Cost Of Capital PRESENTED BY:-

ANKUR KUMAR M.COM-4th SEM. 2015MCOM002

INTRODUCTION

Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern.

It is used as a discount rate in determining the present value of future cash flows associated with capital projects.

Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.

Meaning of Cost of Capital

Cost of capital(k) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds.

Cost of capital is the required rate of return on its investments which belongs to equity , debt and retained earnings.

If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.

To meet cost & expenses. Cost of capital is the relationship of Liability on organisation with

respect to usage of funds.

Definitions

According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.

According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.

According to the definition of William and Donaldson, “Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due”.

Assumption of Cost of Capital

There are three basic concepts:-1. It is not a cost as such. It is merely a hurdle rate.2. It is the minimum rate of return.3. It consist of three important risks such as zero risk level, business risk and

financial risk. Cost of capital can be measured with the help of the following equation. K = rj + b + f Where, K = Cost of capital. rj = The riskless cost of the particular type of finance. b = The business risk premium. f = The financial risk premium.

CLASSIFICATION OF COST OF CAPITAL Cost of capital may be classified into the following types on the basis of

nature and usage:- • Explicit and Implicit Cost. • Average and Marginal Cost. • Historical and Future Cost. • Specific and Combined Cost.

Explicit and Implicit Cost

Explicit cost is the rate that the firm pays to procure financing.

Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders.

Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital employed by the company. It considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc.

Marginal cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when the company goes for further raising of finance.

Historical and Future Cost

Historical cost is the cost which as already been incurred for financing a particular project. It is based on the actual cost incurred in the previous project.

Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of previous experience.

Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of capital. It is very useful to determine the each and every specific source of capital.

The composite or combined cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. It is used to understand the total cost associated with the total finance of the firm.

IMPORTANCE OF COST OF CAPITAL

Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.

• Importance to Capital Budgeting DecisionCapital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision. Importance to Structure DecisionCapital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capitalhelps to take decision regarding structure.

IMPORTANCE OF COST OF CAPITAL

Importance to Evolution of Financial PerformanceCost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.

Importance to Other Financial DecisionsApart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.

COMPUTATION OF COST OF CAPITALComputation of cost of capital consists

of two important parts:1. Measurement of specific costs2. Measurement of overall cost of capital

1. Measurement of specific costs

It refers to the cost of each specific sources of finance like:• Cost of equity• Cost of debt• Cost of preference share• Cost of retained earnings

Cost of Equity

cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares”.

Cost of equity can be calculated from the following approach:- • Dividend price (D/P) approach • Dividend price plus growth (D/P + g) approach • Earning price (E/P) approach

Key points to be kept in mind during calculation:-

NP =Net Proceeds which will be as under :- When Shares/Debentures are issued at Par-

NP=Par Value- floatation charges or Expenses on issue

When Shares/Debentures are issued at Discount-

NP= Par Value-Discount- floatation charges or Expenses on issue

When Shares/Debentures are issued at Premium-

NP=Par Value+Premium- floatation charges or Expenses on issue

Cost of Equity(method-1)

A. Dividend price (D/P) approach:-

Ke(after tax)= Ke(before tax)= where; Ke=cost of equity share capital ( before and after tax) DPS=Dividend per Equity Share MPS/NP=Market Price per Share/net proceeds

Q. X Ltd. has issued 2,000 equity shares of Rs100 each as fully paid . The market price of per share is Rs160. The company has paid a dividend of Rs8 per share. Tax rate is 30%. Compute the cost of equity share capital after and before tax.

Ans:-5%,7.143%

Cost of Equity(method-2)B. Dividend price plus growth (D/P + g) approach- Ke(after tax)=(

Ke(before tax)= where; Ke=cost of equity share capital ( before and after tax) DPS=Dividend per Equity Share MPS/NP=Market Price per Share/net proceeds G=Growth rate of the dividend

Q. The current market price of the equity shares of Z Ltd.is Rs95. The floatation costs are Rs5 per share . Dividend per share amounts to Rs4.50and expected to grow at the rate of 7%.find out cost of equity share capital after and before ;if tax rate is 40%.

