Cost of Capital

Every resource has some price or that has its cost. Fund also has a price. Supplier of Funds wants some compensation like interest. If one pays the appropriate interest the supplier will release the funds otherwise not. So the Cost of Capital is the return that is enough to motivate him (Lender) to provide his funds.

Types of funds
Debt Equity

Debt
In this type of fund the supplier (lender) wants fixed return. So, in general we can say the interest paid to the lender is cost of capital. However, in some cases this may be different. The rate of interest is expressed in percentage term. In a simple case of lending & borrowing Cost of Capital = Rate of Interest

But many times the rate of interest received by the lender is not same as cost paid by the borrower. It has prospective difference, like from the view point of lender it is an interest or return while from the view point of borrower it is a cost of capital.

Contd.
In a simple situation it will remain same. However, in the process of lending & borrowing some incidental charges and other expenses are involved that creates difference in between the rate of interest & cost of capital. So in case of debt, the cost of capitalInterest Amount X 100 Kd = Borrowed Amount or Net Receipt of Borrower

Contd.
In the process of borrowing some exp. Like bank charges, processing fees, transport, and documentation expenses etc. may incurred. So the net receipt of the borrower would become less than the amount lent by lender.

Example:
Let us assume that in order to borrow Rs. 1,00,000 the borrower has to spend Rs. 5,000 on the transport, documentations or as processing fees. Calculate the rate of return and cost of capital if the rate of interest is 12% p.a.

Solution
Interest Amount X 100

Rate of Return =
Amount Lent

12,000 X 100 Rate of Return = 1,00,000 = 12%

Cost of Capital
The Net receipt of borrower = Borrowed amount Incidental charges = 1,00,000 5,000 = 95,000 Interest Amount X 100 Kd = Borrowed Amount or Net Receipt of Borrower 12,000 X 100 Kd = 1,00,000 5,000 = 12.63%

Important Note
This calculation of cost of capital will be correct in perpetual debt. It means that the borrowed amount (Principal amount) will not repaid for an infinite period. It may not happen in the real life. When issue bonds / debentures take place, borrower (Company) has to pay many exp. like underwriting commission, discount on issue etc. So, all these expenses have to be accounted for in calculating the cost of capital.

Types of Cost of Capital

Before Tax Cost & After Tax Cost Average Cost & Incremental Cost / Marginal Cost Weighted Average Cost of Capital

Before Tax Cost & After Tax Cost

If the rate of interest is 10% the cost of capital before tax will be 10% but if the tax rate is 30% than the cost of capital after tax = Before Tax Cost X 1- t t = Tax Rate So, in the above case cost of capital after tax will be = 10% X 1- .3 = 10% X .7 = 7%.

Average Cost & Incremental Cost / Marginal Cost

Average cost of capital refers the average of historical cost and incremental cost of capital. Historical cost means is the cost incurred in the past. While incremental cost is the cost of additional funds. Total Interest Average Cost of Capital = Total Funds Extra Interest Incremental or marginal cost of Capital = Extra Funds

Weighted Average Cost of Capital

It is an average of various cost of capitals on the basis of given proportion of different sources of finance. Weighted Average Cost of Capital= Cost of Capital of Debt (Term Loan + Debenture/ Bonds)+ Preference Share+ Equity Share + Retained Earning X respected weights/ Total Capital

Cost of Debt
Debt includes mainly two types of financial instruments. Long Term Debt (Term Loan) Debenture / Bonds

Long Term Debt (Term Loan)

Debts which are borrowed for a long term period i.e. which are not paid with in an accounting year. The amounts are released in the lump sum form.

Debenture / Bonds
These types of financial instruments are issued by the company in small financial units. Like of Rs. 10, Rs.100 & Rs. 1,000.

Contd.
In case of long term debt (Term Loan) there is no need to make any adjustment except incidental charges at the time of borrowing but in case of issue of debentures / bonds for following transactions some adjustments are need to be done. Discount on issue Premium on issue Premium on redemption Floating Cost

Contd.
From the view point of a company discount on issue & floating cost will raise the cost of capital at the time of issue. While the premium on redemption will increase the cost of capital, not at this time but in the future. Premium on issue will reduce the cost of capital.

Contd.
When we make all these adjustments then we get real cost of capital for any bond or debentures. A formula which gives an appropriate value is as follows. I(1-t) + (F + D + Pr - Pi) / N Kd = (Rv +Sv)/2

Contd.
I = Interest t = Tax Rate F = Flotation Cost or Issue Exp. D = Discount on Issue Pr = Premium on redemption Pi = Premium on issue N = No. of years Rv= Net redemption value Sv = Net Sale Value (Net receipt of Loan)

Example
A company makes an issue of 12% bonds for Rs. 1,00,000. The issue exp. Rs. 6,000 while the issue is made at discount of 2%. The bond will be redeemed after 5 year at a premium of 5%. Find out the after tax cost of Capital if the rate of tax is 30%.

Solution
12,000(1-.3) + (6,000 + 2,000 + 5,000) / 5

Kd =

(1,05,000 + 92,000)/2 12,000(.7) + (13,000) / 5

Kd =

(1,97,000)/2 8,400 + 2,600 98500 11,000

Kd =

Kd =

98,500 Kd = .1117or 11.17 %

Cost of Equity
Preference Share: Preference shares are those shares which have preference in payment over equity shares in respect of following two. Regarding payment of dividend Regarding payment of Principal amount at the time of winding up of a company.

