Cost of Capital

Cost of capital
 Cost of capital refers to the minimum required rate of return of a
proposal that a company must earn to cover the cost of
investment. Funds can be procured from different sources such as
equity and preference shareholders, debt holders and depositors.
All those who have invested in the company, would require a
return on their investment.
 To satisfy the expectations of the stakeholders, the projects of the
firm must be able to attain a minimum cut-off rate. Capital raised
from different sources is called components of capital. Each of
these sources has a cost. In fact cost of capital is the minimum rate
of return expected by its investors which will maintain the market
value of shares at its present level.
 Cost of Capital
 Cost of capital is “ a cut-off rate for the allocation of
capital to investments of projects. It is the rate of return
on a project that will leave unchanged the market price
of stock.’’--------James C.Van Horne
 “ Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditures.”
 Cost of capital is “the rate of return the firm requires
from investment in order to increase the value of the
firm in the market place.”
Cost of Capital
 Factors affecting Cost of Capital: The minimum rate of
return can be achieved by the consideration of risk and the
required rate of return of the firm.
 1. Risk-free interest rate.
 2. Business risk.
 3. Financial risk.
 The cost of capital is the rate of return, which is calculated
through a discount rate to work out the NPV of a project.
Discount rate is the opportunity cost of capital. It is the rate of
return for the compensation of risk and time for the use of capital.
Hence, cost of capital is measured through a discount rate, which
comprises of a risk free rate of interest and compensation for
business and financial risk.
Determination of cost of capital
 Conceptual controversies regarding the relationship between
the cost of capital and capital structure.
 Problems in the computation of cost of equity.
 Problems in the computation of retained earnings.
 Problems in assigning weights.
 Significance of Cost of Capital
 The concept of cost of capital derives its importance from its
usefulness in investment management proposals. Cost of capital is
of immense help in capital budgeting and capital structure
decisions.
 1.As an acceptance criteria in Capital Budgeting.
 2.As a determinant of capital mix in capital structure decisions
 3.As a basis for evaluating the financial performance
 4.As a basis for taking other financial decisions
 TYPES OF COST OF CAPITAL
 1)COST OF DEBT (Kd)
 2)COST OF EQUITY (Ke)
 3)COST OF PREFRENCE SHARES (Kp)
 4)COST OF RETAINED EARNINGS(Kr)

COST OF DEBT (Kd)

Weighted Average Cost

Of Capital(Kw)
COST OF EQUITY (Ke)
Elements of Cost
of Capital COST OF PREFRENCE SHARES
(Kp)

COST OF RETAINED EARNINGS(Kr)

 Computation of Cost of Capital
 Cost of Debt
Kdb =I/P
Where, Kdb= Before tax Cost of Debt
I= Interest
P= Principal Amount
If debt is issued at Premium or Discount
Kdb= I/NP (Where NP= Net Proceeds)
After-tax cost of debt
Kda =I/NP(1-t)
Where
Kda =After tax cost of debt
t=Rate of tax
 Cost of Debt
 Cost of debt capital is associated with the amount of interest that is paid on
currently outstanding debts. It is denoted by (Kd)
Cost Of Irredeemable Debt
Cost Of Redeemable Debt
Example: Cost Of Irredeemable Debt
A) X ltd. Issues Rs. 50000 8% debentures at par. The tax rate
applicable to the company is 50%. Compute the cost of
debt. Capital.
B) Y ltd. Issues Rs. 50000 8% debentures at premium of 10%.
The tax rate applicable to the company is 60%. Compute
the cost of debt. Capital.
C) A ltd. Issues Rs. 50000 8% debentures at discount of 5%.
The tax rate applicable to the company is 50%. Compute
the cost of debt. Capital.
Solution:(A)
Kda =I/NP(1-t)
= 4000 (1-0.5)
50000
= 4000 (0.5) = 4%
50000
 Cost of Debt
 Redeemable Debt
Example-2
Example: 1
A Company issues Rs. 10,00,000 10% redeemable
debentures at a discount of 5%. The cost of flotation amount
to Rs. 30000. The debenture are redeemable after 5 years.
Calculate before tax and after tax cost f debt assuming a tax
rate at 50%.
Solution
Example: 2)
A 5 years Rs 100 debenture of a firm can be sold for a net price
of Rs. 96.50. The coupon rate of interest is 14% par annum,
and the debenture will be redeemed at 5% premium on
maturity. The firm’s tax rate is 40%. Compute the before tax
and after tax cost of debenture.
Solution:
Cost of Preference shares
 The preference share capital is different from equity
share capital on account of two basic features :
 1)the preference shares are entitled to receive dividends
at a fixed rate in priority over equity shares.
 2)in case of liquidation of the company ,the preference
shareholders will get the capital repayment in priority
over the distribution among the equity share holders.
 It is denoted by ( Kp).
 Cost of Equity
Cost of new Issued Equity Shares
Example:
 Cost of Retained Earnings
The profits retained by a Company and used in the expansion Of the Business are
known as ‘Retained Earnings’.It is also Known as ‘Internal Financing’ or ‘Ploughing
back of profits’.
Questions……?
Are Retained Earnings Free of Cost?
Ans:Yes
Are Retained Earnings less Expensive than the new issue of ordinary shares?
Ans:Yes 1)Savings in floataion cost
2)Saving in Taxes
3)Savings in brokerage cost
COMPUTATION OF COST OF RETAINED EARNINGS
Formula: Kr=Ke*(1-t)*(1-b)
where, Kr=Cost of retained earnings
Ke=Cost of equity(rate of return available to equity shareholders)
t=Tax rate applicable
Weighted Average Cost of
Capital
It is the average rate of return that a company is
expected to pay to all it’s different investors or
stakeholders. In other words calculation of a
firm's cost of capital in which each category of
capital is proportionately weighted.
Formula-
WACC = TOTAL WEIGHTED COST X 100
TOTAL CAPITAL
Weighted Average Cost of
Capital
Solved Example:
Leverages

