Description
This PPT on Concept of Cost of Capital (COC)
• Investors’ View Point - the measurement of the sacrifice
made by him/her in order to capital formation.
• For Ex: A invested in a share amounted to Rs. 1 lakh, instead of
investing in a bank which pays 7 % interest.
• Firm’s View Point- It is the minimum required rate of return
needed to justify the use of capital.
• For Ex. A firm raised Rs. 50 lakhs by issuing 10 % Debentures, for
justifying this issue it has to earn a 10 % minimum rate of return on
investment.
• Capital Expenditure View Point
• It is the minimum required rate of return or target rate or any
discount rate used to value cash flows.
–Ex. Firm A is planning to invest in a project, that require Rs. 20 lakhs
& it provides cash flows for 5 years, here for conversion of the future
5 years cash inflows into present values we need cost of capital.
?The project’s cost of capital is the minimum required
rate of return on funds committed to the project, which
depends on the riskiness of its cash flows.
?The firm’s cost of capital will be the overall, or average,
required rate of return on the aggregate of investment
projects.
?Designing Optimal Corporate Capital Structure
?Investment Evaluation / Capital Budgeting
?Financial Performance Appraisal
• A new issue of debt or shares will invariably involve
flotation costs in the form of legal fees, administrative
expenses, brokerage or underwriting commission
(i) Dividends capitalization Approach
According to this approach, the cost of equity capital is calculated on
the basis of required rate of return in terms of the future dividends to
be paid on shares.
K
e
= (D / CMP or NP)100
Where: K
e
= Cost of Equity
D = Dividends Per Share
CMP = Current Market Price per Share/NP = Net Proceed per
Share
Ex: XYZ ltd. is currently earning Rs. 1,00,000, its current market price of share is
Rs. 100, outstanding equity shares are 10,000. The company decides to raise an
additional capital of Rs.2,50,000 through issue of equity shares to the public. It is
expected to pay 10 % per share as floatation cost. Equity capital issued at a
discount rate of 10 %. The company is interested to pay a dividend of Rs.8 per
share. Calculate cost of equity.
(10 %)
? It does not consider future earnings
?It ignores the earnings on retained earnings
?It ignores the fact that market price raise may be
due to retained earnings and not on account of
high dividends.
?It does not take into account the capital gains.
K
e
= (E / CMP or NP)100
Where
• K
e
= cost of equity
• E = earnings per share
• CMP = current market price per share
• NP = net proceeds per share
• Ex:
TISCO is currently earning 15 % operating profit on its share capital of
Rs. 20 lakhs (Face value of Rs. 200 per share). The company requires
an additional capital of Rs. 10 lakhs for expansion. Company is planning
to issue equity shares at 10 % premium and the expected floatation cost
is 5 %. Calculate cost of equity.
(14.29 %)
• K
e
=[(D/NP or CMP) + g]100
Where: K
e
= cost of equity capital
D = dividends per share,
NP = net proceeds per share,
CMP = current market price per share,
g = growth rate (%)
Ex.- A company wants to raise Rs. 1 lakh for the purchasing of a Machinery
by issuing of equity shares. The selling price of equity share is Rs. 95. the
expected dividend in next year is Rs.4.75 and it is expected to grow at 6 %
perpetually. Calculate COC.
• (11 %)
?According to this approach the rate of return required by the
equity shareholder of a company is equal to
?K
e
= Yield on Long-term Bonds + Risk Premium
• XYZ company is planning to sell equity shares. Mr. A who is planning to
invest in XYZ company equity shares. Bond yield of XYZ co. is 12 %.
Calculate required rate of return on equity with 3 % risk premium.
• (15 %)
?Capital Asset Pricing Model (CAPM) was developed by William F. Sharpe.
?CAPM explains the relationship between the required rate of return, or the
cost of equity capital and the non-diversifiable or relevant risk of the firm
as reflected in its index of non-diversifiable risk that is beta (?).
?In simple words CAPM distinguish efficient securities & inefficient
securities.
?K
e
= R
f
+ (R
mf
– R
f
) ?
Where: K
e
= cost of equity capital
R
f
= the rate of return required on a risk free security (%)
? = the beta (a model that calculates the expected return of an asset based
on its beta and expected market returns.)
R
mf
= the required rate of return on the market port folio of assets, that
can be viewed as the average rate of return on all assets.
