Chapter 10
The Cost of Capital
Outline
Some preliminaries
Cost of debt and preference Cost of equity
Determining the proportions
Weighted average cost of capital Weighted marginal cost of capital Determining the optimal capital budget Floatation costs and the cost of capital Factors affecting the weighted average cost of Misconceptions surrounding cost of capital How institutions calculate cost of capital
capital
Company Cost of Capital and Project Cost of Capital
The company cost of capital is the rate of return expected
by the existing capital providers. The project cost of capital is the rate of return expected by capital providers for a new project the company proposes
to undertake
The company cost of capital (WACC) is the right discount rate for an investment which is a carbon copy of the existing firm.
Cost of Debt
n I F P0 = + t = 1 (1 + rD)t (1 + rD)n
P0 = current price of the debenture I = annual interest payment n = number of years left to maturity
F = maturity value
rD is computed through trial-and-error. A very close approximation is: rD = I + (F P0)/n 0.6P0 + 0.4F
Illustration
Face value = 1,000
Coupon rate = 12 percent Period to maturity = 4 years Current market price = Rs.1040
The approximate yield to maturity of this debenture is :
120 + (1000 1040) / 4
rD =
0.6 x 1040 + 0.4 x 1000
= 10.7 percent
Cost of Preference
Given the fixed nature of preference dividend and principal repayment commitment and the absence of tax deductibility, the cost of preference is simply equal to its yield.
Illustration
Face value : Rs.100
Dividend rate : 11 percent Maturity period : 5 years Market price : Rs.95
Approximate yield :
11 + (100 95) / 5 = 12.37 percent
0.6 x 95 + 0.4 x 100
Cost of Equity
Equity finance comes by way of (a) retention of earnings
and (b) issue of additional equity capital.
Irrespective of whether a firm raises equity finance by
retaining earnings or issuing additional equity shares, the cost
of equity is the same. The only difference is in floatation cost.
Floatation costs will be discussed separately.
Approaches to Estimate Cost of Equity
Security Market Line Approach Bond Yield Plus Risk Premium Approach Dividend Growth Model Approach
Security Market Line Approach
rE = Rf + E [E(RM) Rf ] rE = required return on the equity of the company Rf = risk-free rate
E = beta of the equity of the company
E(RM) = expected return on the market portfolio Illustration Rf = 7%,
E = 1.2, E(RM) = 15%
rE = 7 + 1.2 [15 7] = 16.6%
Inputs for the SML
While there is disagreement among finance practitioners, the following would serve.
The risk-free rate may be estimated as the yield on longterm bonds that have a maturity of 10 years or more. The market risk premium may be estimated as the difference between the average return on the market portfolio and the average risk-free rate over the past 10 to 30 years. The beta of the stock may be calculated by regressing the monthly returns on the market index over the past 60 months or so.
Bond Yield Plus Risk Premium Approach
Cost of = equity
Yield on the long-term bonds + Risk premium of the firm
Should the risk premium be 2 percent, 4 percent, or n percent ? There seems to be no objective way of determining it.
Dividend Growth Model Approach
If the dividend per share grows at a constant rate of g percent.
D1 P0 =
rE g
D1 +g P0
So, rE =
Thus, the expected return of equity shareholders, which in equilibrium is also the required return, is equal to the dividend yield plus the expected growth rate
Earnings Price Ratio Approach
According to this approach, the cost of equity is equal to : E1 / P0 where E1 = expected earnings per share for the next year P0 = current market price per share E1 may be estimated as : (Current earnings per share) x (1+ growth rate of earnings per share). This approach provides an accurate measure of the rate of return required by equity investors in the following two cases :
When the earnings per share are expected to remain constant and the dividend payout ratio is 100 per cent. When retained earnings are expected to earn a rate of return equal to the rate of return required by equity investors. The first case is rarely encountered in real life and the second case is also somewhat unrealistic. Hence, the earnings-price ratio should not be used indiscriminately as the measure of the cost of
How Companies Estimate the Cost of Equity
A survey of corporate finance practices in India by Manoj Anand revealed that the following methods (in the order of decreasing importance) are followed by companies in India to estimate the cost of equity. % companies considering as very important or important
Capital asset pricing model Gordons dividend discount model Earnings yield (Earnings per share/ Market price per share, Dividend yield Multifactor model 26.2 7.0 54.3 52.1 34.2
Source: Manoj Anand, Corporate Finance Practices in India: A Survey, Vikalpa, October December 2002,
Determining the proportions or weights
The appropriate weights are the target capital structure weights stated in market value terms.
