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Cost of Capital

Cost of Capital. Batch 2013-16 2 nd Semester MMM/MFM SIMSR. Learning Goals. The meaning of Cost of Capital Costs associated with the principal sources of Long-term Finance Concept of Weighted Average Cost of Capital Weighted Marginal Cost of Capital Schedule. What is Cost of Capital???.

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Cost of Capital

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  1. Cost of Capital Batch 2013-16 2nd Semester MMM/MFM SIMSR

  2. Learning Goals • The meaning of Cost of Capital • Costs associated with the principal sources of Long-term Finance • Concept of Weighted Average Cost of Capital • Weighted Marginal Cost of Capital Schedule

  3. What is Cost of Capital??? “The minimum rate of return that a company must earn on its investments in order to satisfy the various categories of investors who have made investments in the form of shares, debentures or term loans.” Unless the company earns this minimum rate, the investors will be tempted to pull out of the company, leave alone participate in any further capital investment in that company. Eg: equity investors expect a min return as dividends.

  4. Weighted Average Cost of Capital(WACC) A company’s cost of capital is nothing but the weighted arithmetic average of the cost of the various sources of finance that have been used by it. Let us look at a simple example

  5. Brain Teaser A company has a total capital base of Rs. 500 lakh in the ratio of 1:1 of debt-equity. If the post-tax costs of debt and equity are 7% and 18%, what will the weighted average cost of capital of the the company? 250/500 * 7% +250/500 * 18% = 12.5 %

  6. Assumptions Given this definition of cost of capital, it must be noted that the use of this measure for appraising new investments will depend upon two important assumptions: • The risk characterizing the new project under consideration is not significantly different from the risk characterizing the existing investments of the firm, and • The firm will continue to pursue the same financing policies,or in other words- no deviation from the debt-equity mix presently adopted by the firm.

  7. Assumptions For calculating the cost of capital of the firm, we have to first define the cost of various sources of finance used by it: • Debentures • Term Loans • Preference capital • Equity capital • Retained earnings

  8. The methodology The cost of a source of finance is defined as the rate of discount which equates the present value of the expected payments to that source of finance with the net proceeds received from that source of finance. The formulae discussed in this chapter for obtaining the costs of the different sources have been derived using this definition.

  9. Cost of Debentures The cost of a debenture is defined as that discount rate which equates the net proceeds from issue of debentures to the expected cash outflows……. in the form of…… Interest Principal Repayments

  10. Cost of Debentures n P =  I(1-T) + F t=1 (1+kd)^t (1+kd)^n Where Kd = post tax cost of debenture capital I = annual interest payment per debenture capital T = corporate tax rate , t=time period F = redemption price per debenture P = net amount realized per debenture N = maturity period

  11. Cost of Debentures (kd) Q) What is the interest payment (I) multiplied by the factor(1-t)?? ‘cos interest on debt is a tax –deductible expense and only Post –tax costs are considered An approximation formula as given below can be used : Kd = I(1-t) + (F-P)/n (F+P)/2

  12. Brain Gym Q1) Ajay Ltd.has recently made an issue of non-convertible debentures for Rs.400 lakh. The terms of the issue are as follows: each debenture has a face of Rs.100 and carries a rate of interest of 14%. The interest is payable annually and the debenture is redeemable at a premium of 5% after 10 yrs. If Ajay Ltd. realizes Rs.97 per debenture and the corporate tax rate is 50%, what is the cost of the debenture to the company?

  13. Solution to Brain Gym Given I=Rs.14, t=0.5, P=Rs.97 and n=10 yrs, F=Rs.105. The cost per debenture(kd) will be: Kd = 14(1-0.5) + (105-97)/10 (105+97)/2 = 7.7%

  14. Cost of Term Loans (kt) The cost of the term loans will be simply equal to the interest rate multiplied by (1-tax rate). The interest rate to be used here will be the interest rate applicable to the new term loan. The interest is multiplied by (1-tax) as interest on term loans is also tax deductible. Kt = I(1-t)

  15. Cost of Preference Capital (kp) Similar to debentures, the cost of redeemable preference share is defined as the discount rate which equates the proceeds from preference capital issue to the payments associated with the same ie. Dividend payments Principal payments

  16. Cost of Preference Capital (kp) n P =  D + F t=1 (1+kp)^t (1+kp)^n Where Kp = cost of preference capital D = preference dividend per share payable annually F = redemption price P = net amount realized per share N = maturity period

  17. Cost of Preference Capital (kp) An approximation formula as given below can also be used: Kp = D + (F-P)/n (F+P)/2

  18. Brain Gym Q2) The terms of the preference share issue made by Color-dye-Chem are as follows: Each preference share has a face value of Rs.100 and carries a rate of dividend of 14% payable annually. The share is redeemable after 12 years at par. If the net amount realized per share is Rs.95, what is the cost of the preference capital?

