cost of capital by prof. manish b tardeja. liabilities & equity assets equity shares current...

Cost of CapitalCost of Capital

By Prof. Manish B TardejaBy Prof. Manish B Tardeja

Liabilities & Equity Liabilities & Equity AssetsAssets

Equity SharesEquity Shares Current assets Current assets

Preference SharesPreference Shares

Long-term debtLong-term debt

Fixed assetsFixed assets

Current Liabilities Current Liabilities







The investment decisionThe investment decision

IngredientsIngredients

Cost of capitalCost of capital

LeverageLeverage

Capital StructureCapital Structure

The Dividend DecisionThe Dividend Decision

Working CapitalWorking Capital

The financing decisionThe financing decision......







The financing decisionThe financing decision





Current Liabilities Current Liabilities Fixed assetsFixed assets

Long-term debtLong-term debtPreference SharesPreference Shares Capital StructureCapital StructureCommon EquityCommon Equity

Cost of CapitalCost of Capital

For InvestorsFor Investors the rate of return on the rate of return on a security is a benefit of investing.a security is a benefit of investing.

For Financial ManagersFor Financial Managers that same that same rate of return is a cost of raising rate of return is a cost of raising funds that are needed to operate funds that are needed to operate the firm.the firm.

In other words, the cost of raising In other words, the cost of raising funds is the firm’s funds is the firm’s cost of capitalcost of capital..

How can the firm raise How can the firm raise capital?capital?

Debenture and Long term LoansDebenture and Long term Loans Equity SharesEquity Shares Preference SharesPreference Shares Each of these offers a Each of these offers a rate of returnrate of return to to

investors.investors. This return is a This return is a costcost to the firm. to the firm. ““Cost of capitalCost of capital” actually refers to the ” actually refers to the

weighted cost of capitalweighted cost of capital - a weighted - a weighted average cost of financing sources. average cost of financing sources.

The Weighted Cost of CapitalThe Weighted Cost of Capital

To calculate the firm’s weighted To calculate the firm’s weighted cost of capital, we must first cost of capital, we must first calculate the costs of the individual calculate the costs of the individual financing sources:financing sources:

Cost of DebtCost of Debt Cost of Preference SharesCost of Preference Shares Cost of Equity SharesCost of Equity Shares

Cost of Cost of DebtDebt

Cost of DebtCost of Debt

For the issuing firm, the For the issuing firm, the cost of debtcost of debt is: is: the the rate of returnrate of return required by required by

investors,investors, adjusted for adjusted for flotation costsflotation costs (any costs (any costs

associated with issuing new Debt), associated with issuing new Debt), and and

adjusted for adjusted for taxes.taxes.

Example: Tax effects Example: Tax effects of financing with debtof financing with debt

with stockwith stock with debtwith debt

EBITEBIT 4,00,000 4,00,000 4,00,000 4,00,000

- interest expense- interest expense 0 0 (50,000)(50,000)

EBTEBT 4,00,000 4,00,000 3,50,000 3,50,000

- taxes (34%)- taxes (34%) (1,36,000)(1,36,000) (1,19,000)(1,19,000)

EATEAT 2,64,000 2,64,000 2,31,000 2,31,000



EBITEBIT 4,00,000 4,00,000 4,00,000 4,00,000


EBTEBT 4,00,000 4,00,000 3,50,000 3,50,000

- taxes (34%)- taxes (34%) (1,36,000)(1,36,000) (1,19,000)(1,19,000)

EATEAT 2,64,000 2,64,000 2,31,000 2,31,000

Now, suppose the firm pays Rs.50,000 in Now, suppose the firm pays Rs.50,000 in dividends to the stockholders.dividends to the stockholders.



EBITEBIT 4,00,000 4,00,000 4,00,000 4,00,000


EBTEBT 4,00,000 4,00,000 3,50,000 3,50,000

- taxes (34%)- taxes (34%) (1,36,000)(1,36,000) (1,19,000)(1,19,000)

EATEAT 2,64,000 2,64,000 2,31,000 2,31,000

- dividends- dividends (50,000) (50,000) 0 0

Retained earnings Retained earnings 2,14,000 2,14,000 2,31,000 2,31,000

After-tax cost Before-tax cost TaxAfter-tax cost Before-tax cost Tax

of Debt of Debt Savingsof Debt of Debt Savings

-=



33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000

-=



33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000

OROR

-=



33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000

OROR

33,000 = 50,000 ( 1 - .34)33,000 = 50,000 ( 1 - .34)

-=



33,000 = 50,000 - 17,00033,000 = 50,000 - 17,000

OROR

33,000 = 50,000 ( 1 - .34)33,000 = 50,000 ( 1 - .34)

Or, if we want to look at Or, if we want to look at percentagepercentage costs: costs:

-=

After-tax Before-tax After-tax Before-tax Marginal % cost of % cost of x Marginal % cost of % cost of x tax Debt Debt tax Debt Debt rate rate

-= 11


KKdd = k = kd d (1 - T) (1 - T)

-= 11


KKdd = k = kd d (1 - T) (1 - T)

.066 = .10 (1 - .34).066 = .10 (1 - .34)

-= 11

Example: Cost of DebtExample: Cost of Debt

Persistent Ltd. issues a Persistent Ltd. issues a Rs.1,000Rs.1,000 par, par, 20 20 yearyear debentures paying the market rate debentures paying the market rate of of 10%.10%. Interest is annual. The Interest is annual. The debenture will sell for par since it pays debenture will sell for par since it pays the market rate, but flotation costs the market rate, but flotation costs amount to amount to Rs.50Rs.50 per debenture. per debenture.

