cost capital
Post on 16-Apr-2017
234 Views
Preview:
TRANSCRIPT
CHAPTER 13
CONTENTS Introduction Opportunity Cost of Capital WACC – Preview Cost of Debt
Cost of Redeemable Debt Cost of Perpetual Debt Post Tax Cost of Debt
Cost of Preferred Capital
Cost of Capital
2
Chapter 13
CONTENTS Cost of Equity
Dividend capitalization Approach Earning Based Approach CAPM Based Approach Cost of External Equity
Assigning Weights Marginal Cost of Capital WACC as Discount Rate & Risk Pure Play Approach-
Unlevering & Relevering Beta Factors Affecting Cost of Capital
Cost of Capital
3
Chapter 13
Cost of CapitalIntroduction
Cost of capital is an extremely important input requirement for capital budgeting decision.
Without knowing the cost of capital no firm can evaluate the desirability of the implementation of new projects.
Cost of capital serves as a benchmark for evaluation.
Cost of Capital
4
Chapter 13
Opportunity Cost Of Capital
The basic determinant of cost of capital is the expectations of the suppliers of capital.
The expectations of the suppliers of capital are dependent upon the returns that could be available to them by investing in the alternatives.
The returns provided by the next best alternative investment is called opportunity cost of capital. This could serve as basis for cost of capital.
Cost of Capital
5
Chapter 13
WACC Besides opportunity cost the cost of capital must also
consider1. Business risk 2. Financial risk
There are predominantly two suppliers of capital1. Debt 2. Equity
WACC is a composite figure reflecting cost of each component multiplied by the weight of each component.
WACC = we x re + wp x rp + wd x rd
we = Proportions of equity re = Cost of equitywp = Proportion of pref capital rp = Cost of preference capitalwd = Proportion of Debt rd = Cost of debt
Cost of Capital
6
Chapter 13
Cost Of Perpetual Debt
Cost of debt is determined by equating the cash flows of the instrument to its market price.
Cost of perpetual debt, rd is
Most debts are repayable in the specified time interval. Is debt perpetual?
Where a firm decides to maintain a fixed component of debt by replacing one debt with another, it becomes the case of perpetual debt.
Chapter 13Cost of Capital
7
ot
ddt
o PC=ror r
C=P
Cost Of Debt
3d
3d
2dd )r1(
105)r1(6.0x11
)r1(6.0x11
r16.0x1195
Chapter 13Cost of Capital
8
Cost of redeemable debt is determined by equating the cash flows of the instrument to its market price.
Cost of redeemable debt is
Post tax cost of debt = rd (1-T)
For a bond paying 11% coupon annually and redeemable after three years at Rs 105 that sells for Rs 95 the cost of debt is 10.12% given by
∑N
1tN
dt
d
to )r(1
R)r(1
CP
Cost Of Debt
ISSUE EXPENSES To mobilise debt one has to incur
floatation cost which increases the cost of debt
WHICH DEBTS TO CONSIDER While computing the cost of debt the
claims of the suppliers of long-term debt are only considered.
Cost of Capital
9
Chapter 13
Cost Of Preference Capital
Preference capital is in between pure debt and equity that explicitly states a fixed dividend.
The dividend has claim prior to that of equity holders.
But unlike interest on the debt the dividend on preference capital is not tax deductible.
Cost of preference capital, rp is determined by equating its cash flows to market price. No adjustment for tax is required.
Cost of Capital
10
N
1t N
pt
p
to )r(1
R)r(1
DP
Chapter 13
Cost Of Equity Capital
Cost of equity capital is most difficult to determine because It is not directly observable There is no legal binding to pay any
compensation, and It is not explicitly mentioned.
Does this mean that cost of equity is zero?
Cost of Capital
11
Chapter 13
Types Of Equity Capital
Equity capital is classified as1) Internal: the profits that are not distributed but
retained by the firm in funding the growth, is referred as internal equity, and
2) External: equity capital raised afresh to fund, is called external equity
And external equity may have cost differential on account of
Floatation cost associated with raising fresh equity, Inability to deploy external equity instantaneously, Underpricing of fresh issue.
Cost of Capital
12
Chapter 13
ApproachesCost Of Equity
Cost of equity is determined by Dividend capitalization approach CAPM based approach.
Both approaches are driven by market conditions and measure the cost of equity in an indirect manner.
The price to be used in any of the model is the market determined.
Cost of Capital
13
Chapter 13
Dividend Capitalization
Approach Dividend capitalization approach determines the
cost of equity by equating the stream of expected dividends to its market price.
For constant dividend cost of equity is equal to dividend yield.
For constant growth of dividend at ‘g’
Cost of Capital
14
Yield DividendPDr or ; r
DP Then
D......DDD . i.e constant is dividend if
...................)r(1
D)r(1
D)r(1
D)r(1
DP
0e
e0
321
4e
43
e
32
e
2e
10
g+PD=r or ; g-r
D=P then
...................)r+(1g)+(1D+
)r+(1g)+(1D+
)r+(1g)+(1D+)r+(1
D=P
01
ee
0
4e
31
3e
21
2e
1e
10
Chapter 13
Cost Of Equity PE Approach
01
ee1
0
e1
e1
0
PE=r or r
E=P k;=b whenAnd
bxk-rb)-x(1E= g-r
D=P
Chapter 13Cost of Capital
15
Earnings based approach, as manifested by Dividend capitalization Approach equates the value as
Under the special case when the firm uses the earnings at the same rate as expected by shareholders earnings based approach measures the cost of equity as
bxk-rb)-x(1E= g-r
D=P e1
e1
0
Cost Of EquityCAPM Approach
CAPM based determination of cost of equity considers the risk characteristics that dividend capitalization approach ignores.