  19. Solution to Brain Gym Given D=Rs.14, P=Rs.95 and n=12 yrs, F=Rs.100. The cost per preference share (kp) will be: Kp = 14 + (100-95)/12 (100+95)/2 = 14.8%

  20. Cost of Equity (Ke) Measuring the rate of return required by the equity shareholder is a difficult and complex exercise ……’cos the dividend stream receivable by the equity shareholders is not specified by any legal contract( unlike in the case of debenture holders)

  21. Cost of Equity (Ke) Different approaches for estimating Ke: • Dividend Forecast Model • Capital Asset Pricing Approach(CAPM) • Realized Yield Approach • Earnings Price Ratio • Bond Yield plus risk premium

  22. Dividend Forecast Approach The “ Intrinsic Value “ of an equity is equal to the sum of the present values of the dividends associated with it, i.e., n Pe =  Dt t=1 (1+Ke)^t Where, Pe = Price per equity share; Dt= expected dividend per share; Ke = rate of return reqd by the equity shareholders

  23. Dividend Forecast Approach In practice, the model suggested by the above equation can not be used in its present form…….why????? ‘cos it is not possible to forecast the dividend stream completely and accurately over the life of the company. Hence growth in dividends comes into picture…… called as “g” This can be categorized as nil/constant growth/ super normal growth.

  24. Dividend Forecast Approach Cost of equity from the company’s point of view is nothing but the rate at which the intrinsic value is equal to the discounted value of the dividends. Assuming a constant growth rate (g) in DPS. ( what is DPS????), the previous equation can be written as: Pe = D1 Ke-g Where D1 = Do(1+g)

  25. Dividend Forecast Approach Recall, P0 = D/(1+Ke)^1 + D/(1+Ke)^2 +………………D/(1+Ke)^ On simplification, P = D/Ke Similarly if we do valuation with constant growth in dividends……

  26. Dividend Forecast Approach Dt = D0(1+g)^t Dt = dividend for yr t D0 = dividend for year 0 g = constant compound growth rate P0 = D1/(1+Ke) + D1(1+g)/(1+Ke)^2 +………………… On simplification it becomes P0 = D1/(Ke-g)

  27. Dividend Forecast Approach Q) Now derive Ke from the given equation in the previous slide??? Ke = D1/(P) + g

  28. Brain Gym Q) The market price per share of Mobile Glycols Ltd is Rs. 125. The dividend per share expected a year hence is Rs.12 per share and the DPS is expected to grow at a constant rate of 8% p.a. What is the cost of the equity capital to the company?

  29. Solution to Brain Gym Ke = D1/(P) + g =12/125+.08 =17.6%

  30. Realized Yield Approach In this approach , the past returns on a security are taken as a proxy for the return required in the future by the investors. Assumptions: • The actual returns have been in line with expected returns • The investors will continue to have the same expectations from the security.

  31. Realized Yield Approach It is calculated as: (W1*W2*………………….Wn)^(1/n) –1 Where, Wt = referred to as the wealth ratio Wt = (Dt+Pt)/(Pt-1) Dt = DPS for year t payable at the end of year Pt = Price per share at end of year t Pt-1 = Price per share at end of year t-1

  32. Brain Gym Q) Calculate Ke through the realized yield method:

  33. Solution to Brain Gym S Realized Yield = (1.35*1.08*1.23)^(1/3) –1 = 21%

  34. Capital Assets Pricing Model approach According to this approach, the cost of equity is reflected by the following equation: Ke = Rf + e( Rm - Rf ) Where: Ke = rate of return required on security e Rf = risk –free rate of return e = Beta of security e Rm = rate of return on market portfolio

  35. Cost of Retained Earnings (Kr) Cost of retained earnings is same as cost of equity capital……… Why? Ke=kr?????????? ‘cos the same share capital is being ploughed back into the company.