What is the pre-tax and after-tax cost of What is the pre-tax and after-tax cost of debt for Persistent Ltd.?debt for Persistent Ltd.?

Pre-tax cost of debtPre-tax cost of debt::

950 = 100(PVIFA 950 = 100(PVIFA 20, k20, kdd) + 1000(PVIF ) + 1000(PVIF 20, k20, kdd))

using the calculator,using the calculator,

kkdd = 10.61%. = 10.61%.

After-tax cost of debtAfter-tax cost of debt::

Kd = kd (1 - T)Kd = kd (1 - T)

Kd = .1061 (1 - .34)Kd = .1061 (1 - .34)

Kd = .07 = 7%Kd = .07 = 7%

Pre-tax cost of debtPre-tax cost of debt::

950 = 100(PVIFA 950 = 100(PVIFA 20, k20, kdd) + 1000(PVIF ) + 1000(PVIF 20, k20, kdd))

using the calculator,using the calculator,

kkdd = 10.61%. = 10.61%. So, a 10% So, a 10% debenturedebenture

costs the firmcosts the firm After-tax cost of debtAfter-tax cost of debt: only 7% (with: only 7% (with

Kd = kd (1 - T) Kd = kd (1 - T) flotation costs)flotation costs)

Kd = .1061 (1 - .34) Kd = .1061 (1 - .34) since the interestsince the interest

Kd = .07 = 7%Kd = .07 = 7% is tax deductible.is tax deductible.

Cost of Preference SharesCost of Preference Shares

Finding the cost of Preference Shares is Finding the cost of Preference Shares is similar to finding the rate of return, similar to finding the rate of return, except that we have to consider the except that we have to consider the flotation costs associated with issuing flotation costs associated with issuing Preference Shares.Preference Shares.

Cost of Preference Cost of Preference SharesShares

Formula:Formula:

kp = = kp = = DDPoPo

DividendDividend PricePrice


Formula:Formula:

kp = = kp = =

From the From the firm’sfirm’s point of view: point of view:

kp = =kp = =

NPo = price - flotation costs!NPo = price - flotation costs!

DDPoPo

DividendDividend PricePrice

DividendDividendNet PriceNet Price

DDNPoNPo

Example: Cost of Example: Cost of Preference SharesPreference Shares

If Persistent Ltd. issues Preference If Persistent Ltd. issues Preference Shares, it will pay a dividend of Shares, it will pay a dividend of Rs.8Rs.8 per year and should be valued at per year and should be valued at Rs.75Rs.75 per share. If flotation costs per share. If flotation costs amount to amount to Re. 1Re. 1 per share, what is per share, what is the cost of Preference Shares for the the cost of Preference Shares for the Company?Company?


kpkp = = = =


DDNPoNPo


kpkp = = = =

= = 10.81% = = 10.81%


DDNPoNPo

8.008.0074.0074.00

Cost of Equity SharesCost of Equity Shares

There are 2 sources of Equity Capital:There are 2 sources of Equity Capital:

1) 1) InternalInternal Resources (retained earnings, Resources (retained earnings, Reserves and Surplus), and Reserves and Surplus), and

2) 2) External External Equity Shares (new Shares Equity Shares (new Shares issue)issue)

Do these 2 sources have the same cost?Do these 2 sources have the same cost?

Cost of Internal EquityCost of Internal Equity

Since the stockholders own the firm’s Since the stockholders own the firm’s retained earnings, the cost is simply the retained earnings, the cost is simply the stockholders’ required rate of return.stockholders’ required rate of return.

Why?Why? If managers are investing stockholders’ If managers are investing stockholders’

funds, stockholders will expect to earn funds, stockholders will expect to earn an acceptable rate of return.an acceptable rate of return.


1) 1) Dividend Growth ModelDividend Growth Model



Kc = + gKc = + gDD11

PoPo



Kc = + gKc = + g

2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)

DD11

PoPo



Kc = + gKc = + g

2) 2) Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)

kkcc = k = krfrf + B ( k + B ( kmm - k - krfrf ) )

DD11

PoPo

Cost of External EquityCost of External Equity

Dividend Growth ModelDividend Growth Model


knc = + gknc = + gDD11

NPoNPo




knc = + gknc = + gDD11

NPoNPo

Net proceeds to the firmNet proceeds to the firmafter flotation costs!after flotation costs!

Weighted Cost of CapitalWeighted Cost of Capital

The weighted cost of capital is just The weighted cost of capital is just the weighted average cost of all of the weighted average cost of all of the financing sources.the financing sources.

Weighted Cost of CapitalWeighted Cost of Capital

CapitalCapital

Source Cost Structure Source Cost Structure

debt 6% 20%debt 6% 20%

Preference 10% 10%Preference 10% 10%

Equity 16% 70%Equity 16% 70%

Weighted cost of capital =Weighted cost of capital =

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

= 13.4%= 13.4%

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

cost of capital by prof. manish b tardeja. liabilities & equity assets equity shares current...

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