CHAPTER 13 COST OF CAPITAL

CONTENTS
Introduction Opportunity Cost of Capital WACC Preview Cost of Debt

Cost of Redeemable Debt Cost of Perpetual Debt Post Tax Cost of Debt Historical Yields and Current Yields Treating Floatation Cost and Issue at Premium/Discount Which Debts to Consider
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Chapter 13 Cost of Capital

CONTENTS
Cost of Preferred Capital Cost of Equity

Assigning Weights

Dividend Capitalisation Approach Earning Based Approach CAPM Based Approach Cost of External Equity

Marginal Cost of Capital

Chapter 13 Cost of Capital

Marginal Proportions Book Value Vs. Market Value Proportions

CONTENTS
Optimal Capital Budget WACC as Discount Rate & Risk Pure Play ApproachFactors Affecting Cost of Capital
Unlevering & Relevering Beta

Chapter 13 Cost of Capital

COST OF CAPITAL Introduction

Cost of capital is an extremely important input requirement for capital budgeting decision. Without knowing the cost of capital no firm can evaluate the desirability of the implementation of new projects. Cost of capital serves as a benchmark for evaluation.

Chapter 13 Cost of Capital

OPPORTUNITY COST OF CAPITAL

The basic determinant of cost of capital is the expectations of the suppliers of capital. The expectations of the suppliers of capital are dependent upon the returns that could be available to them by investing in the alternatives. The returns provided by the next best alternative investment is called opportunity cost of capital. This could serve as basis for cost of capital.
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WACC
Besides opportunity cost the cost of capital must also consider 1. Business risk 2. Financial risk There are be many suppliers of capital; predominantly two 1. Debt 2. Equity WACC is a composite figure reflecting cost of each component multiplied by the weight of each component.
we = Proportions of equity

WACC = we x re + wp x rp + wd x rd
re = Cost of equity

wp = Proportion of pref capital wd = Proportion of Debt

Chapter 13 Cost of Capital

rp = Cost of preference capital rd = Cost of debt

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COST OF DEBT
Cost of redeemable debt is determined by equating the cash flows of the instrument to its market price C C Po = t or rd = t Cost of perpetual debt, rd is rd Po Cost of redeemable debt is
Po = C (1 + r
t t =1 N t d)

R (1 + rd ) N

Post tax cost of debt = rd (1-T)

For a bond paying 11% coupon annually and redeemable after three years at Rs 105 that sells for Rs 95 the cost of debt is 10.12% given by
95 =
Chapter 13 Cost of Capital

11x 0 .6 11x 0 . 6 11x 0 . 6 105 + + + 1 + rd (1 + rd )2 (1 + rd )3 (1 + rd )3

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COST OF DEBT
To mobilise debt one has to incur floatation cost which increase the cost of debt While computing the cost of debt the claims of the suppliers of long-term debt are only considered.

Chapter 13 Cost of Capital

COST OF PREFERENCE CAPITAL

Preference capital is in between pure debt and equity that explicitly states a fixed dividend. The dividend has claim prior to that of equity holders. But unlike interest on the debt the dividend on preference capital is not tax deductible. Cost of preference capital , rp is determined by equating its cash flows to market price. There is no adjustment of tax.
Po =
Chapter 13 Cost of Capital

t =1

Dt R + (1 + rp ) t (1 + rp ) N

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COST OF EQUITY CAPITAL

Cost of equity capital is most difficult to determine because
It is not directly observable There is no legal binding to pay any compensation and It is not explicitly mentioned

This does not mean that cost of equity is zero Equity capital is classified as

1) Internal: the profits that are not distributed but retained by the firm in funding the growth, is referred as internal equity and 2) External: equity capital raised afresh to fund, is called external equity
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Chapter 13 Cost of Capital

APPROACHES - COST OF EQUITY

Cost of equity is determined by Both approaches are driven by market conditions and measure the cost of equity in an indirect manner The price to be used in any of the model is the market determined.
Dividend Capitalisation approach CAPM based approach.