Contd.
However, when the preference share holders get above two privileges than they have to forego the voting right in the companys management and they are not entitled to receive excess dividend over the predetermined rate of dividend. They get only fixed return on their capital contribution.

Contd.
On the basis of payment the preference shares can be divided in to two parts. Perpetual Preference Share Redeemable Preference share

Perpetual Preference Share:

In case of perpetual Preference share the cost of capital can be calculated as follows. d Kp = Amount of Issue (Exp. on issue or discount Premium if any) d = Rate of Dividend.

Redeemable Preference share

In case of redeemable preference share the cost of capital can be calculate through the following formulad + (F + D + Pr - Pi) / N Kp =

(Rv +Sv)/2

Contd.
d = Dividend F = Flotation Cost or Issue Exp. D = Discount on Issue Pr = Premium on redemption Pi = Premium on issue N = No. of years. Rv= Net redemption value Sv = Net Sale Value (Net receipt of Capital)

Contd.
In the above formula we will not consider tax impact (1 - t), because the dividend is not deductible from profit & Loss A/c as an expenditure while calculating taxable business income.

The simple reason behind this is that the Interest paid to the lender is expenditure and the debenture holders are not owner of the company, where as preference share holders are owner of the company and they do not form risk capital like lenders.

So, how we can deduct the owners return from Profit & Loss A/c while computing dividend which is to paid to them after deduction of corporate tax. The Company has to show the dividend part in the Profit & Loss Appropriation A/c.

Equity Share:
Equity share holders are real owner of the company because They have voting right in the companys management. They are risk bearer i.e. they get dividend after making all the payments like payment of interest to the debenture holders and other lenders, corporate tax and payment of dividend to the preference share holders.

Important Tips
Although, it is not mandatory for a company to pay dividend on equity but still the company is required to pay the return to the share holders which they expecting, otherwise the shareholders will start selling their shares even on the low price to recover their capital which will bring down the market price of the share and ultimately the wealth of the share holders. Therefore company is required to pay the return to the shareholders as per their expectation. i.e. Cost of Capital.

Contd.
Shareholders expect two things form their investment in share Current Return (Dividend) Growth in Return (Capital Gain)

Growth in return (Dividend) can be achieved by way of following two ways.

By increase in dividend rate By increase in dividend amount through bonus shares.

Contd.
If we incorporate current return & growth in return, we get the Cost of Equity as Follows. d Ke = +g p
d = Current Dividend Amount p = Market Price of the Share g = Growth rate of dividend.

Example
Suppose a company makes an issue of equity share of Rs. 10 at premium of Rs. 40. The current dividend rate is 40%. This expected to 10% p.a. Calculate the cost of equity.

Solution
d

Ke =
p
4

+g

Ke =

+ .1 50 .08 + .1 .18 or 18%.

Ke = Ke =

Retained Earning
The cost of retained earnings determined by this dividend growth model implies that if the firm would have distributed earning to the shareholders, they could have invested it in the shares of the firm or in the shares of other firms of similar risk at the same market price to earn equal rate of return. So, the cost of capital of retained earning will be equal to the cost of capital to the equity shares.

Weighted Average Cost of Capital

In the Weighted Average Cost of Capital (WACC), one has to find out the average cost of capital from different sources of finance like debt & equity. As we know that WACC is nothing but it is sum total of all the average costs of different sources of capital after considering their individual ratio the total capital. These individual ratios are termed as weight.

Contd.
For example in any capital structure if 10% debentures of Rs. 1,00,000 are issued out of total Capital of say 8,00,000. The ratio of debt to total capital will be 1,00,000 / 8,00,000 = 1/8 or .125, while calculating WACC we will consider this weight also and in this case average cost of capital of debt will not be 10% but it will be .125 X 10% = 1.25. and sum total these type of average cost of capital calculated on the basis of their respective weight will be WACC. It represents the amount which is to be paid or payable by the company to obtain the funds.

Contd.
The concept of WACC is so important the company has to decide how the company can reduce this rate. In the different sources of funds one has to decide which the cheapest source of finance is & what should be it ratio in this total capital.

Example
Let us assume that Company X has to raise Rs. 5,00,000 for its new project. The company has to decided to raise it to following manner Rs. 1,00,000 by a term loan from IDB & rate of interest is 14%. Issue of bonds of Rs. 1000 each at coupon rate of 12% p.a. at discount of 3%. The issue exp. comes to Rs. 8,000. The bond are redeemable at par after 6 years. Total amount is Rs. 2,00,000. Perpetual preference shares @ 14% p.a. & the issue exp. are 5%. The total amount is Rs. 50,000. Equity Rs. 10 each. The current market price is Rs. 40 current dividend rate is 40% & growth is 12%. The amount is Rs. 1,00.000 Internal Sources Rs. 50,000. The tax rate is. 40%. Calculate Weighted Average Cost of Capital (WACC) of the X Company.

Solution
Sources Individual Cost Weight Weighted Cost

1 2

8.4 8.67

.2 .4

1.68 3.47

3
4

14.74
22.00

.1
.2

1.47
4.40

5
Total

22.00

.1

2.20
13.22