CHAPTER NINE
COST OF CAPITAL & CAPITAL STRUCTURE
Learning Objectives:
After studying this chapter, you should be able to-
Explain the underlying risk assumptions, the role of taxes, and the key
factors affecting firm’s cost of capital,
Discuss the basic concepts of cost of capital,
Illustrate the computation of cost of specific sources of long-term
finance, viz., long-term debt and debentures, preference shares, equity
shares, and retained earnings,
Discuss and illustrate the various weighting approaches and the
weighted average cost of capital (WACC),
Highlight the uses of cost of capital.
9.1 The Concept and Measurement of Cost of Capital
A company’s cost of capital is the average rate of return required by investors
on the company’s securities. The cost of capital is an important element, as
basic inputs information, in capital investment decisions. This average rate
is often used by the company as a minimum acceptable rate of return for new
investments being considered by the firm. In the present value method of
discounted cash flow technique, the cost of capital is used as the discount
rate to calculate the net present value (NPV). When the internal rate of return
(IRR) method is used the computed IRR is compared with the cost of capital
(K0).
The cost of capital, thus, constitutes an integral part of investment decisions.
It provides a yardstick to measure the worth of investment proposal and,
thus, perform the role of ‘accept-reject’ decision. It also referred to as cut-off
rate, target rate hurdle rate, minimum required rate of return, standard return
and so on. Thus, as the firm estimates the initial investment and cash flows of
capital expenditure, it must also estimate its cost of capital.
Two basic conditions must be fulfilled so that the company’s cost of capital
can be used to evaluate new investments:
1. The new investments being considered have the same risks as the
typical or average investment undertaken by the firm
2. The financing policy of the firm is not affected by the investments
that are being made.
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Definition of Cost of Capital
In operational terms ‘cost of capital’ refers to the “Discount Rate” that is
used in determining the present value of the estimated future cash proceeds
and eventually deciding whether the project is worth under taking or not, in
this sense, it is defined as the ‘minimum rate of that firm must earn on its
investment for market value of the firm remain unchanged’. The cost of
capital is visualized as being composed of several elements. These elements
are the cost of each component of capital.
The term “component” means the different sources from which funds are
raised by a firm. Obviously each source of funds or each component of capital
has its cost. The cost of each source of component is called ‘specific cost’ of
capital. When the specific costs are combined to arrive at over all cost of
capital, it is referred to as ‘Weighted Average Cost of Capital’ (WACC).
The terms, Cost of Capital, Weighted Average Cost of Capital, Composite
Cost of Capital and Combined Cost of Capital are used interchangeably.
9.2 Risk and Cost of Capital
The two types of risk may be considered: Business risk and Financial risk.
Both of these, according to the assumptions of the Traditional Cost of Capital
Analysis are an affected by the acceptance and financing of the projects.
The response of a firm’s Earnings Before Interest and Taxes (EBIT) or
operating Profits to changes in sales indicates business risk. If this degree of
responsiveness of EBIT to change in sales is the same for new projects as for
the earlier ones, the business risk of the firm does not change. However, if the
firm accepts a new project which is considerably riskier than the average ones,
the suppliers of funds (debt or equity) will increase the cost of these funds to
compensate themselves for the increased risk. The firm’s cost of capital will
also increase thereby. Hence, for analyzing firm’s cost of capital, the business
risk is assumed to be unchanged.
The response of the firm’s Earnings Per Share (EPS) to changes in Earnings
Before Interest and Taxes (EBIT) indicates the degree of financial risk of the
firm. The financial risk is affected by the capital structure (i.e., the mix of long
term sources of funds, viz., debt and equity). By increasing the proportion of
debt, preference shares, leases, the firm will increase its financial risk, as these
are fixed cost sources and reduction in EBIT can affect EPS. Financing costs
will also increase as the suppliers of equity capital will expect higher return to
compensate for the increase risk. Hence to analyze the cost of capital, the
firm’s financial risk is assumed to be unaffected, i.e., the proportion of
various types of funds in future is supporting to be the same as the one in the
existing capital structure.
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9.4 Measurements of Specific Costs of Capital
The computation of the cost of capital involves two steps:
(1) The computation of the cost of the different sources of financing (specific
costs); and
(2) The calculation of the overall cost by combining the specific costs in to a
composite cost.
In calculating the cost of capital, the focus is on long term funds because they
constitute the major sources of financing of fixed assets. Thus, specific costs
have to be calculated for:
(i) Long term debt including debenture
(ii) Preference shared
(iii) Equity capital, and
(iv) Retained earnings.
