Cost of Capital- Himakshee

SIGNIFICANCE OF COST OF CAPITAL  As an Acceptance Criterion in Capital Budgeting It helps in estimating the total capital budget, if the  present value of expected returns are more then the  project is likely to be accepted. 

 As a Determinant of Capital Mix in Capital Structure decisions While designing the optimal capital structure, the management has to keep in mind the objective of  maximizing the vale of firm and minimizing the cost of  capital. 

 As a Basis for Evaluating the Financial Performance Evaluate the financial performance of the top management. Actual cost of capital is compared to  projected cost of capital. 

 As a Basis for taking other Financial Decisions Dividend policy, making the right issue and working capital decisions etc 

Problems in Determination of Cost of Capital Conceptual controversies regarding the relationship between the cost of capital and the capital structure. Net Income Approach VS Net Operating Income 

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Historic Cost and Future Cost (Concept of Cost itself)

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Problems in computation of cost of equity 

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Problems in computation of cost of retained earnings

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Problems in assigning weights

A)

COMPUTATION OF COST OF SPECIFIC SOURCE OF FINANCE

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Cost of Debt 

Cost of Perpetual/Irredeemable Debt The cost of debt is the rate of interest payable on debt 

i. Before Tax  Kdb = I/P Where, Kdb= Before tax cost of debt I= Interest P=Principal

ii. After Tax  Kda = Kdb (1-t)= I/NP (1-t) Where, Kda= After tax cost of debt t=Rate of tax

QUESTIONS 1.

X Ltd issues Rs. 50000 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital. Kda = I/NP (1-t) = 4000/50000 (1-0.5) = 4000/50000 * 0.5 = 4%

DO SOLVE… 2. Y Ltd issues Rs 50000 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute the cost of debt capital. Ans: 2.91% 

3. A Ltd issues Rs 50000 8% debentures at a discount of 5%. The tax rate is 50%. Compute the cost of debt capital. Ans: 4.21% 

2.

Kda = I/NP (1-t) = 4000/(50000+5000) (1-0.6) = 4000/55000 *0.4 = 2.91%

3.

Kda = I/NP (1-t) = 4000/(50000-2500) (1-0.5) = 4000/47500 *0.5 = 4.21%

Cost of Redeemable Debt The debt that is issued to be redeemed after a certain period the life time of a firm. 

Short Cut method i.

Before tax 

Kdb = I+ 1/n(RV-NP) ½(RV+NP) Where, I= Annual Interest n=number of years to be redeemed RV= Redeemable value of Debt NP= Net proceeds of Debentures

ii. After tax  Kda = I(1-t)+ 1/n(RV-NP) ½(RV+NP) Where, I= Annual Interest t=tax rate n=number of years to be redeemed RV= Redeemable value of Debt NP= Net proceeds of Debentures

QUESTIONS 1.

A Company issues Rs 10,00,000 10% redeemable debentures at a discount of 5%. The costs of floatation amount to Rs 30000. The debentures are redeemable after 5 years. Calculate before tax and after tax cost of debt assuming a tax rate of 50%.

Before Tax Kdb = I+ 1/n(RV-NP) ½(RV+NP)

= 100000+1/5(1000000-920000) ½(1000000+920000) = 12.08% NP= 1000000- 50000(discount)-30000(floatation) After Tax Kda = I(1-t)+ 1/n(RV-NP) ½(RV+NP) =100000(1-0.5)+1/5(1000000-920000) ½(1000000+920000) = 6.875%

DO SOLVE… 2. A 5 year Rs 100 debenture of a firm can be sold for a net price of Rs 96.50. The coupon rate of interest is 14% per annum and the debenture will be redeemed at 5 per cent premium on maturity. The firm’s tax rate is 40 per cent. Compute before and after tax cost of debenture. Ans: 15.58%

and 10.025%

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Cost of Preference Capital 

A fixed rate of dividend is payable on preference shares. Dividends are usually paid regularly on preference shares except when there are no profits to pay them. Kp = D/P Where, Kp-Cost of Preference Capital D-Dividend, P-Preference share capital In case of Premium or Discount Kp = D/NP, (NP-Net Proceeds)

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Redeemable Preference Shares

Preference shares are issued which redeemed or cancelled on maturity date.

can

be

Kpr=D+(MV-NP)/n ½(MV+NP) Where, Kpr=Cost of Redeemable PreferenceCapital D= Annual Preference Dividend MV= Maturity Value NP=Net Proceeds of Preference Share

QUESTIONS 1.

