Cost of Capital

Estimating the Hurdle Rate

(Cost of Capital)

Cost of Capital
A projects cost of capital is the opportunity cost - which is the minimum rate of return acceptable on the funds committed on a project. Cost of capital, hurdle rate, opportunity cost, required rate of return is the compensation for time and risk in the use of capital by a project. Cost of capital is the rate of return which a company should earn on its investments so as to satisfy the investors expectations. The concept of cost of capital links the Investment Decision and the Financing decision.

Cost of Capital

Pankaj Varshney

Cost of Capital

Cost of Debt
Discount rate which equates the present value of interest payments and principal repayments with the net proceeds of the debt issued or its current market price.

P0 =

C1 C2 C3 Cn Fn + + + ........ + + (1 + k d )1 (1 + k d )2 (1 + k d )3 (1 + k d )n (1 + k d )n

P0 =
where, P0 Ct Fn n Kd
Cost of Capital

Ct Fn + t (1+ kd )n t=1 (1+ kd )

(Fn P0 ) n kd (P0 + Fn ) 2 C+

= = = = =

net amount realised on debt issue (or CMP) Periodic interest on Debentures Face Value/ Redemption price Maturity period Cost of debt An approximation:

Cost of Debt - Illustration

NTPC issues 14% bonds of Rs.100/- face value, redeemable after 5 years and realises Rs.97/- (net). Fn=100 ; C= 14% ; n = 5 Years; P0 = 97/5

97 =

(1 + k
t =1

14
d

100 (1 + k d )5

By trial & error: kd = 14.89%

14 +

Or approximately:
Cost of Capital

kd

(100 97) 14.6 5 = = 14.82% (97 + 100) 98.5 2

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Cost of Capital

Cost of Debt - Adjustment for Taxes

Interest on debt is tax-deductible.
Particulars EBIT Interest PBT Taxes @ 20% PAT A 1000 --1000 200 800 B 1000 200 800 160 640 160 200 Change

Interest payment of 200 in case B, has resulted in reducing the Tax outflow from 200 to 160, i.e. by 40 which is 200* 20% (Interest*tax rate) PBT has decreased by 200, while PAT decreased only by 160, due to Interest outgo acting as a shield to the profits. Post-tax Cost of Debt = Pre-tax Cost of Debt* (1-tax rate)
Cost of Capital

Post-tax kd= 14.89%*(1 - 0.30) = 10.42%

Cost of Preference Shares

Discount rate which equates the present value of Dividend payments and redemption value with the net proceeds of the preference shares(or its current market price)

P0 =

PD1 PD2 PD3 PDn Fn + + + ........ + + 1 2 3 n (1 + k p ) (1 + k p ) (1 + k p ) (1 + k p ) (1 + k p )n

n PDt Fn P0 = + t (1+ kp )n t=1 (1+ kp )

where, P0 = PDt = Fn = n = kp =

net amount realised on issue of Preference share Dividend on Preference Shares Redemption Value (F P0 ) Maturity period of Preference Shares PD t + n Cost of Preference Shares n k
p

An approximation:
Cost of Capital

(P0 + Fn ) 2

Pankaj Varshney

Cost of Capital

Cost of Preference Shares-Illustration

ABC Ltd. issues Rs.100 face value preference shares carrying 14% dividend, redeemable at par after 12 years. Net amount realised is Rs.92/-. Tax Rate= 40% Fn = 100 ; PDt= 14 ; n =12 years; P0 = 92
92 =
12

t =1

14 100 + t (1 + k p ) (1 + k p )1 2

By trial & error: kp = 15.508% or

14 + kp (1 0 0 9 2 ) 1 4 .6 6 7 12 = = 1 5 .2 7 8 % (1 0 0 + 9 2 ) 96 2

Irredeemable (Perpetual) Preference Shares

P0 =
Cost of Capital

PDt t t =1 (1+ kp )

or

kp =

PDt P0

Cost of Equity Shares

There is no legal obligation to pay dividends to the shareholders Quantum of dividends is also not fixed. Cost of Equity shares is an Implicit cost.(not explicit) It is an Opportunity Cost. (Returns forgone on the next best investment opportunity of comparable risk) Equity External equity (additional /Outside) and Internal equity(Retained Earnings) In both cases, the shareholders are providing the funds to the firm, hence they would expect same returns on both. But, Internal Equity is cheaper than External Equity due to: New equity is issued at less than the Current Market Price; Issue of new Equity involves Floatation Costs. Methods of computing Cost of Equity Capital: Dividend Discount Model (DDM) Capital Asset Pricing Model (CAPM)
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Cost of Capital

Pankaj Varshney

Cost of Capital

Cost of Equity Share:

Dividend Discount Model (DDM)

Discount rate that equates the present value of the stream of expected future dividends with the current market price/Issue Price.

