1. Amity School Of Business 1 Amity School Of Business BBA Semister four Financial Management-II Ashish Samarpit Noel

2. Amity School Of Business Cost Of Capital Cost of Capital is the cost of raising capital and using it. In other words it is evaluation of the required rate of return to firms investors. Signifiance:- Evaluating Investment decision Designing a firm’s debt policy Appraising the financial performance of top management 2

3. Amity School Of Business 3 Factors determining the cost of capital General economic conditions –Demand for and supply of capital within the economy and the level of expected inflation Market conditions A firm’s operating and financing decisions –Business Risk-Company’s investment decisions –Financial Risk-Use of Debt

4. Amity School Of Business 4 Project cost of capital & Company’s cost of capital The project cost of capital is the minimum required on funds committed to a project, which depends on the riskiness of its cash flows. The company cost of capital is the overall or average, required rate of return on the aggregate of investment projects.

5. Amity School Of Business 5 Explicit and Implicit Costs Explicit Cost –Discount rate that equates the PV of incremental cash inflows to the PV of incremental cash outflows Implicit Cost/Opportunity Cost –Rate of return of the foregone opportunity, E.g. Retained Earnings

6. Amity School Of Business 6 Weighted Average Cost of Capital (WACC) vs. Specific Costs of Capital The cost of capital for each source of capital is known as specific or component cost of capital The component costs are combined according to the weights of each component capital to obtain weighted average cost of capital or overall cost of capital

7. Amity School Of Business 7 Tax Adjustment The interest paid on debt is tax deductible The higher the interest charges, lower would be the amount of tax payable by the firm As a result, the after-tax cost of debt to the firm will be substantially lower than the investor’s required rate of return After-tax-cost of debt = k d (1-T) –Where T is the corporate tax rate Loss making firms will not have after tax cost of debt In Calculation of WACC after-tax-cost of debt is to be used

8. Amity School Of Business 8 In case of preference capital, payment of dividends is not legally binding The cost of preference capital is a function of the dividend expected by the investors Irredeemable Preference Shares If Preference shares are perpetual, where, –k p is the cost of preference shares –PDIV is the expected preference dividend –P 0 is the issue price of preference shares Cost of Preference Capital

9. Amity School Of Business 9 Redeemable Preference Share Cost of Redeemable Preference Shares can be computed as: The cost of preference share is not adjusted for taxes because preference dividend is paid after the corporate taxes have been paid Since interest is tax deductible & Preference dividend is not, the cost of preference is substantially higher than the after tax cost of debt

10. Amity School Of Business 10 Cost of Equity Capital Equity capital can be raised internally by retained earnings or the firm can distribute dividends & raise capital by new issue of equity shares In both the cases the shareholders are providing funds to the firms to finance their capital expenditures Equity shareholders’ required rate of return would be same Difference between cost of retained earnings & cost of external equity would be floatation costs

11. Amity School Of Business 11 Is equity Capital Free of Cost? Equity capital involves opportunity cost; ordinary shareholders provide funds to the firm in expectation of dividends and capital gains The shareholder’s required rate of return equates the PV of the expected dividends with the market value of shares Two difficulties in measurement: –Difficult to estimate expected dividends –Future earnings & Dividends are expected to grow

12. Amity School Of Business 12 Cost of Internal Equity: Dividend Growth Model The opportunity cost of retained earnings is the rate of return foregone by equity shareholders 1.Normal Growth: The cost of Equity is equal to the expected dividend plus capital gain rate Where, –k e = cost of equity –DIV 1 = DIV 0 (1+g) –g= expected growth in dividends

13. Amity School Of Business 13 Cost of Internal Equity: Dividend Growth Model Can be written as follows: These equations are based on the following assumptions: –Market price of shares is a function of expected dividends –The Dividend is positive –The dividends grow at a constant rate & g = ROE X Retention Ratio –The dividend payout ratio is constant Also called as GORDON’s model Implies the opportunity cost for the shareholders, if these earnings were to be distributed as dividends

14. Amity School Of Business 14 2. Supernormal Growth When dividends grow at different rates, the dividend valuation model is used as follows: Where, g s = super-normal growth rate for n years & g n is the growth rate beginning in the year n+1, perpetually 3. Zero – growth:

15. Amity School Of Business 15 Cost of External Equity: Dividend Growth Model The firm’s external equity consists of funds raised externally through public or rights issue The minimum rate of return required by equity shareholders to keep the market price of share same is the cost of equity Cost of retained earnings is lesser than the cost of external equity

16. Amity School Of Business 16 Earnings Price Ratio & Cost of Equity The firm’s external equity consists of funds raised externally through public or rights issue The minimum rate of return required by equity shareholders to keep the market price of share same is the cost of equity

17. Amity School Of Business 17 Cost of Equity & Capital Asset Pricing Model The CAPM is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset Assumptions: –Market Efficiency –Risk Aversion –Homogeneous expectations –Single time period –Risk-free rate Risk has two parts: –Unsystematic Risk (Diversifiable) –Systematic Risk (Cannot be reduced)

18. Amity School Of Business 18 CAPM & Cost of Equity According to CAPM, the required rate of return on equity is given by the following relationship: (Security Market Line) Where, –R f = The risk free rate: The yields on the Government Treasury securities are used –R m – R f = Market Risk Premium: Measured as the difference between the long term arithmetic averages of market return and the risk-free rate (same for all securities) –Β j =The beta of the firm’s share: The sensitivity of a security’s return vis-à-vis the market return which reflects its risk is the beta (systematic risk)

19. Amity School Of Business 19 Cost of Equity: CAPM Vs. Dividend-Growth Model The dividend-growth approach has limited application in practice –The expected dividend growth rate, g, should be less than the cost of equity, k e, to arrive at the simple growth formula –Can’t be used if a company is not paying dividends –Fails to deal with risk directly

20. Amity School Of Business 20 Cost of Equity: CAPM Vs. Dividend-Growth Model CAPM has a wider application although it is based on restrictive assumptions: –The only condition for its use is that the company’s share is quoted on the stock exchange –All variables in the CAPM are market determined and except the company specific share price data, they are common to all companies –The value of beta is determined in an objective manner by using sound statistical methods. One problem with the use of beta is that it does not remain stable over time

21. Amity School Of Business 21 Weighted Average Cost of Capital (WACC) The following steps are involved for calculating the firm’s WACC: –Calculate the cost of specific sources of funds –Multiply the cost of each source by its proportion in the capital structure. –Add the weighted component costs to get the WACC. Weighted Marginal Cost of Capital (WMCC): –Marginal cost is the new or incremental cost of new capital (equity & debt) issued by the firm –New funds are raised at new costs according to the firm’s target capital structure –WMCC is the WACC of new capital given the firm’s target capital structure

22. Amity School Of Business 22 Book Value Versus Market Value Weights Managers prefer the book value weights for calculating WACC: –Firms in practice set their target capital structure in terms of book values. –The book value information can be easily derived from the published sources. –The book value debt—equity ratios are analysed by investors to evaluate the risk of the firms in practice. The use of the book-value weights can be seriously questioned on theoretical grounds: –First, the component costs are opportunity rates and are determined in the capital markets. The weights should also be market-determined. –Second, the book-value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus, they do not reflect economic values.

23. Amity School Of Business 23 Book Value Versus Market Value Weights Market-value weights are theoretically superior to book-value weights: –They reflect economic values and are not influenced by accounting policies –They are also consistent with the market-determined component costs. The difficulty in using market-value weights: –The market prices of securities fluctuate widely and frequently. –A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.