The opportunity cost of an investment; that is, the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected. For example, when an investor purchases stock in a company, he/she expects to see a return on that investment. Since the individual expects to get back more than his/her initial investment, the cost of capital is equal to this return that the investor receives, or the money that the company misses out on by selling its stock.
COST OF CAPITAL
Minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price.
In economic terms there are two approaches to define CoC:
It is the borrowing rate of the firm, at which it can acquire funds to finance the proposed project
It is the lending rate which the firm could have earned if the firm would have invested elsewhere.
FACTORS AFFECTING COST OF CAPITAL OF THE FIRM
These are the factors affecting cost of capital that the company has control over:
Capital-structure policy
Dividend policy
Investment policy
Capital Structure Policy
As we have been discussing above, a firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.
Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed. For example, as the payout ratio of the company increases the breakpoint between lower-cost internally generated equity and newly issued equity is lowered.
Investment Policy
It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.
Uncontrollable Factors Affecting the Cost of Capital
These are the factors affecting cost of capital that the company has no control over:
Level of interest rates
Tax rates
Level of Interest Rates
The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital.
Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.
BASIC COST OF CAPITAL
Cost of Equity Capital: the cost of obtaining funds through the sale of common stock.
Cost of Preference Shares
Cost of Debt
Cost of Retained Earnings
COST OF EQUITY CAPITAL
Ke is 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.
APPROACHES TO MEASURE COST OF EQUITY SHARE CAPITAL
Constant growth dividend
Ke = (D1/Po) + g; where
D1 = expected dividend per share
Po = net proceeds per share/current market price
g = growth in expected dividends
Zero growth dividend
Ke= D1/P0; where
D1 = expected dividend per share
Po = net proceeds per share/current market price
COST OF PREFERENCE SHARE CAPITAL
Cost of preference share capital is the annual preference share dividend divided by the net proceeds from the sale of preference shares.
COST OF IRREEDEMABLE PREFERNCE SHARE
Kp= PD/P0; where
Pd = Preference dividend
P0= current market price
COST OF REEEEMABLE PREFERNCE SHARE
Kp = PD + (RV-P0)/N
(RV+P0)/2
RV= Redemption value
COST OF DEBT
Debt is the cheapest form of long-term debt from the company's point of view as:
It's the safest form of investment from the point of view of creditors because they are the first claimants on the company's assets at the time of its liquidation. Likewise they are the first to be paid their interest. Another, more important reason for debt having the lowest cost if the tax-deductibility of interest payments.
COST OF IRREDEEMABLE DEBT
ki=I/B0; where
Ki= cost of debt before tax
I= Interest rate
B0= net proceeds
Kd = Ki (1-t); where
T= tax rate
COST OF REEDEMABLE DEBT
Kd = I (1-t) + (RV-B0)/N
(RV+B0)/2
RV= Redemption value
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
This gives us the overall cost of capital. Weight age is given to the cost of each source of funds by assessing the relative proportion of each source of fund to the total, and is ascertained by using the book value or the market value of each type of capital. The cost of capital of the market value is usually higher than it would be if the book value is used.
Steps in Calculation of WACC (Ko)
Assigning weights to specific costs.
Multiplying the cost of each source by the appropriate weights.
Dividing the total weighted cost by the total weights.
WACC MAY BE CALUCULATED ON THE BASIS OF MARKET WEIGHT OR BOOK WEIGHT
Market Value vs. Book Value Weights
MV sometimes preferred to BV for the MV represents the true expectations of the investors. However, it suffers from the following limitations:
MV undergoes frequent fluctuations and have to be normalized;
The use of MV tends to cause a shift towards larger amounts of equity funds, particularly when additional financing is undertaken.
MV more appealing than BV as
Market values of securities closely approximate the actual amount to be received from their sale
Costs of specific sources of finance which constitute the capital structure of the firm are calculated using prevalent market prices.
Solution- PROBLEM SOLVING
Determine the weighted average cost of capital of the company. It had been paying dividends at a consistent rate of 20% per annum.
Calculation of specific cost of capital
Cost of equity-
Ke =D1
P0
D1=20% 0f 100= Rs. 20
P0=100
Then, Ke =20/100= 20%
Cost of debt (debentures) =12%
Cost of debt (term loan) = 18%
Calculation of weighted average cost of capital
Sources of capital
Specific cost of capital (a)
Value
Weight
(b)
WACC
(a)*(b)
Equity share capital
20%
400
0.2
4%
12% debenture
12%
400
0.2
2.4%
Term loan
18%
1200
0.6
10.8%
Total
2000
17.2%
Therefore, weighted average cost of capital (without consideration of market value of equity and not taking into consideration the effect to income tax) is 17.2% p.a.
What difference will it make if the current price Rs. 100 share is Rs. 160?
If the current price of equity share is Rs. 160 then,
Ke = D1/P0
=20/160=12.5%
WACC will be therefore,
Sources of capital
Specific cost of capital (a)
Value
Weight
(b)
WACC
(a)*(b)
Equity share capital
12.5%
400
0.2
2.5%
12% debenture
12%
400
0.2
2.4%
Term loan
18%
1200
0.6
10.8%
Total
2000
15.7%
WACC is 15.7% if current price is Rs. 160.
Determine the effect of Income Tax on the cost of capital under both premises (tax rate 40%).
Cost of debt (debenture) = I (1-t)
=12 (1-0.40)
=7.2%
Cost of debt (term loan) = I (1-t)
= 18 (1-0.40)
=10.8%
WACC after tax benefit if current price of equity is Rs. 100.
Sources of capital
Specific cost of capital (a)
Value
Weight
(b)
WACC
(a)*(b)
Equity share capital
20%
400
0.2
4%
12% debenture
7.2%
400
0.2
1.44%
Term loan
10.8%
1200
0.6
6.48%
Total
2000
11.92%
So, the WACC is 11.92%
WACC after tax benefit if current price of equity is Rs. 160.
Sources of capital
Specific cost of capital (a)
Value
Weight
(b)
WACC
(a)*(b)
Equity share capital
12.5%
400
0.2
2.5%
12% debenture
7.2%
400
0.2
1.44%
Term loan
10.8%
1200
0.6
6.48%
Total
2000
10.42%
So, the WACC is 10.42%