P0 =

D1 D2 D3 D + + + .......... + 1 2 3 (1 + k e ) (1 + k e ) (1 + k e ) (1 + k e )
Dt t t =1 (1 + k e )

P0 =
where,

DDM - General Form

Po = Current Market Price of the Equity Share at time to Dt = Expected Dividend per share at time t Ke = Cost of Equity
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Cost of Capital

DDM - Constant Growth

If the dividends are expected to grow at a constant rate g, and Ke> g, then,

D1 D1(1 + g)1 D1(1 + g)2 D1(1 + g)3 P0 = + + + + ..........+ (1 + k e )1 (1 + k e )2 (1 + k e )3 (1 + k e )4

P0 =

D1 (k e g)

Or

ke =

D1 +g P0
Assumptions: D1 > 0 Dividends grow at a constant growth rate g =ROE*b Dividend Payout ratio (1-b) is constant 10

D1 = Rs.3/- g= 7% forever, P0= Rs.50/-. Find Ke Ke = (3 / 50) + 7% = 6%+ 7% = 13%. Used for companies in the mature stage of their life cycle
Cost of Capital

Pankaj Varshney

Cost of Capital

DDM - Multiple Growth Rate

A firm may pass through different growth phases and hence dividends may also grow at different rates.
n
Stage 1 Stage 2
Years

Stage 3

D0 (1+ gs )t Pn D + P0 = where Pn = n+1 t (1+ ke )n Ke - gn t =1 (1+ ke )

D D0 (1+ gs )t 1 P0 = + n+1 t (1+ ke )n Ke - gn t =1 (1+ ke )

n
Cost of Capital 11

DDM - Multiple Growth Rate -Illustration

D D0(1+ gs )t 1 P0 = + n+1 t (1+ ke )n Ke - gn t =1 (1+ ke ) 6 8.743 3.50 (1.15)6 1 134 = + (1+ ke )t (1+ ke )6 Ke - 8% t =1
n

D1 = 4.025; D2 = 4.629; D3 = 5.323; D4 = 6.122; D5 = 7.040; D6 = 8.096; D7 = 8.743 By trial & error: ke = 12%
Cost of Capital 12

Pankaj Varshney

Cost of Capital

Cost of Equity Share:

Capital Asset Pricing Model (CAPM)

Expected rate of return on any security Ri is given by:

Ri = Rf + i (Rm Rf )
where, Ri =Rate of return on security i Rf =Risk-free rate of return i =beta of security i Rm=Rate of return on Market Portfolio

Rf =10%; Rm=15%; A= 0.5;

B =1.0; C = 1.5; Find Ri

RA =10% + 0.5(15%-10%) = 12.5% RB =10% + 1.0(15%-10%) = 15.0% RC =10% + 1.5(15%-10%) = 17.5%

Cost of Capital 13

Estimating Beta Direct Method

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Total
Cost of Capital

Ra 12 14 16 12 -5 21 20 16 9 -2 13 15 19 15 20 195

Rm 10 12 13 8 3 14 14 8 4 -1 10 16 12 10 17 150

(Ra Ra )

(Rm Rm )

(Ra Ra )(Rm Rm )

(Rm Rm )2

-1 1 3 -1 -18 8 7 3 -4 -15 0 2 6 2 7

0 2 3 -2 -7 4 4 -2 -6 -11 0 6 2 0 7

0 2 9 2 126 32 28 -6 24 165 0 12 12 0 49 455

0 4 9 4 49 16 16 4 36 121 0 36 4 0 49 348
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Cost of Capital

Estimating Beta Direct Method (Contd.)

n

Covariance(a,m) =
1

(Ra -Ra )(Rm -Rm ) 455 = = 32.50 (n-1) 14

n

Variance (m ) =

(R m -R m ) 2 348 = =24.86 (n-1) 14

a (Beta) =

Covariance(a,m) Variance(m)

32.50 = 1.3075 24.86

Cost of Capital

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Estimating Beta Index or Regression Method

Re gress Raon Rm Ra = + aRm + ea

Intercept Rm Coefficients -0.07471 1.307471

-10 0

95% C I/Fitted values/Ra 0 10 20

30

5 95% CI Ra

10 Rm

15 Fitted values

20

Ra = 0.0747 + 1.3075Rm
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Cost of Capital

Pankaj Varshney

Cost of Capital

Cost of Equity Share:

Cost of External Equity

As External Equity is expensive than Internal Equity, an adjustment has to be made.

Internal Equity k re =

D1 +g P0 D External Equity k e = 1 + g I0

CMP = Rs 100/- ; I0 = Rs 95/- ; D1 = Rs 5/- ; g = 6% Find Cost of Retained Earnings& External Equity.

ke =

5 + 6% = 5.26%+ 6% = 11.26% 95

k re =

5 + 6% = 11% 100
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Cost of Capital

Weighted Average Cost of Capital

After having calculated the cost of individual components of the capital structure, we need to calculate the Weighted Average Cost of Capital (WACC). Weights MAY be either: (a) Market Value of the various forms of financing, which the company intends to employ Consistent with the objective of maximization of shareholders wealth (b) Book Value of the Capital Structure. WACC should be estimated on post-tax basis.

WACC(k0 ) = ke
Cost of Capital

E D + kd (D + E) (D + E)
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Cost of Capital

Marginal Cost of Capital

WACC is calculated based on the various sources of capital already employed by the firm. Such WACC provides a historical perspective can at best be used to compare with some predetermined cost of capital. However, the most important use of the concept of Cost of Capital is to evaluate Investment decisions. Therefore, more relevant cost to be worked out should be cost of raising new funds to finance new projects and not the historical costs which have been incurred in the past. Therefore, weighted average cost of capital should be calculate for the incremental or marginal capital Weighted Marginal Cost of Capital (WMCC).
Cost of Capital 19

Pankaj Varshney

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