1. 1 CONCEPT AND MEASUREMENT OF THE COST OF CAPITAL PRESENTATION SLIDES BY PROF. SANJAY SEHGAL DEPARTMENT OF FINANCIAL STUDIES UNIVERSITY OF DELHI SOUTH CAMPUS NEW DELHI-110021 PH.: 0091-11-24111552 Email: sanjayfin15@yahoo.co.in

2. 2 THE CONCEPT Cost of capital is the minimum required rate of return for an investor who provide funds. Companies use weighted average cost of capital or WACC which is the weighted average cost of alternative sources of finance. For business valuation purposes, companies use WACC to discount the free cash flows which are available to all the fund providers.

3. 3 ESTIMATING WACC: THE THREE STEP PROCESS Step I: Determining costs of specific sources of finance - Debt-based financing - Preference share based financing - Equity based financing Step II: Assigning weight to each source of finance Step III: Computing WACC for the company.

4. 4 TAXES ASPECTS OF COST OF CAPITAL -Cost of debt is estimated on post tax basis as interest charge is treated as a tax-deductible expense and hence, provides tax-shield to companies. -Post-tax cost of debt is always lower than pre-tax cost of debt except in case of zero-tax companies or government bond issues. -In case of preference as well as equity shares, the pre-tax and post-tax costs are the same as dividend payments on such securities are treated as appropriation of profits and not expenses.

5. 5 DEBT BASED FINANCING 1. Cost of non-redeemable debt C After-tax K = ----------- (1 – T C ) P M (1-f) Where, C = annual coupon, P M = Issue price, f = flotation cost, T C corporate tax rate. Example: A 10% Rs.100 irredeemable bond is issued at Rs.80. T C = 50%. Find the cost of non-redeemable debt Ans: 10 K = ----- (1 – 0.5) = 6.25% 80

6. 6 2. Cost of coupon-bearing redeemable Annual coupon C C C + P N P M = ----------- + ----------- + …. ------------ (1 + K) 1 (1 + K) 2 (1 + K) N Semi-annual coupon C/2 C/2 (C/2 + P N ) P M = ------------- + ------------- + …. -------------- (1 + K/2) 1 (1 + K/2) 2 (1 + K/2) 2N Approximate cost P N + P M C(1 – T C ) + ------------ N K = --------------------------------------------------- P N + P M ----------- 2

7. 7 Example: A 10% Rs.100 bond S is issued at Rs.80. Bond maturity is 5 years, T C = 50%. Ans: 100 – 80 9 10(1 -.5) + ----------- = ---- = 100 = 10% 5 90 K = ---------------------------------------------- (100 + 80) ------------- 2

8. 8 COST OF ZERO-COUPON BOND P N P M = ------------ (1 + K) N On-post tax-basis, cost of debt = K (1 – T C ) Example: A Rs.100 zero-coupon, bond, issued at Rs.50. Bond maturity is 5 years, T C = 50%. 100 Ans: 50 = ----------- = 14.4% (1 + K) 5 K (Post-tax) = 14.4% (1 – 0.5) = 72.%

9. 9 Cost of Callable Bond Annual coupon C C C + P C P M = ------------- + ------------- + …. ------------- (1 + K C ) 1 (1 + K C ) 2 (1 + K C ) NC Approximate cost of callable debt P C - P M C(1-T) + ----------- N C K C = --------------------------------- P C – P M ---------- 2

10. 10 Example: A 10% Rs.100 bond is issued at Rs.80. Bond maturity is 5 years. The bond is callable after 3 years at a call price of Rs.110 corporate tax rate = 50%. The cost of callable bond P C - P M C(1-T) + ----------- N C K C = --------------------------------- P C – P M ---------- 2 110 - 80 10 (1 – 0.5) + -------------- 3 15 = ------------------------------------- = ----- = 15.78% 110 + 80 95 ----------- 2

11. 11 COST OF CONVERTIBLE BONDS CF 1 CF 2 CF N P m (1 - f) = ----------- + ---------- + … + ----------- (1 + K) 1 (1 + K) 2 (1 + K) N The cost of debt K is the IRR which balances the equation involving net amount of bond issue and the future cash outflows that incorporate all conversion features. Operating and Finance Lease All leases are generally treated as alternatives to debt and lease rental is a tax deductible expense. Hence, cost of a lease is taken as equivalent to after-tax cost of debt.