Ans.-12%,20%

Cost of Equity(method-3)C. Earning price (E/P) approach-

Ke(after tax)=

Ke(before tax)= where; Ke=cost of equity share capital ( before and after tax) EPS=Earning per Equity Share MPS/NP=Market Price per Share/net proceeds

Q. A Ltd. is earning Rs1,00,000. It has issued 10,000 shares of 100 each as fully paid. The market price of these shares is Rs160. Corporate tax rate is60%. Find out the cost of equity share capital after and before the tax. Ans.-6.25%,15.625%

Cost of Equity(method-4)

D. Realized Yield Approach-

Ke = PVf ×D=…%Where, Ke = Cost of equity capital. PVƒ = Present value of discount factor. D = Dividend per share

Q. ABC Ltd has issued 2,000 equity shares of Rs100 each as fully paid. The company has paid a dividend of Rs8 per share. Present value of discount factor for the first year is @10%. Calculate cost of equity share capital.Ans-7.273%

Cost of debt-Cost of debt is the after tax cost of long-term funds through borrowing.

Perpetual/Irredeemable:-

Kd (before tax)= Kd (after tax)= Kd (before tax)=…% where, Kd=cost of debt capital(before/after tax) IP =Interest payable NP= Net proceeds from issue(capital received)

Q.Ankur Ltd. is willing to issue ,10% debentures of Rs500. The company will have to incur following expenses- Underwriting Commission 2%,Brokerage0.5%,Printing Rs10 per debenture, other expenses Rs4,000.calculate cost of debt capital before and after tax assuming corporate tax rate is 60%.

Ans-10.48%,4.192%

Cost of debt-

Redeemable debt:- Kd (before tax)=

Kd (after tax)=Kd (before tax)=…% where, Kd=cost of Debt.(before/after tax) IP=Interest Payable NP=Net proceeds MV=Maturity value N=Maturity period (No. of years)

Q.A company has issued 7% debentures of Rs100 each at a premium of 6% for the period of 12years. Corporate Tax rate is 30%. Find out cost of debt capital before and after tax.

Ans-6.31%,9.014%

Cost of preference share-Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share.

Perpetual/Irredeemable Pref. share:- KP (after tax)= KP (before tax)==…% where, Kp=Cost of pref. share capital Pd=Dividend on preference share NP=Net Proceeds from issue of pref. share

Q. Sunil Ltd. has issued 9%,10,000 Pref. shares of Rs100 each and incurred the following expenses :-Underwriting commission 2%,Brokerage 1%,Other expenses Rs10,000. Find out the cost of capital after and before tax; assuming that tax rate is 50%. Ans-9.375%,18.75%

Cost of preference share-

Redeemable Pref. shares:-

Kp (after tax)=

Kp (before tax)==…% where, Kd =cost of Pref. share capital(before/after tax)

Pd=Dividend on Pref. shares NP=Net proceeds MV=Maturity value N=Maturity period (No. of years)

Q. Gaurav Ltd. has issued 10% redeemable Pref. shares of Rs100 each. These shares are redeemable at the end of 10th year . The underwriting costs come to 2%. Calculate the cost of Pref. share capital after and before tax. Tax rate is 40%.

Ans-10.30%,17.17%

Cost of retained earnings-Undistributed part of accumulated profits is kept by company/firms for investment proposal is known as Retained Earnings.

Kr (after tax)= where, Kr= cost of retained earnings AD=Earnings from alternative Investment Td= Personal tax liability B=Brokerage r=Retained earnings Tc=capital gain tax rate

Kr (before tax) = =…%

Q. Gaurav holds 2, 000 shares of Rs20 each in Kavita Ltd. Kavita Ltd. has earned Rs15 per share and distributed Rs10 per share as dividend among shareholders. The balance is being retained earnings. The market price of the share in Kavita Ltd. is Rs80 per share. find out the cost of retained earnings after and before tax in the following conditions: -1. Corporate tax rate is 60%.2. Personal tax liability of Gaurav is 40%.3. Personal capital gain tax rate is 50%.

Ans-22.05%,56.25%

2. Measurement of overall cost of capital-

It is also called as weighted average cost of capital and composite cost of capital. Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firms capital structure.

The computation of the overall cost of capital (Ko) involves the following steps.

(a) Assigning weights to specific costs.(b) Multiplying the cost of each of the sources by the appropriate weights.(c) Dividing the total weighted cost by the total weights.

The overall cost of capital can be calculated with the help of the following formula:-Ko= Kd *Wd + Kp *Wp + Ke *We + Kr *Wr

Where,Ko = Overall cost of capitalKd = Cost of debtKp = Cost of preference shareKe = Cost of equityKr = Cost of retained earningsWd= Percentage of debt of total capitalWp = Percentage of preference share to total capitalWe = Percentage of equity to total capitalWr = Percentage of retained earnings