• Calculate cost of equity capital using CAPM approach.
Company’s risk free rate of return equals to 12 %, beta
equals to 1.7 and return on market portfolio equals to
14.5 %
• K
e
= R
f
+ (R
mf
– R
f
) ?
• = 12+[14.5-12]1.7
• =16.25 %
COST OF RETAINED EARNINGS (K
re
)
Retained earnings is one of the internal sources to raise
equity finance. Retained earnings are those / part of
(amount) earnings that are retained by the form of
investing in capital budgeting proposals instead of
paying them as dividends to shareholders
K
re
= K
e
(1 – Ti) X 100
(1 – Tb)
Where: K
e
= cost of equity capital [D ? P]
? T
i
= marginal tax rate applicable to the individuals concerned.
? T
b
= cost of purchase of new securities / broker
? D = expected dividend per share
? P = net proceeds of equity share / market price
• Examples The company paid a dividend of Rs. 2 per share, market
price per share is Rs. 20, income tax is 60 % and brokerage is 2 %.
Compute cost of retained earnings.
K
re
= K
e
(1 – Ti) X 100
(1 – Tb)
= D/NP[(1-0.6)/(1-0.02)]100
= 2/20[(1-.06)/(1.02)]100
= 0.10x0.408x100=4.1 %
Cost of Irredeemable Preference Share / Perpetual Preference Share:
?The share that cannot be paid till the liquidation of the company are
called as irredeemable preference shares. The cost is measured by the
following formulas.
K
p
(without tax) =D/CMP or NP
Where: K
p
= cost of preference share
D = dividend per share
CMP = market price per share
NP = net proceeds
Cost of irredeemable preference stock (with dividend tax)
K
p
(with tax) =D (1 + Dt)/CMP or NP
where Dt = tax on preference dividend
• RIL issues 12 % perpetual preference shares of face
value of Rs. 200 each. Computed COPS.(without tax).
K
p
(without tax) =D/CMP or NP
= (24/200)100=12 %
RIL issues 14 % perpetual preference shares of face
value of Rs. 250 each with an estimated floatation cost
of 5%.
Computed COPS if tax rate is 10 %.
K
p
(with tax) =D (1 + Dt)/CMP or NP
=35(1+0.10/237.50)100=16.21 %
• Shares that are issued for a specific maturity period or
redeemable after a specific period are known as
redeemable preference share.
K
P
= D+(f+d+pr-pi)/Nm
(RV+NP)/2
D= Dividend per share
F-floatation cost
d- discount on issue of preference shares
Pr-premium on redemption of preference shares
Pi-premium on issue of preference shares
Nm-term of preference shares
RV-redeemable value of preference shares
NP-net proceeds
Example:
A company issues Rs. 1,00,000, 10% preference shares of Rs.100
each redeemable after 10 years at face value. Floatation cost is 10 %.
Calculate cost of preference shares
Solution:
K
P
= D+(f+d+pr-pi)/Nm
(RV+NP)/2
=10+(10+0+0-0)/10
(100+90)/2
=10+1/95*100
=11.58 %
Cost of Irredeemable Debt / Perpetual Debt
?Cost of perpetual debt is the rate of return that lender
expect (i.e., fixed interest rate). The coupon rate or the
market yield on debt can be said to represent an
approximation of cost of debt. Bonds / debentures can be
issued at (i) par / face value, (ii) discount and (iii) premium.
?Cost of Irredeemable Debt / Perpetual Debt
i) PRE-TAX COST
K
d
= I/P
K
d=
Pre-tax cost of debentures
P- face value
I-Interest
ii) POST-TAX COST
K
d
= I(1-t)
NP
EXAMPLE
Rama & co. has 15 % irredeemable debentures of Rs. 100 each for
Rs. 10,00,000. the tax rate is 35 %. Determine cost of debenture
assuming it is issued at
i) face value
ii) 10 % premium
iii) 10 % discount
ISSUED AT PRE-TAX POST-TAX
Face value (15/100)100=15 % 15(1-0.35)100
100
= 9.75 %
10 % premium (15/110)100=13.64 % 15(1-0.35)100
110
=8.86
10 % discount (15/90)/100=16.67 15(1-0.35)100
90
=10.83
• K
d
= I(1-t)+(f+d+pr-pi)/Nm
(RV+NP)/2
• I= Interest (Rs)
• t=Tax rate
• f=Flotation cost(Rs)
• d=Discount on issue of debt (Rs)
• Pr=Premium on redemption of debt(Rs)
• Pi=Premium on issue of debt (Rs)
• Nm=Term of debt.