12. 12 COST OF DEBT - FOREIGN CURRENCY DENOMINATED Cost of domestic debt is linked to the cost of foreign debt by the interest rate parity theorem. X 0 (1 + K 0 ) = ------ (1 + r 0 ) X f where K 0 = Cost of domestic debt r 0 = Cost of foreign debt X 0 = Spot rate (Swiss francs per dollar) X f = t period forward rate (Swiss francs per dollar) Swiss franc denominated interest rates = 4% Spot rate (Swiss francs per dollar) = 1.543 Forward rate (Swiss francs per dollar) = 1.4977 1.543 = ------------ (1.04) -1 = 7.15% 1.49777

13. 13 PREFERENCE SHARE BASED FINANCING Non-redeemable P D K P = -------- P M Where P D = Preference dividend P M = Issue price Redeemable CO 1 CO 2 CO N P M = ----------- + ------------ + …. ------------ (1 + K P ) 1 (1 + K P ) 2 (1 + K P ) N The cash outflows reflect the cumulative/non-cumulative factors of preference shares.

14. 14 EQUITY BASED FINANCING INCOME APPROACH D 1 D 2 D N P M (1 - f) = ----------- + ------------ + … + -------------- N tending to infinity (1 + K e ) 1 (1 + K e ) 2 (1 + K e ) N Assuming that dividends of a company grow at a constant rate g, we get D 1 D 1 P M = ---------- or K e = ------- + g K e – g P M Example: The company is expected to pay a dividend of Rs.1.80 per share at the end of the year. Its issue price is Rs.22. The dividend of the company is expected to grow at a constant rate of 6% p.a. over the life of the firm. Find the cost of equity shares. Ans.: 1.80 K e = ------- + 0.6 = 14% (approx.) 22

15. 15 FACTOR MODEL APPROACH CAPM EQUATION K e or R(R) = R F + [ER M – R F )  i EXAMPLE R F = 5% ER M - R F (price of risk) = 8% Beta = 1.5 K e 5 + 8 (1,5) = 17% R F = Yields on government bonds EM M – R F = long-term risk premium Beta = Sensitivity coefficient Where R it =  +  R Mt + e t Beta is the slope of the regression of security returns on market index returns.

16. 16 ARBITRAGE PRICING THEORY K e or R(R) = R F + (ER 1 – R F )  1 + …. (ER K – R F )  K -The cost of equity reflects risk premiums for K risk factors. -These risk factors could be: Economics, e.g., real GDP growth rate, inflation, levels of interest rates, political upheavals, etc. Fundamental-based: Company size, price-to-boo equity, price-earnings ratio, leverage, etc.

17. 17 CONVERGENCE OF INCOME APPROACH AND FACTOR MODEL -The assumption of market efficiency implies that E(R) = R(R). -If market efficiency does not hold, factor model alone should be used for cost equity estimation.

18. 18 ASSIGNING WEIGHTES TO SPECIFIC SOURCES OF FINANCE -Value weights should be preferred to book value weights. -Re-align the weights in light of (a) Capital structure of comparable companies (b) Management philosophy

19. 19 COMPUTATION OF WACC D P S WACC = K D (1 – T) ---- + K P ---- + K e ---- V V V Where D = Market value of debt P = Market value of preference shares S = Market value of equity V = Total market firm value

20. 20 COST OF CAPITAL AND BUSINESS VALUATION -WACC is the discount rate for future cash flows. -The discounted cash flows provide Business Value -Business Value – Value of Debt = Equity Value