COST OF CAPITAL

Brief Concepts Cost of capital is the rate of return that a firm must earn on its project/ investments to maintain its market value and attract funds. Business risk is the risk to the firm of being unable to cover fixed operating costs. Financial risk is the risk of being unable to cover required financial obligations such as interest and preference dividends. Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of return associated with the best investment opportunity foregone. Cost of debt is the after tax cost of long-term funds through borrowing. Net cash proceeds are the funds actually received from the sale of security. Floatation cost is the total cost of issuing and selling securities. Cost of preference share capital is the annual preference share dividend divided by the net proceeds from the sale of preference shares. Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value. Dividend valuation model assumes that the value of a share equals the present value of all future dividends that it is expected to provide over an indefinite period. Diversifiable/unsystematic risk is the portion of a securitys risk that is attributable to firmspecific random causes; can be eliminated through diversification Non-diversifiable risk is the relevant portion of a securitys risk that is attributable to market factors that affect all firms; cannot be eliminated through diversification Capital asset pricing model (CAPM) describes the relationship between the required return or cost of equity capital and the non-diversifiable risk of a firm measured by beta coefficient, b. Cost of retained earnings is the same as the cost of an equivalent fully subscribed issue of additional shares, which is measured by the cost of equity capital. Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firms capital structure. Market value weights use market values to measure the proportion of each type of capital to calculate weighted average cost of capital. Book value weights use accounting (book) values to measure the proportion of each type of capital to calculate the weighted average cost of capital.

The cost of capital is an integral part of investment decisions as it is used to measure the worth of investment proposal. It is used as a discount rate in determining the present value of future cash flows associated with capital projects. Conceptually, it is the minimum rate of return that a firm must earn on its investments so as to leave market price of its shares unchanged. It is also referred to as cut-off rate, target rate, hurdle rate, required rate of return and so on. In operational terms, it is defined as the weighted average cost of capital (k0) of all long-term sources of finance. The major long-term sources of funds are (i) debt, (ii) preference shares, (iii) equity capital, and (iv) retained earnings. Thus, it comprises of several components in terms of specific cost of each source of finance. When these specific costs are combined, it results in the weighted average cost of capital. The cost of capital can be explicit or implicit. The explicit cost of capital is associated with the raising of funds (from debt, preference shares and equity). The explicit cost of any source of capital (C) is the discount rate that equates the present value of the cash inflows (CIo) that are incremental to the taking of financing opportunity with the present value of its incremental cash outflows (COt). Retained earnings involve no future cash flows to, or from, the fi rm. Therefore, the retained earnings do not have explicit cost. However, they carry implicit cost in terms of the opportunity cost of the foregone alternative (s) in terms of the rate of return at which the shareholders could have invested these funds had they been distributed to them/or not retained by the fi rm. There are four types of specific costs, namely, cost of debt (kd), cost of preference shares (kp), cost of equity capital (ke) and cost of retained earnings (kr). The debt carries a certain rate of interest. Interest qualifies for tax deduction in determining tax liability. Therefore, the effective cost of debt is less than the actual interest payment made by the firm by the amount of tax shield it provides. The debt can be either perpetual or redeemable. In the case of perpetual debt, it is computed dividing effective interest payment, i.e., I (1 t) by the amount of debt/sale proceeds of debentures or bonds (IV). Symbolically, Kd = I (1- t ) / IV kd is computed based on the following equations. I(1-t) +[(RV IV)/n] [(RV + IV)/2] I = Coupon or interest in Rs. t = Corporate tax rate RV = Redeemable value IV= Issue value of the bond (Face value + Premium or Discount Value - floatation cost) n = Remaining years to maturity

The cost of debt is generally the lowest among all sources partly because the risk involved is low but mainly because interest paid on debt is tax deductible. The cost of preference share (kp) is akin to kd. However, unlike interest payment on debt, dividend payable on preference shares is not tax deductible from the point of view assessing tax liability. On the contrary, tax (Dt) may be required to be paid on the payment of preference dividend in some countries The kp in the case of irredeemable preference shares is based on dividends payable on them and the sale proceeds obtained by issuing such preference shares, P0 (1 f ). In terms of equation: Kp = Dp/ P0 (1 f ). Where P0 is price of preference share and f is floatation cost in percent. The kp for redeemable preference shares requiring lump sum repayment (P) is determined on the basis of the following equation: Preference share dividend +[(RV IV)/n] [(RV + IV)/2] RV = Redeemable value of preference share IV= Issue value of preference share (Face value + Premium or Discount Value - floatation cost) n = Remaining years to maturity

The computation of cost of equity capital (ke) is conceptually more difficult as the return to the equity holders solely depends upon the discretion of the company management. It is defined as the minimum rate of return that a corporate must earn on the equity-financed portion of an investment project in order to leave unchanged the market price of the shares. There are two approaches to measure ke: (i) the dividend valuation model approach and (ii) capital asset pricing model (CAPM) approach. As per the dividend approach, ke is defined as the discount rate that equates the present value of all expected future dividends per share which are expected to continue till infinity and growing at a standard growth rate g. In equation terms, Ke = (D1/ Po ) + g The CAPM describes the relationship between the required rate of return or the cost of equity capital and the sensitivity of the stock price to the market index that is, beta. Symbolically, Ke = Rf + b (Km Rf), Rf = Required rate of return on risk-free investment b = Beta coeffi cient, and Km = Required rate of return on market portfolio, that is, the average rate or return on all assets

The cost of retained earnings (kr ) is equally difficult to calculate in theoretical terms. Since retained earnings essentially involve use of funds, it is associated with an opportunity/implicit cost. The alternative to retained earnings is the investment of the funds by the firm itself in a homogeneous outside investment. Therefore, kr is equal to ke. However, it might be slightly lower than ke in the case of new equity issue due to flotation costs. The measurement of the weighted average/overall cost of capital (k0) involves the choice of appropriate weights. For this, a choice is to be made between book value and market value weights. While the book value weights are operationally convenient, the market value basis is theoretically consistent and sound, and therefore, a better indicator of fi rms capital structure. The k0 is computed based on the following equation: K0 = KdWd + KpWp + KeWe + KrWr Wd = Percentage of debt to total capital, Wp = Percentage of preference shares to total capital, We = Percentage of external equity to total capital and Wr = Percentage of retained earnings to total capital