  36. Cost of External Equity ( Ke’) It comes into the picture when there are certain floatation costs involved in the process of raising equity from the market. It is the rate of return that the company must earn on the net funds raised, in order to satisfy the equity holder’s demand for return.

  37. Cost of External Equity ( Ke’) Under the dividend capitalization model, the following can be used for calculating the cost of external equity: Ke’ = D1 + g P0(1-f) Where Ke’ = cost of external equity f = floatation costs as a percentage of the current market price.

  38. Cost of External Equity ( Ke’) For all other approaches, there is no particular method for accounting for the floatation costs. The following formula can be used as an approximation in such cases: Ke’ = Ke/(1-f)

  39. Brain Gym Q) Gamma Asbestos Ltd. has got Rs.100 lakh of retained earnings and Rs.100 lakh of external equity through a fresh issue, in its capital structure. The equity investors expect a rate of return of 18%. The cost of issuing external equity is 5%.Calculate the cost of retained earnings and the cost of external equity .

  40. Solution to Brain Gym Cost of Retained earnings: Kr = Ke ie 18% Cost of external equity raised by the company: Now Ke’ = K/(1-f) = .18/(1-.05) =18.95%

  41. Brain Gym: WACC Q) Ventura Home appliances Ltd. has the following capital structure in Rs. Lakh: 1) Equity cap( 10 lakh shares at Par value) 100 2) 12% Preference Cap ( 10,000 shares at par value) 10 3) Retained earnings 120 4) 14% Non convertible debentures 70 5) 14% term loan from APSFC 100 Total 400

  42. Brain Gym: WACC The market price per equity share = Rs.25 Expected DPS = 2 Growth in DPS = 8% Preference Shares are redeemable after 7 years at par and are currently quoted at Rs.75 Debentures are redeemable after 6 years at par and current market quotation is Rs.90per share. Tax rate applicable: 50% Calculate the WACC

  43. Hint to Brain Gym Step 1 Determine the costs of the various sources of finance:Ke, Kr, Kp, Kd and Kt Step 2 Determine the weights associated with the various sources of finance. Step 3: Multiply the costs of the various sources of finance with the corresponding weights and add these weighted costs to determine the WACC

  44. Decision Regarding Weights • Book Value of the sources of finance included in the present capital structure. • Present Market Value Weights of the sources of finance included in the capital structure • Proportions of financing planned for the capital budget to be adopted for the forthcoming period

  45. Answer to Brain Gym Ke = 16% We = .25 Kr = 16% Wr = .30 Kp = 17.8% Wp = .025 Kd = 9.12% Wd = .175 Kt = 7% WACC = 12.59%

  46. Weighted Marginal Cost of Capital Schedule At the time of developing the concept of cost of capital, we had assumed that the risk profile and financing policy of the firm do not change. Now the question arises that if these assumptions hold, does the weighted average cost of capital remain unchanged irrespective of the magnitude of financing??

  47. Weighted Marginal Cost of Capital Schedule • It does not. Normally, the WACC increases with the level of financing required. The supplies of capital generally require a higher return as they supply more capital. • A schedule showing the relationship between additional financing and the weighted average cost of capital is referred to as the “ Weighted marginal cost of capital.”

  48. Determining the Weighted Marginal Cost of Capital schedule • Steps: • The cost of each source of finance for various levels of usage has to be estimated • Given the ratio of different sources of finance in the new capital structure, find out the levels of the total new financing at which the cost of various sources would change.These levels, called breaking points, can be found out as follows:

  49. Determining the Weighted Marginal Cost of Capital schedule Breaking point on Account of a source= ( Total new financing from that source at the breaking point) (Proportion of that financing source in the capital structure) 3) Calculate the weighted average cost of capital for various ranges of total financing between the breaking points. 4) List out the weighted average cost of capital for each level of total new financing.This is the weighted marginal cost of capital schedule.

  50. Illustration for preparation of WMCC Crypton Ltd. is planning to raise equity, preference and debt capital in the following proportions: Equity: 0.50 Preference: 0.20 Debt: 0.30 The cost of the three sources of finance for different levels of usage has been estimated as following:

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