Determinants of cost of equity under CAPM based approach include three parameters; the risk free rate, rf
the market return, rm and
β, as measure of risk
Cost of Capital
16
Chapter 13
Cost Of EquityCAPM Approach
β,the primary determinant of risk governs the cost of equity.
re = rf + β x (rm – rf)
Cost of Capital
17
Cost of Equity re
rm
Risk Premium(rm-rf)β
rf
β = 1 Risk, β
Chapter 13
Cost of EquityDDM Vs CAPM
Approach CAPM based determination of cost of equity
is regarded superior as it relies on the market information and
incorporates risk
it need not know the dividend policy.
Dividend capitalization approach does not consider risk of the dividend
has assumption of constant pay-out ratio.
Cost of Capital
18
Chapter 13
Cost Of Internal And External
Equity There are three major differences in the
INTERNAL and EXTERNAL equity Existence of flotation cost Under utilisation of external equity Under pricing of fresh capital
If floatation cost is 5% of the issue price and cost of internal equity determined either through DDM or CAP-M is 16% then the cost of fresh equity shall be 16.84% (16/0.95).
Cost of Capital
19
g+PD
f)-(11=f)-(1
equity internal of Cost= equity external for r 01
e
Chapter 13
Assigning Weights
After cost of each component is determined they need to be multiplied by the respective proportions to arrive at WACC.
The proportions may be based on
1) marginal
2) book value or
3) market value
The weights based on the target capital structure are most appropriate though the current capital structure may not conform.
Cost of Capital
20
Chapter 13
Book Value Vs Market Value
The weights for computation of WACC can either be based on
book values or market values
Though book value weights appear convenient and practical it lacks conviction ignoring current trends.
Use of market value based weights is technically superior reflecting the current expectations of investors.
Cost of Capital
21
Chapter 13
Marginal Cost Of Capital
WACC as discount rate, implies that acceptance of projects do not alter the existing capital structure.
When project is large compared to the existing operations, the capital structure as well as the cost of each component would more likely increase.
Lenders tend to raise cost with the quantum, so could be the case with equity suppliers.
In such cases WACC is inappropriate as hurdle rate. Marginal (incremental) cost of capital is more appropriate.
Cost of Capital
22
Chapter 13
Optimal Capital Budget
In practice Marginal Cost of Capital must be used in determination of the optimal capital budget.
Marginal cost of capital governs the value addition.
Incremental benefits must exceed incremental cost.
The capital expenditure level at which incremental benefits are equal to the incremental cost is “Optimal capital budget”.
Cost of Capital
23
Chapter 13
WACC And Risk The discount rate for the project must be appropriate
to its risk.
In most cases WACC adequately represents the risk since most projects selected by the firms belong to the line of activity.
Where project has substantially different risk profile blind use of WACC as discount rate may cause
1. erroneous acceptance of riskier project due to lower discount rate or
2. erroneous rejection of less risky project due to higher discount rate.
Cost of Capital
24
Chapter 13
Pure Play ApproachAdjusting For Risk
Risk-adjusted WACC must be used as discount rate for the cash flow.
Most popular method to incorporate such risk is called a pure-play approach,
identifying a firm that most resembles the risk profile of the new project.
beta of the firm is adjusted for its leverage to find an all equity beta, called unlevering and then
re-adjusting for the proposed capital structure of the project, called relevering.
The value of β so arrived is used in calculating the WACC.
Cost of Capital
25
Chapter 13
Pure Play ApproachAdjusting For Risk
Cost of Capital
26
Chapter 13
Equity of ValueMarket EDebt of ValueMarket Dbeta observed thefirm; leveredfor equity of Betaβdebt of Betaβ firm unlevered theof Betaβ
Where
.ED
EβED
Dββ
L
du
Ldu
ET)-D(1Eβ
ET)-D(1T)-D(1ββ Ldu
D/E} x T)-(1+{1β=β or
E+T)-(1 x DEβ=β
Lu
Lu
Pure Play ApproachAdjusting For Risk
While using beta of the pure play firm it must be unlevered for the financial leverage to reflect only the business risk and then re-levered for the proposed capital structure of the project.
Assume that observed beta of Pure-play firm is 1.2. Besides reflecting the business risk the observed beta also represents the financial risk. This has to be unlevered i.e. converted into β of equity as if it were all equity financed.
If the debt equity ratio based on market values is 1:5 and its marginal tax rate is 30% the beta of pure play firm is
Cost of Capital
27
Chapter 13
0526.15/17.01
20.1D/E} x T)-(1{1
ββor
ET)-(1 x D
Eββ
Lu
Lu
x
Re-Levering This now needs to be relevered with the proposed
financing pattern of the project. This can be done by incorporating debt equity ratio (D*/E*) and tax rate (T*) of the proposed project.
If new project is proposed with debt equity ratio of 2:5 and with tax rate of 35% the beta of the project is
Chapter 13Cost of Capital
28
1.32620.65x2/5)1.0526(1}/ED x )T-(1{1ββ ***U
*L
WACC After incorporating the business risk and leverage in its beta,
the cost of equity may be calculated using CAP-Mre = rf + β x (rm – rf)
Using the risk free return rf of 6% and market return of rm of
16% the cost of equity is 19.262%.re = rf + β x (rm – rf) = 6 + 1.3262 x (16 – 6) = 19.262%
Finding WACC, the discount rate; The WACC is given by WACC = we x re + wd x rd
The cost of equity is arrived at by using 19.262%. Assuming the pre-tax cost of debt at 8%, WACC for with debt at 40% of equity (debt equity ratio at 2:5) would be 5/7 x 19.26% + 2/7 x 8% x (1 – 35%) = 15.244%
Chapter 13Cost of Capital
29
top related