CHAPTER ONE
COST OF CAPITAL
INTRODUCTION
The concept of cost of capital is based on the assumption that the core goal of profit seeking
business firms is to maximize the wealth of shareholders.
The concept of cost of capital has its roots in the items on the right-hand-side of the balance
sheet, which includes various types of debt, preferred stock, common stock, and retained
earnings. These items are called capital components. An increase in the total asset must be
financed by an increase in one or more of these capital components.
Capital is one of the necessary factors of production (input) of any business firm, and like
other factors it has a cost of its own. The cost of each component of capital is called
component/specific cost of capital.
Each sources of capital for the firm such as investors (internal to the firm- common
stockholders, preferred stockholders,) and lenders (external to the firm-banks and financial
institutions whose supply term loan and debenture capital) requires a minimum rate of
return as a result of the capital they supply for the business. From the stand point of the
firm, these sources provide the capital (financial resources) needed to finance the firm’s
investments in its total assets. The minimum rate of return that the business firm must earn
in order to satisfy the overall rate of return required by financers is called firm’s cost of
capital.
THE CAPITAL STRUCTURE
It is the financing plan of a company. It answers the question that - where do we
obtain funds to finance the business?
It is the mix of long term sources of funds (financial resources) used by the firm. It
consists of both debt and equity capital sources.
It determines the proportion of debt and equity capital used by a firm for
investment.
It is the relative contribution of both creditors and owners (shareholders) to the total
fund/capital of the firm.
Note that: capital structure is the financing mix decision. The financing mix decision has no
impact on the firm’s operating income (EBIT), but it has a direct impact on the income
available for shareholders (net income).
LONG TERM SOURCES OF FUNDS/FINANCE
The firm’s capital can be obtained from two sources:
I. EQUITY SOURCES:
The capital obtained from these sources called EQUITY CAPITAL.
It refers the contributions of owners/shareholders the total capital of the business.
The followings are the types of capital obtained from these sources:
1. EQUITY CAPITAL:
This capital is obtained through sale of common stocks.
Like other sources, equity capital has a cost and dividend is a cost for equity capital.
(amount is determined by the board of director---not pre-determined and fixed in
amount)
2. PREFERRED CAPITAL:
This capital is obtained from sale of preference stocks.
A preferred stock has unique characteristics:
It has a fixed rate of dividend.
The firm is legally obligated to pay regular dividend.
It has special vote.
During liquidation, the principal amount is paid out to preferred stockholders
before common stockholders.
Fixed rate of dividend is the cost of preferred capital.
3. RETAINED EARNING CAPITAL:
Retained earnings capital can be obtained from the firm’s annual net income. The
firm’s annual net income can be fully paid out as a dividend to common
stockholders, or fully retained in the business for reinvestment or partially paid out
as a dividend and partially retained in the business.
If a firm retained full or part of the net income for reinvestment, the firm use the
amount as a capital for the budget year.
The cost of retained earnings is the same as the cost of equity capital or the cost of
common stock.
II. DEBT SOURCES:
The fund obtained from such sources is called debt capital.
It refers the contributions of creditors to the firm’s total capital.
There are two possible types of capital which can be obtained from debt sources.
1. TERM LOAN:
It is a long term loan obtained from banks and other financial institutions.
Interest is the cost of term loan.
2. DEBENTURE CAPITAL:
Debenture is a legal certificate issued by the firm to creditors.
It is the fund obtained through issue of debenture certificate.
Fixed rate of dividend is the cost of debenture capital.
Note that: the firm’s capital structure is the mix of two or more of these long term sources
of capital.
DESIGNING AN IDEAL CAPITAL STRUCTURE
DEFINITION OF COST OF CAPITAL
An ideal capital structure is the one that maximize the firm’s market value of the stock.
The followings are the factors that must be considered while determining the firm’s debt-
equity proportion or designing an ideal capital structure:
1. RETURN:
An ideal capital structure should generate maximum and consistence return/benefit
to shareholders for a considerable period of time.
It refers that the rate of return should exceed its cost of capital.
2. RISK:
An ideal capital structure should be free from risk of insolvency.(insolvency occurs
when a firm is unable to pay its financial obligations – which results in bankruptcy)
Use of excessive debt funds may threaten the company’s survival.
Use of maximum debt funds may increase the return to shareholders, but it should
be free from risk of insolvency.
3. FLEXIBILITY:
An ideal capital structure should be able to adapt itself to changing situations with
minimum cost and delay.
Changing situations can be:
The need to raise additional funds.
The need to clear or pay debts before maturity.
The freedom of using funds.
