COST OF CAPITAL & CAPITAL STRUCTURE
The following topics will be discussed in this lecture.
ƒ Cost of Capital & Capital Structure
ƒ Components of Capital
ƒ Cost of Equity
ƒ Estimating g or growth rate
ƒ Dividend growth model
ƒ Cost of Debt / Bonds
ƒ Cost of Preferred Stocks
COST OF CAPITAL
The required return is necessary to make a capital budgeting project such as building a
new factory worthwhile. Cost of capital would include the cost of debt and the cost of
equity.
The cost of capital determines how a company can raise money (through a stock issue,
borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested
its money someplace else with similar risk.
CAPITAL STRUCTURE
Capital structure of a typical company may consist of ordinary shares, preference stock, short
term and long term loan, bonds and leases. These components in capital structure have their own
cost and if we add all the individual components cost after adjusting with the weight age of each,
the resultant value is known as weighted cost of capital. As you have already covered in your
earlier Lectures that normally we use WACC as discount rate to find the present value of future
cash flows emerging from a project, so it is of immense importance to calculate the correct
WACC. And you are also aware that if the WACC is incorrect it may lead to serious
consequences.
In order to compute the WACC we need to calculate the individual components cost. First of all
we take up the Equity part of the capital and will see how we can compute the cost of equity.
COST OF EQUITY
In financial theory, the return that stockholders require for a company is called cost of
equity. The traditional formula is the dividend capitalization model:
A firm's cost of equity represents the compensation that the market demands in exchange for
owning the asset and bearing the risk of ownership.
Let's look at a very simple example: let's say you require a rate of return of 10% on an
investment in stock A. The stock is currently trading at $10 and will pay a dividend of $0.30.
Through a combination of dividends and share appreciation you require a $1.00 return on your
$10.00 investment. Therefore the stock will have to appreciate by $0.70, which, combined with
the $0.30 from dividends, gives you your 10% cost of equity.
We shall discuss two methods we can use to determine the cost of equity.
First, we’ll take up dividend growth models and then security market line approach to
calculate the cost of equity.
Assuming that dividends will grow at a constant rate in future (growth rate =g), price per share
Po (current price) can be found by the following formula:
Po = Do x (1 + g) / Re –
g Or
Po = D1 / Re – g
Where D1 is the dividend after period 1 and Re represents return on equity.
We can re-arrange this equation in order to calculate the Re as under:
Re = D1 / Po + g
This equation tells us that we need three variables to work out the cost of equity. These are
current price Po, dividend in period 0, and Do and growth rate.
Most complex variable in the above equation is to determine the “g” variable. You can obtain
the Po and Do very easily from internal or external sources. We can use some statistical
techniques to forecast g using the historical data. More precisely using trend and regression
analysis we can obtain the value of g.
The primary advantage of dividend growth model is that it is very simple to understand and
use. However, there are some problems also associated with this approach.
It is only applicable to the firms which pay dividend regularly if not constantly. Therefore, a
firm with no dividend history will find it useless.
The other problem is an unrealistic assumption of constant growth of dividends. We may not
find any such company which has a history of constant growth in dividends. These two
limitations make this model to be used in selected scenarios, for example, where the company
may have distributed the dividends consistently in the past.
The other problem is that the estimated cost of equity is very sensitive to the estimated growth
rate.
Finally, this approach does not take into account the risk level. There is no direct adjustment
for the risky-ness of the investment. For instance, there is no adjustment for the degree of
certainty or uncertainty in estimated growth rate for dividends
The other way to compute the cost of equity is SML (security market line) which tells us that
the required rate of return on a risky investment depends on three things.
i)
ii)
iii)
The risk free rate, Rf
Market risk premium, (Erm – Rf)
Systematic risk of the asset known as beta, B
Using SML we can write the equation as under:
Ere = Rf + Be x (Erm – Rf)
Where
Ere = is expected return on equity.
Be = is Beta of equity.
This method is also suffering from advantages and disadvantages. First it explicitly adjusts
the risk and second, it is applicable to companies other than just those with steady dividend
growth. Thus it may be useful in wider circumstances.
The SML approach heavily relies on two things – the market risk premium and beta coefficient.
And if our estimates are not very accurate then the cost of equity number will be incorrect and
misleading as well.
The demerit of both dividend model and SML is that both consider past data to predict the
future. Economic conditions and indicator in future are not the same as were in past. However,
both methods do provide us relative guidance in computing the cost of equity.
Before we move ahead to cost of debt, let’s take a look how we can raise capital in the long
run. From a firm’s perspective, followings are the ways to build the capital:
– venture capital
– issuing share to public – IPOS
– subsequent issue of share – right issue
– private placement of shares
– bank loans
– debt instruments
– leases
There are some rules and regulations for raising capital for each of the above categories. We
shall discuss here some of the issues relating to Equity capital – issuing shares through IPOs
and subsequent issue of shares like right issue.
• company must be listed on stock exchange
• must be registered with security & exchange commission of Kenya – SECP
• company issues prospectus
• underwriting the share issue
– Underwriter refers to a firm that acts as intermediary between a company issuing
shares and the public.
– underwriter normally perform following services
• devising method for issuing shares
• setting the price of new shares
• marketing / selling of securities
– Underwriters may buy securities for less than the price set by the company and then
selling them to public. if any amount of shares not subscribed by the public then
underwriter takes up the under-subscribed shares.
– Often underwriter forms a group to share the risk, known as syndicate.
COST OF DEBT:
Debt component of capital may include several line items like preferred stocks, loans from
various financial institutions with varying terms and cost. Some of the loans may be having
fixed or floating interest rate. The other items in the debt are bonds and leases.
The effective rate that a company pays on its current debt can be measured in either beforeor after- tax returns; however, because interest expense is deductible, the after-tax cost is seen
most often. This is one part of the company's capital structure, which also includes the cost of
equity.
A company will use various bonds, loans and other forms of debt, so this measure is useful
for giving an idea as to the overall rate being paid by the company to use debt financing. The
measure can also give investors an idea as to the risky-ness of the company compared to
others, because riskier companies generally have a higher cost of debt.
To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal tax
rate (before-tax rate x (1- marginal tax)). If a company's only debt were a single bond in which
it paid 5%, the before-tax cost of debt would simply be 5%. If, however, the company's
marginal tax rate were 40%, the company's after-tax cost of debt would be only 3% (5% x (140%)).
Like loans, bonds may have several issues of varying terms, carrying different interest cost
with wide gap between their cost and market value. Leases may have the same characteristics
like loans and debts.
To find the cost of debt, we need to calculate the cost of each class of debt and then finding the
weighted average of the cost of debt. For example, if there are five bond issues outstanding at
any time, we will calculate the cost of each issue and then move to weighted average of cost of
bond by using their individual weight in total bond capital.
COST OF PREFERRED STOCK:
To start computing the cost of debt, we take up the first item in debt family – preferred
stock, which is fairly straightforward calculation.
As we know that preferred stocks carry fixed dividend every period. There’s no variation in
dividend level. This means that dividend from preferred stock is essentially perpetuity.
• cost of preferred stock can be calculated from the following
• R = D/ Po
• for example if the dividend is R 3.50/- per share and current market price is rs.40/-,
then the Rp will be:
• Rp = 3.50 / 40 = 8.75%
We shall take up the two main issues for calculating cost of debt for loans and leases in other
hand outs to be delivered in future.