Cost of Capital By Prof. Manish B Tardeja

Liabilities & Equity Assets Equity Shares Current assets Preference Shares Long-term debt Fixed assets Fixed assets Current Liabilities

Liabilities & Equity Assets Equity Shares Current assets Preference Shares Long-term debt Fixed assets Fixed assets Current Liabilities The investment decision

n Ingredients Cost of capital Cost of capital Leverage Leverage Capital Structure Capital Structure The Dividend Decision The Dividend Decision Working Capital Working Capital n The financing decision...

Liabilities & Equity Assets Equity Shares Current assets Preference Shares Long-term debt Fixed assets Fixed assets Current Liabilities

Liabilities & Equity Assets Equity Shares Current assets Preference Shares Long-term debt Fixed assets Fixed assets Current Liabilities The financing decision

Liabilities & Equity Assets Equity Shares Current assets Preference Shares Long-term debt Current Liabilities Fixed assets Long-term debt Preference Shares Capital Structure Common Equity

Cost of Capital n For Investors the rate of return on a security is a benefit of investing. n For Financial Managers that same rate of return is a cost of raising funds that are needed to operate the firm. n In other words, the cost of raising funds is the firm’s cost of capital.

How can the firm raise capital? n Debenture and Long term Loans n Equity Shares n Preference Shares n Each of these offers a rate of return to investors. n This return is a cost to the firm. n “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources.

The Weighted Cost of Capital n To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: n Cost of Debt n Cost of Preference Shares n Cost of Equity Shares

Cost of Debt

For the issuing firm, the cost of debt is: n the rate of return required by investors, n adjusted for flotation costs (any costs associated with issuing new Debt), and n adjusted for taxes.

Example: Tax effects of financing with debt with stock with debt with stock with debt EBIT 4,00,000 4,00,000 - interest expense 0 (50,000) EBT 4,00,000 3,50,000 - taxes (34%) (1,36,000) (1,19,000) EAT 2,64,000 2,31,000

Example: Tax effects of financing with debt with stock with debt with stock with debt EBIT 4,00,000 4,00,000 - interest expense 0 (50,000) EBT 4,00,000 3,50,000 - taxes (34%) (1,36,000) (1,19,000) EAT 2,64,000 2,31,000 n Now, suppose the firm pays Rs.50,000 in dividends to the stockholders.

Example: Tax effects of financing with debt with stock with debt with stock with debt EBIT 4,00,000 4,00,000 - interest expense 0 (50,000) EBT 4,00,000 3,50,000 - taxes (34%) (1,36,000) (1,19,000) EAT 2,64,000 2,31,000 - dividends (50,000) 0 Retained earnings 2,14,000 2,31,000

After-tax cost Before-tax cost Tax After-tax cost Before-tax cost Tax of Debt of Debt Savings of Debt of Debt Savings - =

After-tax cost Before-tax cost Tax After-tax cost Before-tax cost Tax of Debt of Debt Savings of Debt of Debt Savings 33,000 = 50, ,000 33,000 = 50, ,000 - =

After-tax cost Before-tax cost Tax After-tax cost Before-tax cost Tax of Debt of Debt Savings of Debt of Debt Savings 33,000 = 50, ,000 33,000 = 50, ,000 OR OR - =

After-tax cost Before-tax cost Tax After-tax cost Before-tax cost Tax of Debt of Debt Savings of Debt of Debt Savings 33,000 = 50, ,000 33,000 = 50, ,000 OR OR 33,000 = 50,000 ( ) 33,000 = 50,000 ( ) - =

After-tax cost Before-tax cost Tax After-tax cost Before-tax cost Tax of Debt of Debt Savings of Debt of Debt Savings 33,000 = 50, ,000 33,000 = 50, ,000 OR OR 33,000 = 50,000 ( ) 33,000 = 50,000 ( ) Or, if we want to look at percentage costs: - =

After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate - = 1

K d = k d (1 - T) K d = k d (1 - T) - = 1

After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate After-tax Before-tax Marginal % cost of % cost of x tax Debt Debt rate K d = k d (1 - T) K d = k d (1 - T).066 =.10 (1 -.34).066 =.10 (1 -.34) - = 1