4. CAPACITY:
An ideal capital structure of the firm should have the capacity or ability to pay debts.
The capital structure should be within the debt capacity.
Debt capacity depends on the firm’s ability to generate sufficient income for
repayment of debt.
5. CONTROL:
An ideal capital structure should involve minimum risk of losing control of
management or the company itself.
COST-OF-CAPITAL: is the minimum rate of return that the firm must earn on its invested
capital.
Implication of the definition:
It is the minimum rate of return that the firm must earn to meet the
costs/expenses of the various sources of capital.
It is the minimum rate of return that a firm must earn to maintain the current
market value of the firm.
COST-OF-CAPITAL: Is the minimum rate of return required by financers of a business.
Financers of a business can be lenders or investors (shareholders) who supply the necessary
funds to the firm in the form of loan or through buying stocks or shares of the firm.
Therefore, these financers require return/benefit from the firm in return for the money they
supplies to the business.
Note that: the objective of any capital is to maximize the firm’s wealth:
If the rate of return exceeds its cost of capital, the excess earnings maximize the
firm’s wealth or value.
If the rate of return equals with its cost of capital, the firm can maintain its current
market value.
If the rate of return is less than is cost of capital, the firm’s wealth or current market
value tends to decline.
SIGNIFICANCE OF COST OF CAPITAL
Financial managers of any business organization uses the firm’s or project’s cost of capital
for financial decision making. Such as:
To make investment decision.
To make financing decision.
To decide on lease or purchase of assets.
To calculate the economic value added to the firm.
Used as a discount rate to calculate the present value of project’s cash flows.
COMPUTING DIFFERENT SOURCES OF CAPITAL
A firm can obtain its capital from different sources; all sources of capital have costs either in
the form of interest (for debt capital) and dividend (for equity capital).
I. EQUITY SOURCES:
Equity capital can be obtained from sale of common stocks, sale of preference stocks,
and retained earnings.
1. Cost of preferred capital (KP):
Preference capital can be obtained through issue of preference stocks.
Preferred stocks have the following characteristics:
Have a fixed rate of dividend. (predetermined at the time of issuance)
Have legal obligation to pay regular dividend for preferred
stockholders.
Cost of preference share (KP):- is the minimum rate of return which equates the proceeds
from preference capital issue to the dividend and principal repayments.
Preference capital has the following costs:
1. Cost of preference stock issuance: it includes the cost paid for legal services, cost
of printing a stock, cost of advertising, and discount made by the issuing firm to
attract investors to buy the stock.
2. Fixed rate of dividends made at regular basis.
3. Cost of receiving preference stock: occurs when the firm repays the principal at a
premium price at the maturity date of the stock.
Formula:
Kp= D+ {(F-P) /n}
(F+P) /2
KP = cost of pref. capital
D= dividend per share
F= redemption price
P= selling price per share
N= maturity period
N.B:- the cost of preference share is similar to debenture interest. Unlike debenture interest,
dividends do not qualify for tax deduction.
Example: - XYZ Ltd. has recently come out with a preference share issue; each preference
share has a face value of 100 Br and a dividend of 12% payable. The shares are redeemable
after 10 years at a premium of 4Br. per share. The company hopes to realize 98Br. per share
now. Compute the cost of preference capital?
Solution:
Kp= D+ {(F-P) /n}
(F+P) /2
= 12 + {(104-98) /10}
(104 + 98) /2
= 12.6
101
Kp = 0.1247 or 12.47% / share
2. Cost of equity capital (ke):
Equity capital can be obtained through issue of common or equity shares.
Common or equity shares have the following characteristics:
Equity shares have no fixed rate of dividend which is pre-determined
before. The amount of dividend can be determined by the amount of net
income earned.
Equity shares have no legal obligation to pay regular dividend for
common stockholders. It is determined by the firm’s board of directors.
Is equity capital tree of cost?
Many people think of equity capital is free from cost due to the following reasons:
1. Equity shares do not have fixed rate of dividend.
2. There is no legal obligation to pay regular dividend.
But, the right answer is that no capital source is free of cost, even equity capital. Cost of
equity capital includes:
1. Dividend payable. ( the intrinsic value of equity share is the sum of present values of
dividends associated with them)
2. Capital appreciation. (an increase in market price of the stock)
Generally, it is difficult and complex process to calculate the cost of equity, because
dividends cannot be accurately forecasted. The dividend may be:
It is sometimes nil
have a constant growth rate or
Supernormal growth rate.
