1

Chapter # 15Required returns and Cost of

capital

2

Cost of capital:The cost of funds used for financing a business. Cost of

capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). Cost of capital is extensively used in the capital budgeting process to determine whether the company should proceed with a project.

3

We know, there are three basic sources of long-term funds for the business firms. These are as under:

1. Long-term debt 2. Preferred stock 3. Common Equity

4

1. Long-term debt The following types of debt instruments may

be used for financing by the firm: i). Bond ii). Bank’s loan.

5

i). Bond Bond is a long-term promissory note that promises to

pay bondholder a predetermined, fixed amount of interest each year, based on coupon rate until maturity and at maturity date, the principal/par value will be paid to the bondholder.

Types of Bonds The Bonds are two types: (i).Perpetual Bond-The Bond that never matures (ii).Redeemable Bond-The Bond which will

mature after some period of time.

6

Cost of BondCost of perpetual Bond before tax can be

calculated by the following formula: We know, V0 = I Thus, r = I .

r Vo Where as, V0 = Current market price,

I =Interest coupon rate amount, r = Cost of bond

7

Cost of Redeemable Bond before tax can be calculated from the following formula

Valuation=V0= I (1+r)n –1 + PV .

r (1+r)n (1+r)n

Where as, V0 = Current market price, I =Interest

coupon rate amount, r = Cost of bond, PV= Par value, n= Remaining life (in years) for the maturity of bond 

8

→ Hint to calculate the cost: If the current Market price of the Bond is less

than its face value, then it means that the Bond is selling at discount. Thus the cost of Bond (r) will be higher than its coupon rate (I).

If the current Market price of the Bond is more than its face value, then it means that the Bond is selling at premium. Thus the cost of Bond (r) will be less than its coupon rate (I).

9

Cost of Bank’s loan.Unlike a bond, a bank loan is not traded in the

secondary market. Thus cost of a bank loan is simply the current interest rate the bank would charge if the firm takes a loan from them.

10

Cost of Bond and Bank’s loan (after tax)Since the interest payments on Bond or bank’s

loan are tax deductible, therefore, the net cost of these will always be taken after tax. It will be calculated as under:

Cost of bond or bank’s loan (After tax) = Cost of Bond/bank’s loan before tax (1-tax rate)

11

2. Preferred stockShareholders of preferred stock receive fixed,

regular dividend payments for a specified period of time, unlike the variable dividend payments offered to common stockholders. Preferred stockholders generally do not have voting rights, as common stockholders do, but they have a greater claim to the company’s assets at the time of liquidation. Preferred stock may also be “callable,” which means that the company can purchase shares back from the shareholders at any time for any reason, although usually at a favorable price.

12

Cost of Preferred stockThe required rate of return on investment by

the preferred stock holders of a company. We use the following formula to calculate the

cost of preference stockWe know, Vo = Dp/r

Thus, r = Cost of Preferred stock= Dp /Vo

Where as, Dp = fixed dividend amount on preferred stock, and ,Vo = current market price

13

3. Common stockCommon stock is the most common type of stock

that is issued by companies. It entitles shareholders to share in the company’s profits through dividends and/or capital appreciation. Common stockholders are usually given voting rights, with the number of votes directly related to the number of shares owned. Of course, the company’s board of directors can decide whether or not to pay dividends, as well as how much is paid.

14

Cost of common equityThe required rate of return on investment by

the common stock holders of a company. There are commonly two methods available

for measuring the cost of common stock. However, the method to use in finding out the cost of capital is dependant on the type of given data available. These methods are as under:

(i).Dividend Discount model approach (ii).Capital Asset pricing model approach

15

(i).Dividend Discount model approachA procedure for valuing the price of a stock by using

predicted dividends and discounting them back to present value. The idea is that if the value obtained

from the DDM is higher than what the shares are currently trading at, then the stock is undervalued. We know from the valuation of common stock that

there are four sub dividend models fall under dividend

discount model. These are as under:

16

Model -1: General valuation model:Assumption:[When share is purchased for a finite

period. i.e. for next few years and further yearly expected dividends]

Example: Next n years dividends are given discount rate is r

Valuation=V0= D1 + D2 + . . Dn

(1+r) (1+r)2 (1+r)n

Now “r” can be calculated by the trial & error procedure, i.e. IRR technique.

17

Model –2: Zero growth Model Assumption: [share is purchased for an infinite period and

company’s dividends are not growing, but the company is paying out same amount of dividend every year i.e.Rs5 per share for each year [say]. That is, Do=D1=D2…Dn]

Thus the value of the common stock would be like the PV of perpetuity.

The formula for zero growth will be:Valuation= Vo= D where as, D1 = D0,

r Therefore, Cost of common equity =r = D1 .

Vo

18

Model -3: Constant growth model Assumption: [Share is purchased for an infinite

period and company is paying with a constant dividend payout ratio or constant growth rate of “g” percent]

The formula for constant growth will be: Valuation= V0 = D1

(r-g)Where as, D1= Do (1 + g), g= Growth rate in dividend.

Therefore, Cost of common equity (r) = D1 + g V0

19

Model – 4: Multiple (variable) growth model

Assumption: [share is purchased for an infinite period and growths in dividend are in multiple and ending in constant growth or Zero growth]

For example, Y1 to y3 =Super normal growth, Y4 to y4 = above normal growth

Y5= Constant growth or Zero growth.The valuation of multiple growth stocks will be

calculated by the following procedure:

20

Sum of the present values of future dividends during the multiple growth periods plus the present value of the estimated stock’s price at the end of multiple growth periods.

Example: Multiple growths are up to 4 years (say) and in fifth year constant or zero growth, then the formula for multiple/rapid growths will be:

Valuation=V0= D1 + D2 + D3 + D4 + P4

(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)4

21

Where as, Do=Present dividend per share, D1 =Do(1+g), D2=D1(1+g), D3=D2(1+g),

D4=D3(1+g), D5=D4(1+g) [In case of constant growth from fifth year] or

D5=D4 [In case of zero growth in fifth year]  P4= D5 (r –g) [In case of constant growth from sixth year

i.e., at the end of multiple growth period] Or,

22

P4= D5 r [In case of zero growth from sixth year i.e. at

the end of multiple growth period]. Now “r” can be calculated from the above

example formula by trial & error procedure, .i.e. IRR technique

23

(ii).Capital Asset pricing model approach

Already discussed in Risk & Return Chapter (see chapter #5 notes)

24

Company’ s over all cost of capital or Weighted average cost of Capital (WACC):

 It is the weighted average cost of the various

capital components employed by the firm. It is calculated as under:

Suppose that the firm has been financed by bank’s loan, bonds, common stock and as well as by preferred stock

25

WACC = (Proportion wt of bond) (Cost of bond after

tax) + (Proportion wt of bank’s loan) (Cost of bank’s loan after tax) + (Proportion wt of preferred stock) (Cost of preferred stock) + (Proportion wt of equity stock) (Cost of equity stock)

26

Where as, proportion wt (weight) of each will be calculated as under:

Book value or market value of respective capital

Aggregate (total) Book value or Market value of total capital structure

---------------------

27

◊..…. The end ……◊