Cost of Capital. Cost of Capital. Financial Management - II Chapter 04

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1 Learning Objectives: To provide conceptual understanding of cost of capital its variants. To develop understanding of methodology of measurement, various sources of capital and cost of capital. Structure: Concept Types of Importance Computation of Composite Weighted Cut-Off Rate

2 Concept Cost of capital, as noted in capital budgeting decision, is a major standard of comparison used in modern financial decisions. Acceptance or rejection of an investment project is essentially dependent on cost the company is required to pay for financing it. As seen earlier, while using NPV method to screen investment projects, cost of capital serves as the discount rate to ascertain whether project yields a positive net present value. In case of IRR, the rate is compared with cost of capital to determine whether the project is financially viable or not. Computation of cost of capital is thus inescapable for taking logical investment decisions.

3 Concept represents the rate of return which the company must pay to the suppliers of capital for use of their funds. This would be the minimum rate of return that a project must yield to keep the value of the enterprise intact. Economists define cost of capital in two senses, viz., i] cost of capital in terms of garnering funds needed to finance the project and ii] cost of capital in terms of opportunity cost of the funds to the firm.

4 Concept In the first sense cost of capital refers to borrowing rate. In economic terms it denotes combined cost of capital which is average of the costs of each sources of funds employed by the company properly weighted by the proportion of each source of funds to the total amount obtained. Cost of capital used in the second sense of opportunity cost, refers to the rate of return which company would have earned if the funds were invested elsewhere. In sum, cost of capital can be defined as, either the minimum rate of return an investment project must earn to keep value of enterprise intact or the combined cost of financing the corporate enterprise.

5 Types of It is noteworthy that the cost of capital is always expressed in terms of percentage. Besides the general concept of cost of capital, discussed earlier, there are other concepts of cost of capital. It is, therefore, necessary to take a look at those. There are four types of cost of capital. Which are presented, in chart form, in next slide.

6 Types of Explicit Implicit Cost Future Historical Cost Types of Cost of Capital Average Marginal Cost Component Cost Composite Cost

7 Types of Future Historical Cost : Future cost refers to the expected cost of funds to be raised to finance project. Latter refers to cost incurred in the past in acquiring funds. For financial decision, future cost is more significant and relevant. In investment decisions Finance Manager attempts to minimize future costs. Historical cost is useful in evaluating the past performance of the company predicting future costs.. Future Historical Cost Explicit Implicit Cost Types of Cost of Capital Component Composite Cost Average Marginal Cost

8 Types of Component Cost Composite Cost : The company may want to raise funds by means of different sources like debentures, shares, common stock etc. These sources constitute components of funds. Each such source involves cost to company. Such cost is called component cost. When these costs are combined to determine overall cost of capital, it is regarded as composite cost. Future Historical Cost Explicit Implicit Cost Types of Cost of Capital Component Composite Cost Average Marginal Cost

9 Types of Average Marginal Cost : The average cost represents the weighted average of the cost of each source of funds employed by the enterprise, whereas marginal cost means incremental cost associated with new funds raised by the firm. In financial decisions marginal cost concept is more significant. Future Historical Cost Explicit Implicit Cost Types of Cost of Capital Component Composite Cost Average Marginal Cost

10 Types of Explicit Implicit Cost : The explicit cost of any source of capital is the internal rate of return of the cash flows of financing opportunity. Where as implicit cost of capital refers to the rate of return associated with the best investment opportunity of firm that will be forgone if the project under consideration by the firm were accepted. It is the opportunity cost of funds invested elsewhere. Retained earnings has implicit cost. Future Historical Cost Explicit Implicit Cost Types of Cost of Capital Component Composite Cost Average Marginal Cost

11 Importance The cost of capital plays crucial role in the capital budgeting decision. The cost of capital determines the acceptability of all investment opportunities regardless of the techniques employed to judge the financial viability of a project. It provides useful guideline in determining optimal capital structure of a company. When company s quantum of funds its make up is such that average cost of capital is minimized, then its average cost marginal cost is same. The company is said to have optimal capital structure. It serves as a screening tool to evaluate decisions at the time of dissolution of the company.