Formula:
Ke= (D1/pe) + g
Where:
Ke = cost of equity capital
D1 = dividend forecast
Pe = current market price of stock
g = growth rate
Example: - XYZ Company expected to declare a dividend of 5Br per share and the growth
rate in dividends is expected to grow at 10%. The price of the share is currently at 110 Br in
the market. Calculate ke?
Solution:
Ke = (D1/pe) +g
= (5/110) + 0.10
= 0.1454 or 214.54 % per share
3. Cost of retained earnings capital (Kr):
Retained earnings capital can be obtained from the firms net income earned for the
year. The net income can be retained and reinvested to maximize the firm’s value.
Company’s earnings can be reinvested in full to fill the increasing demand for funds.
The company’s earing (net income)can be:
Fully retained and reinvested to fulfil the demand for fund
Partly paid and pertly reinvested.
Fully paid out as a dividend to equity shareholders.
These decisions are made based on the company’s growth stage.
Companies with high growth opportunity- fully retained the net income for
reinvestment.
Companies with constant growth rate –the firm’s net income might be partly
retained and partly paid out as a dividend.
Companies with no opportunity for growth- fully paid out the net income as a
dividend.
There are two difficulties in calculation of the cost of retained earning capital:
They are not securities like preference shares and common stocks, therefore,
they do not have market value or price that can be used for computing their
cost. They are obtained from internal sources (net income).
They do not represent funds provided directly by common stockholders, there
may be a tendency to equate or relate the cost of retained earnings capital to
zero.
The cost of retained earnings capital is estimated on the basis of the specific cost of
equity capital.
Therefore, the cost of retained earnings is the same as the cost of equity capital.
But, the main difference from cost of equity is, ignoring the selling cost (floating cost)
because, retained earnings are not marketable securities.
Formula
Kr = Ke
II. COST OF DEBT SOURCES
The fund obtained from debt source is called debt capital, which have a cost in the
form of interest.
1. Cost of debenture (Kd):
Debenture: is the agreement to repay debt with fixed interest rate using the
company’s assets as a security.
Debenture certificate or voucher acknowledging a debt.
Debentures carry a fixed rate of interest.
Interests qualify for tax deduction.
Cost of debenture: is the discount rate which equates the net proceeds from issue of
debentures to the expected cash outflow interest and principal repayments.
Formula:
Kd = I (1-T) + {(F-P)/n}
(F=P)/2
Where:
Kd = cost of debenture.
I = Annual interest payment per unit of debenture.
T = corporate tax rate.
F= redemption price per debenture.
P= net amount realized per debenture.
n = Maturity period
Example: - XYZ enterprise wants to have an issue of non- convertible debentures for 10Cr.
Each debenture is of a bar value of Br 100 having an interest rate of 15%. Interest is payable
annually and they are redeemable after 8 years at a premium of 5%. The company is planning
to issue the NCD at a discount of 3% to help in quick subscription. If the corporate tax rate is
50%, what is Kd?
Solution:-
Kd = I (1-T) +{(F-P)/n}
(F+P) /2
= 15 (1-0.5) + {(105-97)/8
(105+97)/2
= 7.5 + 1
101
Kd = 0.084 or 8.4 %
2. Cost of term loan(Kt):
Term lean:- is a learn taken from banks or financial institutions for a specified
number of years at a pre-determined interest rate.
The cost of term loans id equal to the interest rate multiplied by 1—tax rate.
The interest is multiplied by 1 –tax rate as interest on term loans is also taxed.
Formula:
Kt = I (1-T)
Where:
Kt = cost of term loan
I = annual interest rate
T = tax rate.
Example: - XYZ has taken a loan of Br 5,000.000 from bank at 9 % interest rate. What is the
cost of the loan if tax rate is 40%?
Kt = I (1-T)
= 0.09 (1 -0.4)
= 0.054 or 5.4 %
Weighted average cost of capital (WACC)
- The preious part helps us to compute the cost of each component in the overall capital of
the company.
- WACC is the overall cost all sources of finance.
- The term cost capital refers to the overall composite cost of capital or the weighted
overage cost of each specific types of fund.
- The purpose of using weighted overage is to consider each component in proportion of
their contribution to the total fund.
- Weighted overage is preferable than simple overage method b/c firms do not procure
funds equally from difference sources.
Steps in weighted overage cost of capital
Step 1: calculate the cost of each specific source of fund (debenture equity, preferred, loan
and retained earnings)
Step 2: determine the weights associated with each source,
Step 3: multiply the cost of each source by the appropriate weights /we ke/ /wr kp/ /wd kd/
/wt kt/
Step 4: WACC = we ke= Wr Kr+ Wp Kp + Wd + Kp +Wt Kt