The primary reason for using the target capital structure is that the current capital structure may not reflect the capital
structure expected in future. Market values are superior to book values because in order to justify its valuation the firm must earn competitive returns for shareholders and debtholders on the current
(market) value of their investments.
Weighted Average Cost of Capital (WACC)
WACC = wErE + wprp + wDrD (1 tc) wE = proportion of equity rE = cost of equity wp = proportion of preference rp = cost of preference wD = proportion of debt
rD = pre-tax cost of debt
tc = corporate tax rate
WACC
Source of Capital
Proportion (1)
Cost (2)
Weighted Cost [(1) x (2)]
Debt
Preference Equity
0.60
0.05 0.35
16.0%
14.0% 8.4%
9.60%
0.70% 2.94%
WACC = 13.24%
Some Problem Areas in Cost of Capital
Privately owned firms Measurement problems
Derivative securities
Capital structure weights
Floatation Costs
Floatation or issue costs consist of items like underwriting
costs, brokerage expenses, fees of merchant bankers, underpricing cost, and so on. One approach to deal with floatation costs is to adjust the WACC to reflect the floatation costs: WACC Revised WACC = 1 Floatation costs
A better approach is to leave the WACC unchanged but to consider floatation costs as part of the project cost.
Factors Affecting the Weighted Average Cost of Capital
Factors Outside a Firms Control The level of interest rates Market risk premium Tax rates Factors within a Firms Control
Investment policy
Capital structure policy Dividend policy
Misconceptions Surrounding Cost of Capital
The concept of cost of capital is too academic or impractical. Current liabilities (accounts payable and provisions ) are
considered as capital components.
The coupon rate on the firms existing debt is used as the pre-tax cost of debt. When estimating the market risk premium in the CAPM method, the historical average rate of return is used along with the current risk-free rate. The cost of equity is equal to the dividend rate or return on equity.
Misconceptions Surrounding Cost of Capital
Retained earnings are either cost free or cost significantly
less than external equity Depreciation has no cost
Book value weights may be used to calculate the WACC
The cost of capital for a project is calculated on the basis of the specific sources of finance used for it The project cost of capital is the same as the firms WACC.
How Financial Institutions Calculate Cost of Capital
Financial institutions calculate cost of capital as post-tax weighted average cost of the mix of funds employed for the project. The cost for different sources of funds are taken as follows: Equity share capital : Cash accruals/Retained earnings : Preference share capital : Subsidy/Incentive loans : Debt : (Long-term loans, non-convertible debentures, deferred credits, bank borrowings for working capital, unsecured loans from public) Convertible debenture : 15% 15% Preference dividend rate Zero cost Post-tax rate of interest
Convertible portion at 15% Non-convertible portion at post-tax interest rate
Cost of Capital Calculation
Means of Financing (A) 1. 2. 3. 4. Equity and cash accruals Preference share capital Rupee term loans (@14%) Non-convertible debentures (@12%) 5. Convertible portion of convertible debentures 6. Non-convertible portion of convertible debentures (@10%) 7. Bank borrowing for working capital (@15%) Amount (Rs. in million) (B) 900 100 800 400 100 100 200 Cost of Funds (C) 15% 10% 10.5% 9% 15% 7.5% 11.25% Total Cost (post-tax) (D)= C x B 135 10 84 36 15 7.5 22.5
2600 The average cost of capital (post-tax) is : 310 / 2600 = 11.92%
310
Summary
Capital, like any other factor of production, has a cost. A companys cost of capital is the weighted average cost of the various sources of finance used by it, viz., equity, preference, long-term debt, and short-term debt. Note that many companies leave out the cost of short-term debt while calculating the weighted average cost of capital (WACC). In principle, this is not correct. Investors who provide short-term debt also have a claim on the operating earnings of the firm. So, if a company ignores this claim, it will misstate the rate of return required by its investors. WACC is a central concept in financial management. It is used for evaluating investment projects, for determining the capital structure, for setting the rates that regulated organisations like electric utilities can charge to their customers, so on and so forth. In general, if a firm uses n different sources of capital its WACC is : piri