12 Computation of Composite In order to compute composite cost (overall cost) of capital, finance manager has to - determine the type of funds to be raised and their share in total capital. - determine cost of each type of funds. - calculate the combined cost of capital by assigning weights in terms of proportion of each fund so raised to the total. Finance manager must determine the cost of each type of fund needed in the capital structure of the company. The various components of capital are depicted in the chart form on next slide

13 Computation of Composite Components of Capital Cost of Short Term Debt Cost of Long Term Debt Cost of irredeemable debt Cost of redeemable debt Implicit Cost of Debt Cost of Preferred Stock Cost of irredeemable Preferred Stock Cost of redeemable Preferred Stock Cost of Equity Stock Dividend Price Approach Earnings Price Approach Realised Yield Approach Cost of Retained Earnings

14 Computation of Composite Cost of Short Term Debt: Short term debt [ from banks ] to meet temporary working capital does not constitute a source of financing capex, hence its cost is disregarded in cost of capital. However, if short term loan is converted into medium and then into long term through renewal process, then its cost needs to be included. Usually requirements of permanent working capital are satisfied by such funds.

15 Computation of Composite Cost of Long Term Debt: Cost of long term debt is defined as the minimum rate of return that must be earned on debt financed investments, if the company s total wealth is to remain intact. The computation is easy as the rate of interest at which funds are borrowed is fixed by the company in the agreement with its creditors.. The debt can be perpetual or irredeemable and redeemable.

16 Computation of Composite Cost of Irredeemable Debt: Cost of irredeemable debt is the minimum rate of return expected by the lenders on funds supplied to the company. Contractual annual interest payment when related to actual proceeds realized from the sale of debentures is the actual cost of the debt. When this cost of debt is adjusted after tax, we get effective cost of perpetual debt.

17 Computation of Composite Cost of Redeemable Debt: There are two methods of computation of cost of redeemable debt. Under Yield to Maturity Method cost of long term debt is the yield to maturity [i.e. % return on money to be received by the debenture holders on maturity] adjusted by the firm s tax rate plus distribution cost. Under Present Value method cost of debt is the discount rate which equates the present value of interest and repayment of principal to the sale price of debentures.

18 Computation of Composite Implicit Cost of Debt Increase in debts beyond a certain limit can down grade company s credit rating. This increases the rate at which it can access credit and reduces its share prices. This constitutes Implicit Cost of Debt. To arrive at the actual cost of debt capital, hidden or implicit cost should be added in the explicit cost. However, the task of computing this implicit cost is complex and reason for many finance managers to ignore it.

19 Computation of Composite Cost of Preferred Stock Cost of Preferred Stock represents the rate of return that must earned on the preferred stock financed investments to keep earnings available to the residual stockholders unchanged. To arrive at the actual cost of preferred stock, dividend stipulated per share is divided by current market price of the share.

20 Computation of Composite Cost of Irredeemable Preferred Stock Cost of Irredeemable Preferred Stock can be calculated by formula DP Kp = MP Where Kp is cost of preferred stock, DP is dividend per share and MP is the market price. Cost of Redeemable Preferred Stock The explicit cost of redeemable stock is the discount rate that equates the net proceeds from the sale of preference shares with the present value of the future dividends and principal repayments.

21 Computation of Composite Cost of Equity Stock The cost of equity stock is most difficult to compute as it is based on forecast and hence not exact. The rate of dividend is not stipulated. Simple formula, under Dividend Price Approach is to divide current dividend per share by current market price. Under Earnings Price Approach EPS denotes cost of equity stock. Under Realized Yield Approach average rate of previous years are considered for future costs.

22 Computation of Composite Cost of Retained Earnings The opportunity cost here represents sacrifice of the dividend income which the shareholders would have otherwise received immediately from the retained earnings of the company. Shareholders expect that the company will, at minimum, earn market rate of return on such retained earnings.

23 Weighted After computing individual cost of different components of capital, then they are combined to determine weighted cost of capital so that the same may be compared with the discounted rate of return of the project. The weighted cost of capital can be defined as, the average of the cost of each source of funds employed by the company, properly weighted by the proportion they hold in the capital structure of the organisation.

24 Weighted The cost of each components of the proposed capital is then weighted by the relative proportion of that type of funds in the capital structure. The sum of multiplied figures of the different components of the capital structure is divided by the total number of weights. The resulting figure would be the weighted cost of capital.

25 Cut-Off Rate A cut-off rate is the optimal point of selecting viable projects. It is expressed in terms of percentage. After estimating the rates of return of different projects, they are compared with this rate. Projects promising higher or equal rate of return are accepted and rest are rejected. Composite cost of capital serves as a cut-off point for approval of projects. Many finance managers set cut-off rate in the range of say 10% to 15% above weighted or composite cost of capital. This is a wise step to counteract uncertainty and assumptions associated with proposed investments and different sources of capital funds.

26 The end. Next Chapter Five. Portfolio management Good Luck!