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Cost of Capital AFM BNU

Bengaluru North University

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mathew creation
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81 views17 pages

Cost of Capital AFM BNU

Bengaluru North University

Uploaded by

mathew creation
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Meaning and Objective The minimum required rate of return expected by the investors on their investment is the cost of capital. Cost of capital acts as a cut-off rate in selection of tong term investment proposals. It is also useful in capital structure decisions. Cost of capital is also known as cut-off rate, overall cost of capital, weighted averdge cost of capital, hurdle rate, composite cost of capital, WACC, KO, etc. ‘Scope In this chapter we will tearn (1) Calculation of Spetific cost of Capital (2), Calculation of Overall cost of Capital. (3) Capital structure theories * Specific cost of capitat (0) Cost of Debt (Kd) (i) Cost of irredeemable / perpetual debt kg Interest(1-taxrate) _ NetProceeds | (ii) Cost of Redeemable Debt jade Interest(1-taxrate) +(RV-NP)/n (RV+NP)/2 Where, RV is the redemption value and NP is the Net Proceeds. «100 of Preference Shares (Kp) ()) Cost of irredeemable / perpetual preference shares Preference Dividend = PreferenceDividend 199 NetProceeds ‘Ke SHAN beta factor {Rin = If)» Market risk premium is a measure of the systematic risk of a security. j Bis on Index of how sensitive the returns of a security are to the market returns. B 4.0 measure of how responsive the price of a share is to the market movement. If + 1, it means the security exactly copies the market movement ic. has same risk a5, the market. if» 2 it means the share is twice os risky as market. f= 0.5, it means, that security is only half as risky as market Le only half of the market movernent Is reflected in the price of the share, GD (4) Typ Cost of retained Earnings (Kr) Generally, companies do not distribute the entire profits by way of dividends ‘among the shareholders. A part of such profits is retained for future expansion and development. Hence, the equity shareholders block their money with the company in two ways (i) directly by subscribing to the shares and (ii) arnount retained by the company. Apparently, retained earnings may appear to carry no cost since they represent funds which have not been raised from outside, but that is not the case. If earnings are not retained they will be distributed in the form of dividends and hence cost of retained earnings must therefore be viewed as the opportunity cost of the forgone dividends to the equity shareholders. Cost of retained earnings is equal to the income what a shareholder could have earned otherwise by investing the sarne in an alternative investment, if the company would have distributed the earnings by way of dividends instead of retaining it in the business. Therefore every shareholder expects from the company that much of income on the retained earnings for which he is deprived of the income arising on its alternative investment.Since it is very difficult to ascertain the opportunity Cost forgone, in absence of information, it is assumed that the equity shareholders expected the same rate of return which they expect on their equity share capital: Hence, if no information is given kr = Ke. Note: While computing Kr floatation costs are to be ignored. Weighted Average Cost of Capital Sources Debt Preference Share Capital Equity Share Capital Retained Earnings to ascertain WACC Book Value / Balance Sheet Value weights In this case, to calculate the WACC Book Values or Balance Sheet Values of each source of finance are considered for ascertaining weights. Market Value weights In this cass for calculating WAC, Market value of each source of Finance is considered for ascertaining weights. Between Market values and Book values preference is |sK, SHAH 2 9ondo Enter 1 to be given to Market Value as Investors Invest always at Market Values and y Book Values. While calculating WACC as per Market Value weights ignore Retain, Earnings as the market value of Equity Share Capital includes the Value of Retain, earnings, 3. Marginal Value Weights Whenever we have to calculate WACC for any specific or additional project, Ma: Fine Value Welghts are considered. In this case, the proportion of additional funds raise Is considered as weights to calculate WACC. * Capital Structure Theories General assumptions of Capital structure theories The relationship between the leverage, cost of capital and the value of the firm ha been analysed and examined in different ways. However, the following assumptiog have been made to understand this relationship.» (1) There are only two sources of funds Le.equity and debt, which is having fixe interest. (No preference share capital). (2) The total assets of the firm are given-and there would be no change in th, Investing decision of the firm (Total assets of the firm remain the same) The firm has a policy of distributing the entire profits among the shareholders (100% Poyout Ratio) The operating profits of the firm are given and are expected to remair constant. (EBIT to remain constant) The Operating or the business risk of the firm is given and assumed to bt 3 (4) (5) constant. (Operating Leverage to remain same) (6) There are no corporate or Personal taxes (7) dis tess than ko Net Income Approach | This theory was suggested by David Durand, The NI approach to the relationship between Debt-Equity Mix, cost of Copital and Value of the firm is the simplest in approach and explanation. This theory states that there is a relationship between the capital structure and the Ko of the firm. if there will be change in the capital structure, WACC will definitely change. GD PK AAT

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