taxes (34%) (1,36,000)(1,36,000) (1,19,000)(1,19,000)
EATEAT 2,64,000 2,64,000 2,31,000 2,31,000
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 4,00,000 4,00,000 4,00,000 4,00,000
- interest expense- interest expense 0 0 (50,000)(50,000)
EBTEBT 4,00,000 4,00,000 3,50,000 3,50,000
- taxes (34%)- taxes (34%) (1,36,000)(1,36,000) (1,19,000)(1,19,000)
EATEAT 2,64,000 2,64,000 2,31,000 2,31,000
Now, suppose the firm pays Rs.50,000 in Now, suppose the firm pays Rs.50,000 in dividends to the stockholders.dividends to the stockholders.
Example: Tax effects Example: Tax effects of financing with debtof financing with debt
with stockwith stock with debtwith debt
EBITEBIT 4,00,000 4,00,000 4,00,000 4,00,000
- interest expense- interest expense 0 0 (50,000)(50,000)
EBTEBT 4,00,000 4,00,000 3,50,000 3,50,000
- taxes (34%)- taxes (34%) (1,36,000)(1,36,000) (1,19,000)(1,19,000)
EATEAT 2,64,000 2,64,000 2,31,000 2,31,000
- dividends- dividends (50,000) (50,000) 0 0
Retained earnings Retained earnings 2,14,000 2,14,000 2,31,000 2,31,000
After-tax cost Before-tax cost TaxAfter-tax cost Before-tax cost Tax
of Debt of Debt Savingsof Debt of Debt Savings
-=
After-tax cost Before-tax cost TaxAfter-tax cost Before-tax cost Tax
of Debt of Debt Savingsof Debt of Debt Savings
33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000
-=
After-tax cost Before-tax cost TaxAfter-tax cost Before-tax cost Tax
of Debt of Debt Savingsof Debt of Debt Savings
33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000
OROR
-=
After-tax cost Before-tax cost TaxAfter-tax cost Before-tax cost Tax
of Debt of Debt Savingsof Debt of Debt Savings
33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000
OROR
33,000 = 50,000 ( 1 - .34)33,000 = 50,000 ( 1 - .34)
-=
After-tax cost Before-tax cost TaxAfter-tax cost Before-tax cost Tax
of Debt of Debt Savingsof Debt of Debt Savings
33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000
OROR
33,000 = 50,000 ( 1 - .34)33,000 = 50,000 ( 1 - .34)
Or, if we want to look at Or, if we want to look at percentagepercentage costs: costs:
-=
After-tax Before-tax After-tax Before-tax Marginal % cost of % cost of x Marginal % cost of % cost of x tax Debt Debt tax Debt Debt rate rate
-= 11
After-tax Before-tax After-tax Before-tax Marginal % cost of % cost of x Marginal % cost of % cost of x tax Debt Debt tax Debt Debt rate rate
KKdd = k = kd d (1 - T) (1 - T)
-= 11
After-tax Before-tax After-tax Before-tax Marginal % cost of % cost of x Marginal % cost of % cost of x tax Debt Debt tax Debt Debt rate rate
KKdd = k = kd d (1 - T) (1 - T)
.066 = .10 (1 - .34).066 = .10 (1 - .34)
-= 11
Example: Cost of DebtExample: Cost of Debt
Persistent Ltd. issues a Persistent Ltd. issues a Rs.1,000Rs.1,000 par, par, 20 20 yearyear debentures paying the market rate debentures paying the market rate of of 10%.10%. Interest is annual. The Interest is annual. The debenture will sell for par since it pays debenture will sell for par since it pays the market rate, but flotation costs the market rate, but flotation costs amount to amount to Rs.50Rs.50 per debenture. per debenture.
What is the pre-tax and after-tax cost of What is the pre-tax and after-tax cost of debt for Persistent Ltd.?debt for Persistent Ltd.?
Pre-tax cost of debtPre-tax cost of debt::
950 = 100(PVIFA 950 = 100(PVIFA 20, k20, kdd) + 1000(PVIF ) + 1000(PVIF 20, k20, kdd))
using the calculator,using the calculator,
kkdd = 10.61%. = 10.61%.