(a)

A company issues 10,000 10% Preference Shares of Rs 100 each. Cost of issue is Rs 2 per share. Calculate cost of preference share if these shares are issued (a) at par (b) at a premium of 10% © at a discount of 5% Kp=

100000 (1000000-20000)

=10.2%

*100

(b)

Kp=

100000

*100

1000000+100000-20000 =9.26%  ©

Kp=

100000 1000000-50000-20000

=10.75%

*100

DO SOLVE… 2. A company issues 10000 10% preference shares of Rs 100 each redeemable after 10 years at a premium of 5%. The cost of issue is Rs 2 per share. Calculate the cost of preference capital Ans :

10.54%

3. A company issues 1000 7% Preference shares of Rs 100 each at a premium of 10% redeemable after 5 years at par. Compute the cost of preference capital Ans :

4.76%

Cost of Equity Share Capital  The cost of equity is the ‘maximum rate of return that a company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock 

Dividend Yield Method/ Price Ratio Method 

Stable earnings and dividend policy over a time Ke= D/NP or D/MP Where, Ke= Cost of Equity Capital D= Expected Dividend per share NP= Net proceeds per share MP= Market Price per share

QUESTIONS 1.

A company issues 1000 equity share of Rs 100 each at a premium of 10%. The company has been paying 20% dividend to equity share holders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs 160? Ke= D/NP or D/MP Ke= D/NP

Ke= D/MP

=20/110 *100

= 20/160 *100

=18.18%

= 12.5%

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Dividend Yield Plus Growth in Dividend Method 

When dividends are expected to grow at a constant rate and the dividend pay out ratio is constant. Ke= (D1 /NP) + G = D0 (1+g) + G NP/MP Where, Ke= Cost of Equity Capital D1= Expected Dividend per share at the end of a year NP= Net proceeds per share G= Rate of Growth of Dividends MP= Market Price per share

QUESTIONS 1.

A company plans to issue 1000 new shares of rs 100 each at par. The floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares. If the current market price of an equity share is Rs 150, calculate the cost of existing equity share capital. Ke = D0 (1+g) + G NP/MP

Ke =

D1 + G NP

= 10/(100-5) *100 +5% =15.53%

Ke =

D1 + G MP

=10/150 *100 + 5% = 11.67%

DO SOLVE… 1.

Your company’s share is quoted in the market at Rs. 20 currently. The company pays a dividend of Re 1 per share and the investor’s market expects a growth of 5 % per year.

(a)

Compute the company’s equity cost of capital

(b)

If the anticipated growth rate is 6% p.a Calculate the indicated market price per share. Ans :

10%, Rs. 26.5

Cost of Retained Earnings  The cost of retained earnings may be considered as the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities. Kr =

D1

+G

NP/MP Where, Kr= Cost of Retained Earnings D= Expected Dividend per share G=Growth Rate NP= Net proceeds of Equity Issue MP= Market Price per share

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Adjustments for tax and costs of purchasing new securities Kr =

D1 NP/MP

where, t= tax rate b=brokerage cost

+ G (1-t) (1-b)

QUESTIONS 1.

A firm’s Ke (return available to shareholders) is 15%, the average tax rate of shareholders is 40% and it is expected that 2% is the brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings. Kr = Ke (1-t) (1-b) = 15% (1-0.4) (1-0.02) = 8.82%

DO SOLVE… 2. A firm’s Ke (return available to shareholders) is 12%, the average tax rate of shareholders is 60% and cost of retained earnings is 9.75%. What must be the brokerage cost that the shareholders must pay for investing their dividends in alternate securities? Ans :

0.979%

B) COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL Weighted Average Cost of Capital is the average cost of the costs of various sources of financing. It is also known as Composite cost of capital, Overall cost of Capital or Average Cost of capital. Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights (MV or BV) to the specific costs of capital in proportion of the various sources of fund to the total. Kw= ∑XW ∑W X= Cost of specific sources of finance, W=Proportion of finance

QUESTIONS 1. A firm has the following capital structure and after-tax costs for the different sources of funds. Find the Weighted Average cost Sources of Funds

Amount (Rs)

Proportion %

After-tax cost %

Debt

1500000

25

5

Preference Shares

1200000

20

10

Equity Shares

1800000

30

12

Retained Earnings

1500000

25

11

TOTAL

6000000

100

Solution: Sources of Funds

Proportion % (W)

After-tax cost % (X)

XW/100

Debt

25

5

1.25

Preference Shares

20

10

2.00

Equity Shares

30

12

3.60

Retained Earnings

25

11

2.75

WEIGHTED AVERAGE COST

100

9.60%

DO SOLVE… 2. Calculate the weighted average cost of capital (before tax and after tax) from the following information. Assume that the tax rate is 55%. Type of Capital

Proportion in New Capital Structure %

Before-tax Cost of Capital %

Equity Capital

25

24.44

Preference Capital

10

27.29

Debt Capital

50

7.99

Retained Earnings

15

18.33 Ans :15.58%,13.39%