• RV=Redeemable value
• NP=Net proceeds realized.
• BE company issues Rs. 100 par value of debentures
carrying 15 % interest. The debentures are repayable
after 7 years at face value. The cost of issue is 3 % and
tax rate is 35 %. Calculate cost of debenture.
• K
d
= I(1-t)+(f+d+pr-pi)/Nm
(RV+NP)/2
= 15(1-0.35)+(3+0+0-0)/7
x100
(100+97)/2
= 10.33 %
?It is the average cost of the costs of various sources of
financing.
?It is also known as composite cost of capital, overall cost of
capital .
Steps of finding WACC
?Determination of the type of funds to be raised and their
individual share in the total capitalization of the firm
?Computation of cost of each type of funds by putting weights
Kw= ?
WX
/ ?
W
Kw=WACC
X= cost of specific source of finance
W= weight, proportion of specific source of finance
A firm has the following capital structure and after tax costs for the
different sources of funds used:
Sources of Funds Amount(Rs.) Proportion After-tax cost %
Debt 15 lakhs 0.25 5
Preference shares 12 lakhs 0.20 10
Equity shares 18 lakhs 0.30 12
Retained earnings 15 lakhs 0.25 11
Total 60 lakhs 1
You are required to computed the WACC
Computation of Weighted Average Cost of Capital
Sources of funds Proportion
(W)
Cost %
(X)
WX
Debt 0.25 5 1.25
Preference share 0.20 10 2.00
Equity shares 0.30 12 3.60
Retained earnings 0.25 11 2.75
Weighted average cost of capital 9.60 %
• Sometimes, we may required to calculate the cost of
additional funds to be raised, called the marginal cost of
capital.
• The marginal cost of capital is the weighted average cost
of new capital calculated by using the marginal weights.
• The marginal weights represent the proportion of various
sources of funds to be employed in raising additional
funds.
doc_246251584.ppt
This PPT on Concept of Cost of Capital (COC)
• Investors’ View Point - the measurement of the sacrifice
made by him/her in order to capital formation.
• For Ex: A invested in a share amounted to Rs. 1 lakh, instead of
investing in a bank which pays 7 % interest.
• Firm’s View Point- It is the minimum required rate of return
needed to justify the use of capital.
• For Ex. A firm raised Rs. 50 lakhs by issuing 10 % Debentures, for
justifying this issue it has to earn a 10 % minimum rate of return on
investment.
• Capital Expenditure View Point
• It is the minimum required rate of return or target rate or any
discount rate used to value cash flows.
–Ex. Firm A is planning to invest in a project, that require Rs. 20 lakhs
& it provides cash flows for 5 years, here for conversion of the future
5 years cash inflows into present values we need cost of capital.
?The project’s cost of capital is the minimum required
rate of return on funds committed to the project, which
depends on the riskiness of its cash flows.
?The firm’s cost of capital will be the overall, or average,
required rate of return on the aggregate of investment
projects.
?Designing Optimal Corporate Capital Structure
?Investment Evaluation / Capital Budgeting
?Financial Performance Appraisal
• A new issue of debt or shares will invariably involve
flotation costs in the form of legal fees, administrative
expenses, brokerage or underwriting commission
(i) Dividends capitalization Approach
According to this approach, the cost of equity capital is calculated on
the basis of required rate of return in terms of the future dividends to
be paid on shares.
K
e
= (D / CMP or NP)100
Where: K
e
= Cost of Equity
D = Dividends Per Share
CMP = Current Market Price per Share/NP = Net Proceed per
Share
Ex: XYZ ltd. is currently earning Rs. 1,00,000, its current market price of share is
Rs. 100, outstanding equity shares are 10,000. The company decides to raise an
additional capital of Rs.2,50,000 through issue of equity shares to the public. It is
expected to pay 10 % per share as floatation cost. Equity capital issued at a
discount rate of 10 %. The company is interested to pay a dividend of Rs.8 per
share. Calculate cost of equity.
(10 %)
? It does not consider future earnings
?It ignores the earnings on retained earnings
?It ignores the fact that market price raise may be
due to retained earnings and not on account of
high dividends.
