The Cost of Capital
Cost of Capital
• To properly evaluate investment decisions, the firm must know
how much it will cost them to raise capital funds
• Sources of capital:
Borrowing, such as Bonds, bank loans, etc.
Issuing Preferred stock
Issuing Common stock
Net Income (earnings)
• Each of these sources carries a different cost based on the
required rate of return of each provider (source) of these funds
Explicit Cost
• Explicit Cost: The discount rate that equates the PV of the cash
inflows that are incremental to the taking of the financing opportunity
with the PV of its incremental cash outflows
• Retained Earnings involve no future cash flows to, or, from the firm;
so do not have explicit cost
• It is the IRR that the firm pays to procure financing
Implicit Cost
• It is the rate of return associated with the best investment opportunity
foregone
• R.E. carry implicit cost in terms of opportunity cost of foregone
alternatives in the rate of return at which shareholders could have
invested these funds had they been distributed to them
• Explicit cost arises when funds are raised, where as the Implicit costs
arise when funds are used
• Viewed in this perspective, Implicit Costs are everywhere; they arise
when ever funds are used- irrespective of their source
WACC
•
WACC is a composite figure reflecting cost of each component multiplied by the
weight of each component.
•
WACC = (we x ke) + (wp x kp) + (wd x kd)
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we = Proportions of Equity Capital
ke = Cost of Equity Capital
wp = Proportion of Preference capital
kp = Cost of Preference capital
wd = Proportion of Debt
kd = Cost of debt
Suppose a hypothetical Company has a capital structure composed of the following, in
billions: Debt Rs.10; Common Equity Rs.10. If the before-tax cost of debt is 9%, the required
rate of return on equity is 15%, and the marginal tax rate is 30%, what is company’s
weighted average cost of capital?
WACC = [(0.5)(0.09)(1-0.30)] + [(0.5)(0.15)] = 0.0315 + 0.075 = 0.1065 or 10.65%
•
Floatation Costs
• Costs incurred when the firm issues new bonds or stocks - include legal
fees, filing fees, underwriting fees, registration fees, etc. - amount varies
depending upon the type of offering and its size.
• This cost is heavy in the case of equity capital in comparison to debt and
preferred stock. - this is one of the many considerations before selecting
new equity as a mode of financing
• If a firm needs Rs.100 million to finance its new project and the floatation
cost is expected to be 5.5%, the Floating Cost adjusted money need should
be…….
• Rs.100 million ÷ (1-.055) = Rs.105.82 million; where Rs.5.82 million may be
considered as the floatation cost.
• Floatation Cost adjusted initial outlay = [Required financing / (1 – Floatation
cost%)]
Cost of Debt
• Interest qualifies for tax deduction in determining tax liability
• So effective cost of debt is less than the actual interest payment made by
the firm by the amount of tax shield it provides
• Cost of Debt is generally the lowest among all sources partly because the
risk involved is low but mainly because interest paid on debt is tax
deductible
• Debt can either be perpetual or redeemable
Perpetual Debt
• Bonds with no maturity date - issuers are not under any obligation to ever
repay the bond purchaser’s principal amount - however, the issuer is
obligated to make coupon payments in perpetuity – theoretically, forever
• Perpetual bonds are generally considered a very safe investment, but they do
expose the bond purchaser to the credit risk of the issuer for an indefinite
period of time
• Banks issue these bonds in order to meet their Tier 1 Capital Requirement as
per Basel -III norm (in September 2021, SBI has raised Rs 4,000 crore in
capital through the Basel compliant Additional Tier 1 (AT1) bonds at a coupon
of 7.72%)
• Typically, intervals of 5 to 10 years are considered as the maturity period and
accordingly their maturity is set - SEBI’s new rule changed the valuation to
100 years maturity
Cost of Perpetual Debt
• Kd = I(1-t)/D
–
–
–
–
Kd = Post-tax cost of Debt
I = Annual Interest payment
t = Company’s effective tax rate
D = Net proceeds of issue of debentures,
bonds, term loans etc.
• X Ltd issued Rs. 2,00,000, 9%
perpetual debentures at a premium
of 10%. The costs of floatation are
2%. The tax rate is 35%. Compute
the after tax cost of debt
• After tax cost of debt
• = [(Rs.18,000/ Rs.
2,15,600) (1 – 0.35)]
• = 5.43%
Cost of Redeemable Debt
(Trial & Error/ Long approach)
• Here repayment of debt principal (P) either in installment or in lump
sum along with interest (I) is considered
1. Principal is paid in lump sum: Or
n
It
Pn
kd  
(1  t ) 
t
n
(
1

k
)
(
1

k
)
t 1
d
d
2. Principal is paid in installment:
n
It
Pt
(
1

t
)

t
t
(
1

k
)
(
1

k
)
t 1
d
d
kd  
Cost of Redeemable Debt
(Shortcut Approach)
I (1  t ) ( f  d  pr  pi) / N m
kd 
( RV  SV ) / 2
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•
•
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•
•
•
I = Annual interest payment
RV= Redeemable value of
debenture/debt
SV= Net Sale Proceeds from the issue of
debt (face value of debt minus issue
expenses)
f = Floatation cost; d = Discount on issue
of debentures
Pi = Premium on issue of debentures
Pr = Premium on redemption of
debentures
t = Tax rate N= Number of years
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•
•
•
•
•
•
•
Calculate Kd for each of the following:
(a) Debentures sold at par &
floatation costs are 5%;
(b) Debentures sold at premium of
10% & floatation costs are 5% of
issue price;
(c) Debentures sold at discount of 5%
& floatation costs are 5% of issue
price;
Assume (i) coupon rate of interest is
10%; (ii) face value of debentures is
Rs.100; (iii) maturity period is 10
years; and (iv) tax rate is 35%.
(a) 7.18%
(b) 5.85%
(c) 7.89%
Cost of Preference Capital
(Irredeemable Preference Share)
• A company issues 11%
irredeemable preference shares of
the face value of Rs.100 each.
Floatation costs are estimated at
5% of the expected sale price.
What is the cost if the Pref. shares
are issued at: (i) par, (ii)10%
premium, (iii) 5% discount?
Assume 13.125 % dividend tax.
•
Ans: (i) 13.1 %, (ii) 11.9%, (iii) 13.8%
Cost of Preference Capital
(Redeemable Preference Share)
•
The cost of redeemable preference
shares requiring lump sum repayment
is as per the following long method:
n
Dt
Pn
Po (1  f )  

t
(1  k p ) n
t 1 (1  k p )
•
The short-cut method is:
kp 
•
D p  {( RV  SV ) / n}
( RV  SV ) / 2
n= years to redemption; RV=
Redeemable value at the time of
redemption, SV= sale out value less
discount & floatation expenses, D =
constant annual dividend payment.
• Dell Ltd. has Rs.100
preference share redeemable
at a premium of 10% with 15
years maturity. The coupon
rate is 12%. Floatation cost is
5%. Sale price is with 5%
discount. Calculate the cost of
preference capital.
• {12+[(110-90)/15] ÷
[(110+90)/2] = 0.1333 =
13.33%