COST OF CAPITAL

• THE COST OF CAPITAL PART ONE 
• FINANCIAL MGMT
• BY DR SHASHI AGGARWAL

• COST OF CAPITAL

1.  COST OF CAPITAL REPRESENTS THE RETURN A COMPANY NEEDS IN ORDER TO TAKE ON A CAPITAL PROJECT SUCH AS PURCHASING NEW EQUIPMENT OR CONSTRUCTING A NEW BUILDING
2. COST OF CAPITAL REPRESENTS A HURDLE RATE THAT A COMPANY MUST OVERCOME BEFORE IT CAN GENERATE VALUE AND IS USED EXTENSIVELY IN THE CAPITAL BUDGETING PROCESS TO DETERMINE WHETHER A COMPANY SHOULD PROCEED WITH A PROJECT.
3. A COMPANY’S INVESTMENT DECISIONS FOR NEW PROJECTS SHOULD ALWAYS GENERATE A RETURN THAT EXCEEDS THE FIRM’S COST OF THE CAPITAL USED TO FINANCE THE PROJECT OTHERWISE THE PROJECT WILL NOT A GENERATE A RETURN FOR INVESTORS
4. COST OF CAPITAL
5. COST OF CAPITAL FROM THE VIEW POINT OF THE INVESTOR IS THE RETURN EXPECTED BY WHOEVER IS PROVIDING THE CAPITAL FOR A BUSINESS
6. ASSESSMENT OF THE RISK OF COMPANY’S EQUITY
7. AN INVESTOR PROVIDES LONG TERM FUNDS ( EQUITY,SHARES,PREFERENCE SHARES,RETAINED EARNING,DEBENTURES ETC ) TO A COMPANY AND HE EXPECTS A GOOD RETURN ON HIS INVESTMENT

• MEANING

1. IT IS THE MINIMUM RATE OF RETURN EXPECTED BY THE INVESTORS.  IT IS THE WEIGHTED AVERAGE COST OF VARIOUS SOURCES FOR EXAMPLE EQUITY ,PREFERENCE AND DEBT.
2. MAY BE DEFINED AS COST OF OBTAINING FUNDS I.E., THE AVERAGE RATE OF RETURN IN A FIRM WOULD EXPECT FOR SUPPLYING FUNDS TO FIRM.
3. IN ORDER TO MAXIMIZE THE SHAREHOLDER’S WEALTH THROUGH INCREASED PRICE OF SHARES A COMPANY HAS TO EARN MORE THAN COST OF CAPITAL. CAN BE DETERMINED BY WORKING OUT THE WEIGHTED AVERAGE COST OF CAPITAL

• DEFINITION
• EZRA SOLOMON ,” COST OF CAPITAL IS THE MINIMUM REQUIRED RATE OF EARNING OR CUT OFF RATE OF CAPITAL EXPENDITURE.
• THE MINIMUM RATE OF RETURN THAT A FIRM MUST EARN ON ITS INVESTMENT FOR THE MARKET VALUE OF THE FIRM TO REMAIN UNCHANGED.
• JAMES C VAN HORNE DEFINES COST OF CAPITAL AS CUT OFF RATE FOR THE ALLOCATION OF CAPITAL TO INVESTMENT OF PROJECT. IT IS THE RATE OF RETURN ON A PROJECT THAT WILL LEAVE UNCHANGED THE MARKET PRICE OF THE STOCK.
• BASIC ASPECTS OF COST OF CAPITAL
• COST OF CAPITAL IS NOT A COST AS SUCH : RATE OF RETURN THAT A FIRM REQUIRES TO EARN FROM ITS PROJECT
• MINIMUM RATE OF RETURN WHICH WILL AT LEAST MAINTAIN THE MARKET VALUE OF THE SHARES
• COMPRISE THREE ELEMENTS:
• COST OF CAPITAL  COMPRISE OF THREE ELEMENTS :

1. EXPECTED NORMAL RATE OF RETURN AT ZERO RISK LEVEL
2. PREMIUM FOR THE BUSINESS RISK
3. THE PREMIUM FOR FINANCIAL RISK ON ACCOUNT OF PATTERN OF CAPITAL STRUCTURE

• COST OF CAPITAL
• COST OF CAPITAL IS THE THAT MINIMUM RATE OF RETURN WHICH A FIRM, MUST AND IS EXPECTED TO EARN ON ITS INVESTMENTS  SO AS TO MAINTAIN THE MARKET VALUE OF THE FIRM.
• COST OF CAPITAL MAY BE REPRESENTED AS
• k=r₀+b+f
• K= COST OF CAPITAL
• r₀ = NORMAL RATE OF RETURN AT ZERO RISK LEVEL
• b = PREMIUM FOR BUSINESS RISK
•  f= PREMIUM FOR FINANCIAL RISK