?It does not take into account the capital gains.
K
e
= (E / CMP or NP)100
Where
• K
e
= cost of equity
• E = earnings per share
• CMP = current market price per share
• NP = net proceeds per share
• Ex:
TISCO is currently earning 15 % operating profit on its share capital of
Rs. 20 lakhs (Face value of Rs. 200 per share). The company requires
an additional capital of Rs. 10 lakhs for expansion. Company is planning
to issue equity shares at 10 % premium and the expected floatation cost
is 5 %. Calculate cost of equity.
(14.29 %)
• K
e
=[(D/NP or CMP) + g]100
Where: K
e
= cost of equity capital
D = dividends per share,
NP = net proceeds per share,
CMP = current market price per share,
g = growth rate (%)
Ex.- A company wants to raise Rs. 1 lakh for the purchasing of a Machinery
by issuing of equity shares. The selling price of equity share is Rs. 95. the
expected dividend in next year is Rs.4.75 and it is expected to grow at 6 %
perpetually. Calculate COC.
• (11 %)
?According to this approach the rate of return required by the
equity shareholder of a company is equal to
?K
e
= Yield on Long-term Bonds + Risk Premium
• XYZ company is planning to sell equity shares. Mr. A who is planning to
invest in XYZ company equity shares. Bond yield of XYZ co. is 12 %.
Calculate required rate of return on equity with 3 % risk premium.
• (15 %)
?Capital Asset Pricing Model (CAPM) was developed by William F. Sharpe.
?CAPM explains the relationship between the required rate of return, or the
cost of equity capital and the non-diversifiable or relevant risk of the firm
as reflected in its index of non-diversifiable risk that is beta (?).
?In simple words CAPM distinguish efficient securities & inefficient
securities.
?K
e
= R
f
+ (R
mf
– R
f
) ?
Where: K
e
= cost of equity capital
R
f
= the rate of return required on a risk free security (%)
? = the beta (a model that calculates the expected return of an asset based
on its beta and expected market returns.)
R
mf
= the required rate of return on the market port folio of assets, that
can be viewed as the average rate of return on all assets.
• Calculate cost of equity capital using CAPM approach.
Company’s risk free rate of return equals to 12 %, beta
equals to 1.7 and return on market portfolio equals to
14.5 %
• K
e
= R
f
+ (R
mf
– R
f
) ?
• = 12+[14.5-12]1.7
• =16.25 %
COST OF RETAINED EARNINGS (K
re
)
Retained earnings is one of the internal sources to raise
equity finance. Retained earnings are those / part of
(amount) earnings that are retained by the form of
investing in capital budgeting proposals instead of
paying them as dividends to shareholders
K
re
= K
e
(1 – Ti) X 100
(1 – Tb)
Where: K
e
= cost of equity capital [D ? P]
? T
i
= marginal tax rate applicable to the individuals concerned.
? T
b
= cost of purchase of new securities / broker
? D = expected dividend per share
? P = net proceeds of equity share / market price
• Examples The company paid a dividend of Rs. 2 per share, market
price per share is Rs. 20, income tax is 60 % and brokerage is 2 %.
Compute cost of retained earnings.
K
re
= K
e
(1 – Ti) X 100
(1 – Tb)
= D/NP[(1-0.6)/(1-0.02)]100
= 2/20[(1-.06)/(1.02)]100
= 0.10x0.408x100=4.1 %
Cost of Irredeemable Preference Share / Perpetual Preference Share:
?The share that cannot be paid till the liquidation of the company are
called as irredeemable preference shares. The cost is measured by the
following formulas.
K
p
(without tax) =D/CMP or NP
Where: K
p
= cost of preference share
D = dividend per share
CMP = market price per share
NP = net proceeds
Cost of irredeemable preference stock (with dividend tax)
K
p
(with tax) =D (1 + Dt)/CMP or NP
where Dt = tax on preference dividend
• RIL issues 12 % perpetual preference shares of face
value of Rs. 200 each. Computed COPS.(without tax).
K
p
(without tax) =D/CMP or NP
= (24/200)100=12 %
RIL issues 14 % perpetual preference shares of face
value of Rs. 250 each with an estimated floatation cost
of 5%.
Computed COPS if tax rate is 10 %.