Example: Cost of Debt n Persistent Ltd. issues a Rs.1,000 par, 20 year debentures paying the market rate of 10%. Interest is annual. The debenture will sell for par since it pays the market rate, but flotation costs amount to Rs.50 per debenture. n What is the pre-tax and after-tax cost of debt for Persistent Ltd.?

n Pre-tax cost of debt: 950 = 100(PVIFA 20, k d ) (PVIF 20, k d ) using the calculator, using the calculator, k d = 10.61%. k d = 10.61%. n After-tax cost of debt: Kd = kd (1 - T) Kd = kd (1 - T) Kd =.1061 (1 -.34) Kd =.1061 (1 -.34) Kd =.07 = 7% Kd =.07 = 7%

n Pre-tax cost of debt: 950 = 100(PVIFA 20, k d ) (PVIF 20, k d ) using the calculator, using the calculator, k d = 10.61%. So, a 10% debenture k d = 10.61%. So, a 10% debenture costs the firm costs the firm n After-tax cost of debt: only 7% (with Kd = kd (1 - T) flotation costs) Kd = kd (1 - T) flotation costs) Kd =.1061 (1 -.34) since the interest Kd =.1061 (1 -.34) since the interest Kd =.07 = 7% is tax deductible. Kd =.07 = 7% is tax deductible.

Cost of Preference Shares n Finding the cost of Preference Shares is similar to finding the rate of return, except that we have to consider the flotation costs associated with issuing Preference Shares.

Cost of Preference Shares n Formula: kp = = kp = = DPo Dividend Price Price

Cost of Preference Shares n Formula: kp = = kp = = n From the firm’s point of view: kp = = kp = = NPo = price - flotation costs! DPo Dividend Price Price Dividend Net Price DNPo

Example: Cost of Preference Shares n If Persistent Ltd. issues Preference Shares, it will pay a dividend of Rs.8 per year and should be valued at Rs.75 per share. If flotation costs amount to Re. 1 per share, what is the cost of Preference Shares for the Company?

Cost of Preference Shares kp = = kp = = Dividend Net Price DNPo

Cost of Preference Shares kp = = kp = = = = 10.81% = = 10.81% Dividend Net Price DNPo

Cost of Equity Shares n There are 2 sources of Equity Capital: 1) Internal Resources (retained earnings, Reserves and Surplus), and 2) External Equity Shares (new Shares issue) Do these 2 sources have the same cost?

Cost of Internal Equity n Since the stockholders own the firm’s retained earnings, the cost is simply the stockholders’ required rate of return. n Why? n If managers are investing stockholders’ funds, stockholders will expect to earn an acceptable rate of return.

Cost of Internal Equity

1) Dividend Growth Model

Cost of Internal Equity 1) Dividend Growth Model Kc = + g Kc = + g D 1 Po

Cost of Internal Equity 1) Dividend Growth Model Kc = + g Kc = + g 2) Capital Asset Pricing Model (CAPM) D 1 Po

Cost of Internal Equity 1) Dividend Growth Model Kc = + g Kc = + g 2) Capital Asset Pricing Model (CAPM) k c = k rf + B ( k m - k rf ) k c = k rf + B ( k m - k rf ) D 1 Po

Cost of External Equity Dividend Growth Model Dividend Growth Model

knc = + g knc = + g D 1 NPo Cost of External Equity

Dividend Growth Model Dividend Growth Model knc = + g knc = + g D 1 NPo Net proceeds to the firm after flotation costs!

Weighted Cost of Capital n The weighted cost of capital is just the weighted average cost of all of the financing sources.

Weighted Cost of Capital Capital Capital Source Cost Structure debt 6% 20% Preference 10% 10% Equity 16% 70%

n Weighted cost of capital =.20 (6%) +.10 (10%) +.70 (16).20 (6%) +.10 (10%) +.70 (16) = 13.4% Weighted Cost of Capital (20% debt, 10% preferred, 70% common)