• COST OF CAPITAL DEPENDS UPON :

1. DEMAND AND SUPPLY OF CAPITAL
2. EXPECTED RATE OF INFLATION
3. VARIOUS RISK INVOLVED
4. DEBT EQUITY RATIO OF THE FIRM ETC

• SIGNIFICANCE

• AS AN ACCEPTANCE CRITERION IN CAPITAL BUDGETING : ACCORDING TO THE PRESENT VALUE METHOD OF CAPITAL BUDGETING,IF THE PRESENT VALUE OF EXPECTED RETURN IS MORE THAN COST OF INVESTMENT OTHERWISE THE PROJECT IS REJECTED. THE PRESENT VALUE OF EXPECTED RETURN IS CALCULATED BY DISCOUNTING THE EXPECTED CASH INFLOWS AT THE CUTOFF RATE ( WHICH IS THE COST OF CAPITAL)
• AS A DETERMINATION OF CAPITAL MIX IN CAPITAL STRUCTURE DECISIONS : WHILE DESIGNING AN OPTIMAL CAPITAL STRUCTURE THE MANAGEMENT HAS TO KEEP IN MIND THE OBJECTIVE OF MAXIMIZING THE VALUE OF THE FIRM AND MINIMIZING THE COST OF CAPITAL
• AS A BASIS FOR EVALUATING THE FINANCIAL PERFORMANCE : THE ACTUAL PROFITABILITY OF THE PROJECT IS COMPARED TO PROJECTED OVERALL COST OF CAPITAL AND ACTUAL COST OF CAPITAL.THEN IF THE ACTUAL PROFITABILITY OF THE PROJECT IS MORE THAN PROJECTED AND THE ACTUAL COST OF CAPITAL THE PERFORMANCE IS SAID TO BE SATISFACTORY
• AS A BASIS FOR TAKING OTHER FINANCIAL DECISIONS : SUCH AS DIVIDEND POLICY,CAPITALIZATION OF PROFITS AND MAKING RIGHT ISSUES AND WORKING CAPITAL
• CLASSIFICATION OF COST
• HISTORICAL COST AND FUTURE COST : BOOK COSTS WHICH ARE RELATED TO THE PAST. FUTURE COSTS ARE ESTIMATED COSTS FOR THE FUTURE. IN FINANCIAL DECISIONS FUTURE COSTS ARE MORE RELEVANT BUT HISTORICAL COSTS ACTS A S GUIDE FOR THE ESTIMATION OF FUTURE COSTS.
• SPECIFIC  COST AND COMPOSITE COST
• SPECIFIC COST REFERS TO THE COST OF SPECIFIC SOURCE OF CAPITAL
• WHILE COMPOSITE COST IS COMBINED COST OF VARIOUS SOURCES OF CAPITAL AND IT IS THE WEIGHTED AVERAGE COST OF CAPITAL AND USED FOR DECISION MAKING AND NOT THE SPECIFIC COST
• BUT WHERE ONLY ONE TYPE OF CAPITAL IS EMPLOYED TO THE SPECIFIC COST OF CAPITAL IS USED
• EXPLICIT COSTS AND IMPLICIT COST
• AN EXPLICIT COST IS THE DISCOUNT RATE WHICH EQUATES THE PRESENT VALUE OF CASH INFLOW WITH THE PRESENT VALUE OF CASH OUTFLOW. IT IS THE INTERNAL RATE OF RETURN
• FORMULA FOR CALCULATING THE EXPLICIT COST :
• I₀= ((O₁ )/1+K)+ ((O₂ )/1+K)²+---------------+-((O_n )/1+K)ⁿ)
• I₀ = NET CASH INFLOW AT ZERO POINT OF TIME
• O₁ IS THE OUTFLOW OF CASH IN PERIOD 1,2,AND n
• K IS THE EXPLICIT COST OF CAPITAL
•  
• IMPLICIT COST :KNOWN AS THE OPPORTUNITY COST
• OPPORTUNITY COST IS  THE COST OF OPPORTUNITY FOREGONE IN ORDER TO TAKE UP A PARTICULAR PROJECT. FOR EXAMPLE THE IMPLICIT COST OF RETAINED EARNING IS THE RATE OF RETURN AVAILABLE TO SHAREHOLDERS BY INVESTING THE FUNDS ELSEWHERE.