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DIVIDEND CAPITALISATION APPROACH

Dividend capitalisation approach determines the cost of equity by equating the stream of expected dividends to its market price.
For constant dividend cost of equity is equal to dividend yield.
P0 = D3 D1 D2 D4 + + + .......... ......... (1 + re ) (1 + re )2 (1 + re )3 (1 + re )4 D D ; or re = = Dividend Yield re P0 if dividend is constant i.e . D 1 = D 2 = D 3 = ...... = D Then P0 =

For constant growth of dividend at g

D D ; or re = 1 + g re - g P0

D1 D1(1 + g) D1(1 + g) 2 D1(1 + g) 3 P0 = + + + .......... ......... (1 + re ) (1 + re )2 (1 + re )3 (1 + re )4 then P0 =

Chapter 13 Cost of Capital

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COST OF EQUITY PE APPROACH

Earnings based approach, as manifested by Dividend Capitalisation Approach equates the value as
P0 = D1 E x(1 - b) = 1 re - g r e - bxk

Under the special case when the firm uses the earnings at the same rate as expected by shareholders earnings based approach measures the cost of equity as
P0 = D1 E x(1 - b) = 1 re - g re - bxk E1 re E1 P0
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And when b = k; P0 =
Chapter 13 Cost of Capital

or

re =

COST OF EQUITY CAPM APPROACH

CAPM based determination of cost of equity considers the risk characteristics that dividend capitalisation approach ignores. Determinants of cost of equity under CAPM based approach include three parameters;
the risk free rate, rf the market return, rm and , as measure of risk

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COST OF EQUITY CAPM APPROACH

,the primary determinant of risk governs the cost of equity. re = rf + x (rm rf)
Cost of Equity re rm Risk Premium (rm-rf)

rf

=1 Chapter 13 Cost of Capital

Risk, 16

COST OF EQUITY DDM Vs CAPM APPROACH

CAPM based determination of cost of equity is regarded superior as
it relies on the market information and incorporates risk it need not know the dividend policy.

Dividend capitalisation approach

does not consider risk of the dividend has assumption of constant pay out ratio.
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COST OF INTERNAL AND EXTERNAL EQUITY

There are three major differences in the INTERNAL and EXTERNAL equity
Existence of flotation cost Under utilisation of external equity Under pricing of fresh capital
re for external equity = Cost of internal equity 1 D1 = +g (1- f) (1- f) P0

If floatation cost is 5% of the issue price and cost of internal equity determined either through DDM or CAP-M is 16% then the cost of fresh equity shall be 16.84% (16/0.95).
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ASSIGNING WEIGHTS
After cost of each component is determined they need to be multiplied by the respective proportions to arrive at WACC. The proportions may be based on 1) marginal 2) book value or 3) market value The weights based on the target capital structure are most appropriate though the current capital structure may not conform.
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BOOK VALUES vs MARKET VALUES

The weights for computation of WACC can either be based on
book values or market values

Though book value weights appear convenient and practical it lacks conviction ignoring current trends. Use of market value based weights is technically superior reflecting the current expectations of investors.
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MARGINAL COST OF CAPITAL

WACC as discount rate, implies that acceptance of projects do not alter the existing capital structure. When project is large compared to the existing operations, the capital structure as well as the cost of each component would more likely increase. Lenders tend to raise cost with the quantum, so could be the case with equity suppliers. In such cases WACC is inappropriate as hurdle rate. Marginal (incremental) cost of capital is more appropriate.
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OPTIMAL CAPITAL BUDGET

In practice Marginal Cost of Capital must be used in determination of the optimal capital budget. Marginal cost of capital governs the value addition. Incremental benefits must exceed incremental cost. The capital expenditure level at which incremental benefits are equal to the incremental cost is Optimal capital budget.
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WACC and RISK

The discount rate for the project must be appropriate to its risk. In most cases WACC adequately represents the risk since most projects selected by the firms belong to the line of activity. Where project has substantially different risk profile blind use of WACC as discount rate may cause 1.erroneous acceptance of riskier project due to lower discount rate or 2.erroneous rejection of less risky project due to higher discount rate.
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PURE PLAY APPROACH Adjusting for Risk

Risk-adjusted WACC must be used as discount rate for the cash flow. Most popular method to incorporate such risk is called a pure-play approach, identifying a firm that most resembles the risk profile of the new project. beta of the firm is adjusted for its leverage to find an all equity beta, called unlevering and then re-adjusting for the proposed capital structure of the project, called relevering. The value of so arrived is used in calculating the WACC.
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