7 - cost of capital

7/30/2019 7 - Cost of Capital

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Cost of Capital


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The financing decision

Cost of capital

Leverage

Capital Structure

The Dividend DecisionWorking Capital

Where were going...


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Cost of Capital

For Investors the rate of return on

a security is a benefit of investing.

For Financial Managers that samerate of return is a cost of raising

funds that are needed to operate

the firm.

In other words, the cost of raising

funds is the firms cost of capital.


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How can the firm raise

capital?

Debentures

Preferred Stock

Common StockEach of these offers a rate of return to

investors.

This return is a cost to the firm.

Cost of capital actually refers to the

weighted cost of capital - a weighted

average cost of financing sources.


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What is cost of capital

Solomon Ezra, Cost of capital is the minimumrequired rate of earnings or the cut-off rate ofcapital expenditure.

It is the average cost of various capitalcomponents employed by the firm.

Cost of capital is the minimum rate of returnwhich a firm, must and, is expected to earn on itsinvestments so as to maintain the market value ofits shares.

It is the minimum returns investors expect on theirinvestment.


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Cost of capital

It is the minimum rate of return.

Cost of capital is weighted average cost of

various sources. It has three components:

Expected risk free return (rf)

Premium of business risk (b)

Premium of financial risk (f)

Cost of capital (K) = rf+ b + f


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The Weighted Cost of Capital

To calculate the firms weighted cost

of capital, we must first calculate

the costs of the individual financing

sources:

Cost of Debt

Cost of Preferred StockCost of Common Stock


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Cost of

Debt


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Cost of Debt

For the issuing firm, the cost of debt is:

the rate of return required by

investors, adjusted for flotation costs (any costs

associated with issuing new bonds),

and

adjusted for taxes.


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Example: Tax effects

of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000


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EBIT 400,000 400,000


- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

Now, suppose the firm pays Rs.50,000 in

dividends to the stockholders.


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EBIT 400,000 400,000


- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000- dividends (50,000) 0

Retained earnings 214,000 231,000


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After-tax cost Before-tax cost Tax

of Debt of Debt Savings-=


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of Debt of Debt Savings

33,000 = 50,000 - 17,000

-=


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33,000 = 50,000 - 17,000

OR

-=


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33,000 = 50,000 - 17,000

OR33,000 = 50,000 ( 1 - .34)

-=


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33,000 = 50,000 - 17,000

OR33,000 = 50,000 ( 1 - .34)

Or, if we want to look at percentage costs:

-=


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After-tax Before-tax Marginal

% cost of % cost of x tax

Debt Debt rate

-= 1


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Debt Debt rate

Kd = kd (1 - T)

-= 1


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Debt Debt rate

Kd = kd (1 - T)

.066 = .10 (1 - .34)

-= 1

Cost of Preferred


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Cost of Preferred

Stock It is the return paid in the form of fixed

dividend to shareholders.

kp = =D

Po

Dividend

Price


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Cost of debt (Kd)

Kd = I/ P or NP

Where I = interest paid

P= principal amount

NP = Net proceeds =Pfloatation cost

After tax cost of debt

Kd = I / NP (1-T)

Where T = tax rate

Cost of Preferred


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Cost of Preferred

Stock

kp = =

From the firms point of view:

kp = =

NPo = price - flotation costs!

D

Po

Dividend

Price

Dividend

Net Price

D

NPo


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Cost of Common Stock

There are 2 sources of Common Equity:

1) Internal common equity (retained

earnings), and

2) External common equity (newcommon stock issue)

Do these 2 sources have the same cost?


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Cost of Internal Equity

Since the stockholders own the firmsretained earnings, the cost is simply the

stockholders required rate of return.

Why?

If managers are investing stockholders

funds, stockholders will expect to earnan acceptable rate of return.


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1) Dividend Growth Model


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Kc = + gD1

Po


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Kc = + g

2) Capital Asset Pricing Model (CAPM)

D1

Po


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Kc = + g

2) Capital Asset Pricing Model (CAPM)

kc = krf+ B ( km - krf)

D1

Po


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Cost of External Equity

Dividend Growth Model


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knc = + gD1Npo



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ke = + gD1

NPo

Net proceeds to the firm

after flotation costs!


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Continued

Dividend yield method:

Ke =D / NP or MP

Where: D =dividendNP = Net proceeds = principalFloatation cost

MP = market price of share

Earning Yield method:

Ke = EPS / NP or MP

Where: EPS = earning per share


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Weighted Cost of Capital

The weighted cost of capital is just

the weighted average cost of all of

the financing sources.


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Weighted Cost of Capital

Capital

Source Cost Structure

debt 6% 20%

preferred 10% 10%

common 16% 70%


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Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16)

= 13.4%

Weighted Cost of Capital(20% debt, 10% preferred, 70% common)

7 - cost of capital

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