Financial Management

Cost Of Capital
The cost of capital is the cost of a company's
funds (both debt and equity), or, from an
investor's point of view "the expected return on
a portfolio of all the company's existing
securities." It is used to evaluate new projects
of a company as it is the minimum return that
investors expect for providing capital to the
company, thus setting a benchmark that a new
project has to meet.

COMPONENTS OF COST OF CAPITAL:

1. Return at Zero Risk- this includes the

projected rate of return on investment when
the project does not involve any business or
financial risk.

2. Premium for Business Risk- the cost

of capital includes premium for business risk.
Business risk refers to the changes in
operating profit on account of changes in
sales. The projects involving higher risk than
the average risk can be financed at a higher
rate of return than the normal rate. The
suppliers of funds for such projects will
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expect a premium for increased business

risk. The business risk is generally
determined while taking capital budgeting
decisions.
3. Premium for financial Risk- The cost of
capital includes premium for financial risk
arising on account of higher debt content in
capital structure requiring higher operating
profit to cover periodic payment of interest
and repayment of principal amount on
maturity.

The above three components of cost of capital

may be expressed by the following equation:

K=C + b +f

Where,
K=cost of capital;
C=the riskless cost of financing;
b=business risk premium; f=financial risk
premium.
 Financial Management

CAPITAL STRUCTURE
THEORIES
In finance, capital structure refers to the
way a corporation finances its assets through
some combination of equity, debt, or hybrid
securities.

There are 4 theories:

 NI approach (net income approach).

 NOI approach (net operating income
approach)
 MM approach (Modigliani Millar Approach)
 Traditional approach

1. The Modigliani-Miller theorem - proposed

by Franco Modigliani and Merton Miller, forms
the basis for modern thinking on capital
structure, though it is generally viewed as a
purely theoretical result since it assumes away
many important factors in the capital structure
decision. The theorem states that, in a perfect
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market, how a firm is financed is irrelevant to

its value. This result provides the base with
which to examine real world reasons why
capital structure is relevant, that is, a
company's value is affected by the capital
structure it employs. These other reasons
include bankruptcy costs, agency costs, taxes,
information asymmetry, to name some. This
analysis can then be extended to look at
whether there is in fact an optimal capital
structure: the one which maximizes the value
of the firm.
The theorem was originally proven under the
assumption of no taxes. It is made up of two
propositions which can also be extended to a
situation with taxes.

2. NET OPERATING INCOME APPROACH - The

second approach as propounded by David
Durand the net operating income approach
examines the effects of changes in capital
structure in terms of net operating income. In
the net income approach discussed above net
income available to shareholders is obtained by
deducting interest on debentures form net
operating income. Then overall value of the
firm is calculated through capitalization rate of
equities obtained on the basis of net operating
income, it is called net income approach. In the
second approach, on the other hand overall
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value of the firm is assessed on the basis of net

operating income not on the basis of net
income. Hence this second approach is known
as net operating income approach.
The NOI approach implies that (i)
whatever may be the change in capital
structure the overall value of the firm is not
affected. Thus the overall value of the firm is
independent of the degree of leverage in
capital structure. (ii) Similarly the overall cost
of capital is not affected by any change in the
degree of leverage in capital structure. The
overall cost of capital is independent of
leverage.
If the cost of debt is less than that of
equity capital the overall cost of capital must
decrease with the increase in debts whereas
it is assumed under this method that overall
cost of capital is unaffected and hence it
remains constant irrespective of the change
in the ratio of debts to equity capital. How
can this assumption be justified? The
advocates of this method are of the opinion
that the degree of risk of business increases
with the increase in the amount of debts.
Consequently the rate of equity over
investment in equity shares thus on the one
hand cost of capital decreases with the
increase in the volume of debts; on the other
hand cost of equity capital increases to the
same extent. Hence the benefit of leverage is
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wiped out and overall cost of capital remains

at the same level as before. Let us illustrate
this point.
If follows that with the increase in debts
rate of equity capitalization also increases
and consequently the overall cost of capital
remains constant; it does not decline. To put
the same in other words there are two parts
of the cost of capital. One is the explicit cost
which is expressed in terms of interest
charges on debentures. The other is implicit
cost which refers to the increase in the rate
of equity capitalization resulting from the
increase in risk of business due to higher
level of debts.
3. TRADITIONAL APPROACH- Traditional
approach is an intermediate approach between
the net income approach and net operating
income approach. According to this approach:
a) An optimum capital structure does
exist.
b) Market value of the firm can be
increased and average cost of capital can
be reduced through a prudent
manipulation of leverage.
c) The cost of debt capital increases if
debts are increases beyond a definite
limit. This is because the greater the risk
of business the higher the rate of interest
the creditors would ask for. The rate of
equity capitalization will also increase
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with it. Thus there remains no benefit of

leverage when debts are increased
beyond a certain limit. The cost of capital
also goes up.
Thus at a definite level of mixture of debts to
equity capital, average cost of capital also
increases. The capital structure is optimum at
this level of the mix of debts to equity capital.
The effect of change in capital structure on the
overall cost of capital can be divided into three
stages as follows;