• AVERAGE COST AND MARGINAL COST
• AN AVERAGE COST REFERS TO THE COMBINED COST OF VARIOUS SOURCES OF CAPITAL SUCH AS DEBENTURES,PREFERENCE SHARES AND EQUITY SHARES
• MARGINAL COST OF CAPITAL REFERS TO THE AVERAGE COST OF CAPITAL WHICH HAS TO BE INCURRED TO OBTAIN ADDITIONAL FUNDS REQUIRED BY FIRM. IN INVESTMENT IT IS THE MARGINAL COST WHICH SHOULD BE TAKEN INTO CONSIDERATION
• COMPUTATION OF COST OF CAPITAL
• COMPUTATION OF COST OF SPECIFIC SOURCE OF FINANCE : COMPUTATION OF EACH SPECIFIC SOURCE OF FINANCE : EQUITY,DEBT,PREFERENCE AND RETAINED EARNING
• COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL :

• COST OF DEBT

• COST OF PERPETUAL/ IRREDEEMABLE DEBT :
• THE COST OF DEBT IS THE RATE OF INTEREST PAYABLE ON DEBT
• WHEN DEBT IS USED A S SOURCE OF FINANCE THE FIRM SAVES A CONSIDERATION AMOUNT IN PAYMENT OF TAX AS INTEREST IS ALLOWED AS A DEDUCTIBLE EXPENSE IN COMPUTATION OF TAX
• EFFECTIVE COST OF DEBT IS REDUCED
• COST OF DEBT
• COST OF PERPETUAL/ IRREDEEMABLE DEBT
• RATE OF INTEREST PAYABLE ON THE DEBT.
• K_db =I/P where K_db= before tax cost of debt, I =Interest P=Principal
• K_db =I/NP where NP means Net proceeds
• After –Tax cost of debt
• K_db =(I/NP)(1-t) where t means rate of tax

• EXAMPLE

1. A LTD ISSUES 50,000 RS 8% DEBENTURES AT PAR. TAX RATE IS 50%
2. B LTD ISSUES RS 1,00,000,9% DEBENTURES AT A PREMIUMS OF 10%. THE COSTS OF FLOTATION ARE 2%. THE TAX RAT IS 60%
3. D LTD ISSUES RS 50,000 ,8% DEBENTURES AT A DISCOUNT OF 5%. TAX RATE IS 50%

• SOLUTION
• FIRST SITUATION:A LTD ISSUES 50,000 RS 8% DEBENTURES AT PAR. TAX RATE IS 50%

• K_db =(I/NP)(1-t) =(4000/50,000)(1-0.5) =4%
• =( ( 4000)/50000) X100) X 50/100= 4%
• SECOND SITUATION: B LTD ISSUES RS 1,00,000,9% DEBENTURES AT A PREMIUMS OF 10%. THE COSTS OF FLOTATION ARE 2%. THE TAX RATE IS 60%:
• SOLUTION : ISSUE PRICE = 1,00,000+((10/100)x1,00,000)
• TOTAL PROCEEDS= 1,10,000
• FLOTATION COST : 1,10,000X2/100= 2200
• NET PROCEEDS = 1,10,000-2200= 1,07,800
• HERE NP =1,00,000+10,000-(2% OF 1,10,000)

• INTEREST = 1,00,000 X 9/100= 9,000

• K_db =(I/NP)(1-t)=((9,000/107800) X100) X(1-0.6) =3.34%
• K_db  = 8.35X40/100=

• THIRD SITUATION: D LTD ISSUES RS 50,000 ,8% DEBENTURES AT A DISCOUNT OF 5%. TAX RATE IS 50%
•  ISSUE PRICE = 50,000 MINUS 2500= 47,500
• K_db =(I/NP)(1-t)
• =((4,000/47,500)X 100 )(1-0.5))= 8.42 X.50
• 4.21%
• =

• COST OF REDEEMABLE DEBT
• DEBT IS ISSUED TO BE REPAID AFTER A CERTAIN PERIOD DURING THE LIFE TIME OF FIRM
• Yield to maturity or Trial and error Method :

·         V₀=(I₁/(1+k_d) + I₂ /(1+k_d)²---------------+ I_n /(1+k_d)ⁿ+ V_n/(1+k_d )ⁿ) (1-t)  where V₀ =Issue price of debt, V_n= where Redeemable value of debt, I_1-------- I_n are amount of interest and n=number of years to redemption

• COST OF Redeemable Debt
• Short cut Method
• Before Tax cost of redeemable Debt
• K_d =( I+1/n ( RV-NP))/(1/2(RV+NP)
• Where I = Interest
• n=number of years in which debt is to be redeemed
• RV =Redeemable value of debt
• NP =Net Proceed
• After Tax Cost
• K_d =( I ( 1-t)+1/n ( RV-NP))/(1/2(RV+NP)

• EXAMPLE
• A company issues Rs 10,00,000 10% at discount 5%debentures. Redeemable after 5 years. Flotation cost is 30,000.
• SOLUTION
• K_d =( I+1/n ( RV-NP))/(1/2(RV+NP) =(1,00,000+1/5 ( 10,00,000-9,20,000))/(1/2X(10,00,000+9,20,000)=1,16000/9,60,000=12.08%