After-tax cost of debtAfter-tax cost of debt::
Kd = kd (1 - T)Kd = kd (1 - T)
Kd = .1061 (1 - .34)Kd = .1061 (1 - .34)
Kd = .07 = 7%Kd = .07 = 7%
Pre-tax cost of debtPre-tax cost of debt::
950 = 100(PVIFA 950 = 100(PVIFA 20, k20, kdd) + 1000(PVIF ) + 1000(PVIF 20, k20, kdd))
using the calculator,using the calculator,
kkdd = 10.61%. = 10.61%. So, a 10% So, a 10% debenturedebenture
costs the firmcosts the firm After-tax cost of debtAfter-tax cost of debt: only 7% (with: only 7% (with
Kd = kd (1 - T) Kd = kd (1 - T) flotation costs)flotation costs)
Kd = .1061 (1 - .34) Kd = .1061 (1 - .34) since the interestsince the interest
Kd = .07 = 7%Kd = .07 = 7% is tax deductible.is tax deductible.
Cost of Preference SharesCost of Preference Shares
Finding the cost of Preference Shares is Finding the cost of Preference Shares is similar to finding the rate of return, similar to finding the rate of return, except that we have to consider the except that we have to consider the flotation costs associated with issuing flotation costs associated with issuing Preference Shares.Preference Shares.
Cost of Preference Cost of Preference SharesShares
Formula:Formula:
kp = = kp = = DDPoPo
DividendDividend PricePrice
Cost of Preference Cost of Preference SharesShares
Formula:Formula:
kp = = kp = =
From the From the firm’sfirm’s point of view: point of view:
kp = =kp = =
NPo = price - flotation costs!NPo = price - flotation costs!
DDPoPo
DividendDividend PricePrice
DividendDividendNet PriceNet Price
DDNPoNPo
Example: Cost of Example: Cost of Preference SharesPreference Shares
If Persistent Ltd. issues Preference If Persistent Ltd. issues Preference Shares, it will pay a dividend of Shares, it will pay a dividend of Rs.8Rs.8 per year and should be valued at per year and should be valued at Rs.75Rs.75 per share. If flotation costs per share. If flotation costs amount to amount to Re. 1Re. 1 per share, what is per share, what is the cost of Preference Shares for the the cost of Preference Shares for the Company?Company?
Cost of Preference Cost of Preference SharesShares
kpkp = = = =
DividendDividendNet PriceNet Price
DDNPoNPo
Cost of Preference Cost of Preference SharesShares
kpkp = = = =
= = 10.81% = = 10.81%
DividendDividendNet PriceNet Price
DDNPoNPo
8.008.0074.0074.00
Cost of Equity SharesCost of Equity Shares
There are 2 sources of Equity Capital:There are 2 sources of Equity Capital:
1) 1) InternalInternal Resources (retained earnings, Resources (retained earnings, Reserves and Surplus), and Reserves and Surplus), and
2) 2) External External Equity Shares (new Shares Equity Shares (new Shares issue)issue)
Do these 2 sources have the same cost?Do these 2 sources have the same cost?
Cost of Internal EquityCost of Internal Equity
Since the stockholders own the firm’s Since the stockholders own the firm’s retained earnings, the cost is simply the retained earnings, the cost is simply the stockholders’ required rate of return.stockholders’ required rate of return.
Why?Why? If managers are investing stockholders’ If managers are investing stockholders’
funds, stockholders will expect to earn funds, stockholders will expect to earn an acceptable rate of return.an acceptable rate of return.
Cost of Internal EquityCost of Internal Equity
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
Kc = + gKc = + gDD11
PoPo
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
Kc = + gKc = + g
2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)
DD11
PoPo
Cost of Internal EquityCost of Internal Equity
1) 1) Dividend Growth ModelDividend Growth Model
Kc = + gKc = + g
2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)
kkcc = k = krfrf + B ( k + B ( kmm - k - krfrf ) )
DD11
PoPo
Cost of External EquityCost of External Equity
Dividend Growth ModelDividend Growth Model
Dividend Growth ModelDividend Growth Model
knc = + gknc = + gDD11
NPoNPo
Cost of External EquityCost of External Equity
Cost of External EquityCost of External Equity
Dividend Growth ModelDividend Growth Model
knc = + gknc = + gDD11
NPoNPo
Net proceeds to the firmNet proceeds to the firmafter flotation costs!after flotation costs!
Weighted Cost of CapitalWeighted Cost of Capital
The weighted cost of capital is just The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.the financing sources.
Weighted Cost of CapitalWeighted Cost of Capital
CapitalCapital
Source Cost Structure Source Cost Structure
debt 6% 20%debt 6% 20%
Preference 10% 10%Preference 10% 10%
Equity 16% 70%Equity 16% 70%
Weighted cost of capital =Weighted cost of capital =
.20 (6%) + .10 (10%) + .70 (16).20 (6%) + .10 (10%) + .70 (16)
= 13.4%= 13.4%
Weighted Cost of CapitalWeighted Cost of Capital(20% debt, 10% preferred, 70% common)(20% debt, 10% preferred, 70% common)