K
p
(with tax) =D (1 + Dt)/CMP or NP
=35(1+0.10/237.50)100=16.21 %
• Shares that are issued for a specific maturity period or
redeemable after a specific period are known as
redeemable preference share.
K
P
= D+(f+d+pr-pi)/Nm
(RV+NP)/2
D= Dividend per share
F-floatation cost
d- discount on issue of preference shares
Pr-premium on redemption of preference shares
Pi-premium on issue of preference shares
Nm-term of preference shares
RV-redeemable value of preference shares
NP-net proceeds
Example:
A company issues Rs. 1,00,000, 10% preference shares of Rs.100
each redeemable after 10 years at face value. Floatation cost is 10 %.
Calculate cost of preference shares
Solution:
K
P
= D+(f+d+pr-pi)/Nm
(RV+NP)/2
=10+(10+0+0-0)/10
(100+90)/2
=10+1/95*100
=11.58 %
Cost of Irredeemable Debt / Perpetual Debt
?Cost of perpetual debt is the rate of return that lender
expect (i.e., fixed interest rate). The coupon rate or the
market yield on debt can be said to represent an
approximation of cost of debt. Bonds / debentures can be
issued at (i) par / face value, (ii) discount and (iii) premium.
?Cost of Irredeemable Debt / Perpetual Debt
i) PRE-TAX COST
K
d
= I/P
K
d=
Pre-tax cost of debentures
P- face value
I-Interest
ii) POST-TAX COST
K
d
= I(1-t)
NP
EXAMPLE
Rama & co. has 15 % irredeemable debentures of Rs. 100 each for
Rs. 10,00,000. the tax rate is 35 %. Determine cost of debenture
assuming it is issued at
i) face value
ii) 10 % premium
iii) 10 % discount
ISSUED AT PRE-TAX POST-TAX
Face value (15/100)100=15 % 15(1-0.35)100
100
= 9.75 %
10 % premium (15/110)100=13.64 % 15(1-0.35)100
110
=8.86
10 % discount (15/90)/100=16.67 15(1-0.35)100
90
=10.83
• K
d
= I(1-t)+(f+d+pr-pi)/Nm
(RV+NP)/2
• I= Interest (Rs)
• t=Tax rate
• f=Flotation cost(Rs)
• d=Discount on issue of debt (Rs)
• Pr=Premium on redemption of debt(Rs)
• Pi=Premium on issue of debt (Rs)
• Nm=Term of debt.
• RV=Redeemable value
• NP=Net proceeds realized.
• BE company issues Rs. 100 par value of debentures
carrying 15 % interest. The debentures are repayable
after 7 years at face value. The cost of issue is 3 % and
tax rate is 35 %. Calculate cost of debenture.
• K
d
= I(1-t)+(f+d+pr-pi)/Nm
(RV+NP)/2
= 15(1-0.35)+(3+0+0-0)/7
x100
(100+97)/2
= 10.33 %
?It is the average cost of the costs of various sources of
financing.
?It is also known as composite cost of capital, overall cost of
capital .
Steps of finding WACC
?Determination of the type of funds to be raised and their
individual share in the total capitalization of the firm
?Computation of cost of each type of funds by putting weights
Kw= ?
WX
/ ?
W
Kw=WACC
X= cost of specific source of finance
W= weight, proportion of specific source of finance
A firm has the following capital structure and after tax costs for the
different sources of funds used:
Sources of Funds Amount(Rs.) Proportion After-tax cost %
Debt 15 lakhs 0.25 5
Preference shares 12 lakhs 0.20 10
Equity shares 18 lakhs 0.30 12
Retained earnings 15 lakhs 0.25 11
Total 60 lakhs 1
You are required to computed the WACC
Computation of Weighted Average Cost of Capital
Sources of funds Proportion
(W)
Cost %
(X)
WX
Debt 0.25 5 1.25
Preference share 0.20 10 2.00
Equity shares 0.30 12 3.60
Retained earnings 0.25 11 2.75
Weighted average cost of capital 9.60 %
• Sometimes, we may required to calculate the cost of
additional funds to be raised, called the marginal cost of
capital.
• The marginal cost of capital is the weighted average cost
of new capital calculated by using the marginal weights.
• The marginal weights represent the proportion of various
sources of funds to be employed in raising additional
funds.
doc_246251584.ppt