First stage
In the first stage the overall cost of capital
falls and the value of the firm increases with the
increase in leverage. This leverage has beneficial
effect as debts as debts are less expensive. The
cost of equity remains constant or increases
negligibly. The proportion of risk is less in such a
firm.
Second stage
A stage is reached when increase in leverage has
no effect on the value or the cost of capital, of
the firm. Neither the cost of capital falls nor the
value of the firm rises. This is because the
increase in the cost of equity due to the assed
financial risk offsets the advantage of low cost
 Financial Management

debt. This is the stage wherein the value of the

firm is maximum and cost of capital minimum.
Third stage
Beyond a definite limit of leverage the cost of
capital increases with leverage and the value of
the firm decreases with leverage. This is because
with the increase in debts investors begin to
realize the degree of financial risk and hence
they desire to earn a higher rate of return on
equity shares. The resultant increase in equity
capitalization rate will more than offset the
advantage of low-cost debt.
It follows that the cost of capital is a function of
the degree of leverage. Hence, an optimum
capital structure can be achieved by establishing
an appropriate degree of leverage in capital
structure.

4. NET INCOME APPROACH - As the name of

the approach suggests, the Income Approach
determines what a business is worth based on
its expected future earnings. This type of
analysis is used in a variety of different
applications such as: determining the value of
publicly traded stock, bonds, real estate and
other financial instruments. One reason that
the Income Approach is so often used is that it
can be applied in virtually all situations.
Regardless of whether a business is a start-up,
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successful and profitable or in financial

distress, the Income Approach can be used to
model virtually any type of business.
The Income Approach is based on three primary
factors:
• Expected future earnings
• Expected long-term growth in earnings
• A discount rate (in other words, the rate of
return an investor expects based on risk)
This approach is perhaps the most technically
complex of the three valuation approaches and
requires the appraiser to possess a thorough
understanding of both the subject company and
the underlying theory of the Income Approach.

THE FOLLOWING IS A SIMPLIFIED EXAMPLE OF

THE INCOME APPROACH:

The forecast below is forecasted net cash

flow to equity. To arrive at forecasted net cash
flow to equity, our appraisers would first need to
forecast the company’s income statement and
balance sheets. As can be seen in the chart
below, the sample company’s forecasted net
cash flow to equity grows at a dramatically
slower rate after 2014. This is when the company
is forecasted to reach its long-term rate of
growth.
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The next step would be to develop the required

rate of return that investors would demand for
taking ownership in the company. If we turn this
rate of return into a multiplier, it is then possible
to demonstrate how much a dollar of earnings
received in the future would be worth to an
investor today.
Assuming a 30% rate of return, the chart below
demonstrates that a dollar of this earnings
stream in 2010 is worth only $0.77 to an investor
today. This chart also means that an investor
would be willing to pay only $0.06 today in return
for $1 of earnings in 2020.
 Financial Management

The next chart describes the value of the

company when you multiply the discount factor
against forecasted net cash flow to equity for
each year. This chart illustrates what the
company’s forecasted earnings in each particular
year would be worth to an investor today. For
example, in 2010 the company is forecasted to
produce $1 in earnings. As illustrated by the
chart below, $1 in earnings in 2010 is only worth
$0.77 to an investor today.
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The sum of all present values, as shown in the

chart above, would be the indicated value of the
business. It is important to note that this
forecast stops in 2020.
One of the assumptions of the discounted cash
flow model (an Income Approach method) is that
the company would continue into perpetuity.
How then, would it be possible to add up an
infinite number of present values?
The answer can be determined by using what is
known as the Gordon Growth Model. This model
is used to calculate the value of all future
earnings once the company has reached its long-
term growth rate (in this case, 3.5%). In this
example, we would divide the company’s
forecasted earnings in 2020 by the capitalization
rate (which is the discount rate minus the long-
term rate of growth), to determine the ‘terminal
value’ of the company as of 2019. From there,
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our appraisers would apply the appropriate

discount factor to determine the value of the
business today.
Using the Gordon Growth Model, it is therefore
possible to determine the indicated value of the
business, which is $14.51. This means that the
company would be worth $14.51 before any
applicable discounts.