A. Cost Debt, kd(1 - T)
The after tax cost of debt kd(1-T), is used to calculate the weighted average
cost of capital (WACC/K0), and it is the interest rate on debt (k d), less the tax
savings that results because interest is tax deductible. This is the same as kd
multiplied by (1-T), where T is the firm’s marginal tax rate.
= Interest rate - Tax savings
After tax component Kd - KdT
Cost of Debt = Kd (1 - T) ---------------( Eq. 1)
Example1: A company has 10 percent debt of $10,000. The tax rate is 35
percent; then it’s after tax cost debt is 6.5 percent calculated as follows.
Kd(1-T) = 10% (1 - 0.35)
= 6.5 percent
B. Cost Preference Stock, kps
The component ‘cost of preferred stock” used to calculate the weighted
average cost of capital (kps) is the preference dividend (Dps) divided by the net
issuing price Pn, which is the price the firm receives after deducting floatation
costs.
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Component cost of = kps = Dps = Dps ------------( Eq. 2)
Preference Stock P0(1-f) pn
Example 2: A company issues 11 percent preferences share of the face value of
$ 100 each. Floatation cost are estimated at 5 percent ( $5) of the expected
sale price. What is the Kps?
Kps = $11 = $11 = 11.6 per cent
$100(1-0.05) $95
Cost Common Stock, ke
a. The cost of new common equity (ke) or external equity, for a constant
growth stock, is found by applying the following formula.
Ke = D1 +g ----------------------- ( Eq. 3)
P0(1-f)
Where:
D1 = Expected dividend per share
P0 = current market price
g = growth in expected dividends
f = Floatation cost as percentage of sale price
(Or)
b. For existing old issued shares:
Ke = D1 +g ------------------------- ( Eq. 4)
P0
Example 3: Suppose that dividend per share of firm is expected to be $1 per
share next year and is expected to grow at 6 percent per year perpetually. The
cost of equity capital, assuming market price per share $ 25 is:
Ke= D1/po + g = $1/$25+0.06 =10 per cent
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Cost Retained Earnings, ks
It is true that a firm is not obliged to pay a return (dividend or interest) on
retained earnings. But, retained of earnings does have implication for
shareholders of the firm. If earning were not retained, they would have been
paid out to the ordinary shareholders as dividends.
When earnings are thus retained, shareholders are forced to forego dividends.
The dividend forgone by the equity shareholders are, in fact, an opportunity
cost. Thus, retained earnings involve an opportunity cost.
Therefore, the cost of retained earnings may be defined as opportunity cost in
terms of dividends forgone by/withheld from equity shareholder.
Then, cost of retained earnings ( ks) is equated to cost equity capital (ke) and
can be estimated as follows:
KS = D1 + g ----------------------------( Eq. 5)
P0
Note: Floatation cost is not considered
C. Computation of WACC (K0)
The target proportion of debt, preference stock, common equity shares and
retained earnings; along with the component cost of capital are used to
calculate the firm’s weighted average cost of capital (WACC) symbolically, k 0.
Assignment of weights:
The aspects relevant to the selection of appropriate weights are:
(1) Historical weights
a) book value weights
b) market value weights
(2) Marginal weights
*Historical weights either book or market value weights are based on actual
capital structure proportions to calculate weights.
*Marginal weights use proportion of each type of capital to the total capital to
be raised.
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Mechanics of Computation Of WACC (k0)
Example 4: (based on book value weights): We now illustrate the mechanics
of computation of the WACC/K0.
(a). The following is the capital structure of a firm.
Source Amount Weights
Long term debt $300,000 30%
Preference capital $200,000 20%
Equity capital (including R/Es) $500,000 50%
Total $1,000,000 100%
(b). The firm cost of capital of the specific sources is as follow:
Kd = 10%
Kps = 14%
Ke = 17%
T = 20%
(c). Calculate the WACC (K0) using the given book value weights:
Solution:
WACC= Pd x Kd (1-T) + Pps x Kps + Pe x Ke
= 0.30(10%) (1-0.20)+ 0.20(14%) +0.50(0.17%)
= 0.30*8% +2.80% +8.5%
= 2.4% + 2.8% + 8.5%
= 13.7 %
Alternatively:
After Tax Total
Source Amount Cost (%) Cost
(1) (2) (3) (2) x (3)
Long term debt $300,000 *8% $24,000
Preference capital $200,000 14% $28,000
Equity capital (Plus R/Es) $500,000 17% $85,000
Total $1,000,000 $137,000
WACC = $137,00 x 100 = 13.7 per cent
$1,000,000
---ENDS---
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