Two basic conditions should be satisfied for using the companys WACC for evaluating new investments : (a) The risk of new investments is the same as the average risk of existing investments. (b) The capital structure of the firm will not be affected by the new investments. Thus strictly speaking, WACC is the right discount rate for a project that is a carbon copy of the firms existing business. However, in practice WACC is used as a benchmark hurdle rate that is adjusted for variations in risk and financing patterns. Since debt and preference stock entail more or less fixed payments, estimating the cost of debt and preference is relatively easy. A company raises debt finance through a variety of instruments like debentures, bank loans, and commercial paper. The cost of debt is the weighted average rate of different kinds of debt employed by it. The weighted average rate of debt is calculated using the market values and yields to maturity of various debt instruments. Note
Since interest on debt is a tax-deductible expense, the pre-tax cost of debt has to be adjusted for the tax factor to arrive at the posttax cost of debt. Preference capital carries a fixed rate of dividend and is redeemable in nature. Given the fixed nature of preference dividend and principal repayment commitment and the absence of tax deductability, the cost of preference is simply equal to its yield. Equity earnings may be obtained in two ways : (i) retention of earnings and (ii) issue of additional equity. The cost of equity or the return required by equity shareholders is the same in both the cases. Remember that when a firm decides to retain earnings, an opportunity cost is involved. A popular approach to estimating the cost of equity is the security Rf + i ( E(RM ) - Rf) market line (SML) relationship. According to the SML, the
Analysts who do not have faith in the SML approach often resort to
a
subjective procedure to estimate the cost of equity. They add a judgmental risk premium to the observed yield on the long-term bonds of the firm to get the cost of equity. According to the dividend growth model approach, the cost of equity is equal to : Dividend yield + Expected growth rate in dividends For calculating the WACC we multiply the cost of each source of capital by the proportion applicable to it. These proportions may be based on book values or target capital structure or market values. Market value proportions are generally recommended unless market values are not available or are highly unreliable or distorted. WACC tends to rise as the firm seeks more and more capital. This
A Schedule or graph showing the relationship between additional
financing and WACC is called the weighted marginal cost of
capital schedule. When projects have risks that are substantially different from
those of the overall firm, applying WACC can potentially lead to
poor decisions. In such cases, the expected return must be compared with the risk-adjusted required return. To determine the optimal capital budget, you have to compare the expected return on proposed capital expenditure projects with the marginal cost of capital schedule. When a firm raises finance by issuing equity and debt, it almost
invariably incurs floatation or issue costs, comprising of items like
underwriting costs, brokerage expenses, fees of merchant bankers, under-pricing costs, so on and so forth.
There are two ways of handling floatation costs. One approach is to adjust the WACC to reflect the floatation costs. A better approach is to leave the WACC unchanged but to consider floatation costs as part of the project cost. The cost of capital is affected by several factors, some beyond the control of the firm and others depending on the investment and financing policies of the firm. Despite the importance of cost of capital in financial management, we find that several misconceptions characterise its application in practice. The more serious ones are : (i) The cost of capital is too academic or impractical, (ii) The cost of equity is equal to the dividend rate or return on equity, (iii) Retained earnings are either cost free or cost significantly less than external equity, (iv) Depreciation has no cost, (v) The cost of capital can be defined in terms of an accounting-based measure, (vi) If a project is financed heavily by debt, its WACC is low.