DR. SHALINI AGGARWAL

ASSOCIATE PROFESSOR
Leverages
Leverages

 In financial management, the term leverage is used

to describe the firm’s ability to use fixed cost assets
or funds to increase the return to its investors i.e.
equity shareholders. The capital structure of a
company is said to be leveraged or geared when
there is the presence of debt in it.
 Leverages
 The concept of leverage assumes significance if one
appreciates that different investors have different
attitudes towards risk and return.
 Some like to bear more risks in the hope of earning
good returns while others prefer fixed and regular
income even at a lower rate provided risk involved is
less.
 The former category makes investment in equity share
capital while the latter in fixed income bearing
securities.
Leverages

 The company chooses a suitable leverage with

another objective also. It has to ensure to its equity
shareholders an adequate amount of dividend as
they are the actual risk bearers. This amply
compensates the real owners of the company for no
dividend or little dividend allowed to them in the
years of lean profits.
 The right gearing/ leverage of capital is also
important for a correct policy of dividend
distribution and creation of reserves.
 Leverages
 To quote Brown and Howard ‘It (capital gearing or
leverage) must be carefully planned since it affects
company’s capacity to maintain an even distribution in
the face of any difficult trading periods which may occur.
 Furthermore its immediate effect may be to enable a
company to pay higher ordinary dividends when there is
only a narrow margin of profit but its long term effects
on the efficiency of the company are far reaching.’
 Types of leverages

 There are basically two types of leverages

 Financial Leverage
 Operating Leverage
Financial Leverage
 It is also called trading on equity. A company may raise funds
either by way of equity or debt. When a concern uses
borrowed funds as well as owned capital, it is said to be
trading on equity.
 The philosophy behind trading on equity is to evolve such a
capital structure which involves minimum cost of capital and
ensures maximum return to equity shareholders.
 Return is a function of risk, debentures and preference
shares being more secure attract less return than dividend on
equity shares.
Financial Leverage
 “The degree to which debt is used in acquiring
assets is known as trading on equity.”------Hastings
 “the use of borrowed funds or preferred stock for
financing is known as trading on equity.”---Guthman
and Dougall
 “When a person or a corporation uses borrowed
capital as well as owned capital in the regular
conduct of its business, he or it is said to be trading
on equity.”
 Illustration
◦ A firm is considering two financial plans with a view to examining their
impact on earnings per share (EPS). The total funds required for investment
in assets are Rs. 5,00,000

◦ Debt(10%) 4,00,000 1,00,000

◦ Equity shares 1,00,000 4,00,000

◦ Total 5,00,000 5,00,000
◦ No. of equity shares 10,000 40,000

◦ EBIT are assumed to be Rs. 50,000, Rs.75,000 and

Rs. 1,25,000.The rate of tax is 50%. Comment
 Significance of financial leverage
 1)Planning of capital structure: The capital structure is
concerned with the raising of long-term funds both from
shareholders and long-term creditors. A financial manager
has to decide about the ratio between fixed cost funds and
equity share capital. The effect of borrowings on cost of
capital and financial risk have to be decided before selecting a
final capital structure.
 Significance----
 2)Profit Planning: The earning per share is effected by the
degree of financial leverage. If the profitability of the concern
is regular and sufficient, then fixed cost funds will help in
increasing the availability of profits for equity shareholders.
 Limitations of financial leverage
 1)Double-edged weapon: Trading on equity is a
double-edged weapon. It can be successfully
employed to increase the earnings of the company
for equity share holders if debt can be raised at a rate
which is less than the rate of dividend. On the other
hand, if it does not earn as much as the cost of
interest bearing securities, then it will work
adversely and hence can not be employed.
 Limitations----
 2) Benefits only to those companies which have
stability of earnings: Trading on equity can be enjoyed
only by those companies which have adequate, stable and
regular earnings. This is so because interest on debentures is a
recurring burden on the company and has to be paid whether
there is profit or not.
 Limitations----
 3) Increased risk and rate of interest: Another
limitation of trading on equity is on account of the fact that
every rupee of extra debt increases the risk and hence the
rate of interest on subsequent borrowings also goes on
increasing. It become difficult for the company to obtain
further debts without offering extra securities and higher
rate of interest, which may result in reduced earnings.
Limitations----
 4)Restriction from financial institutions: The financial
institutions also impose restrictions on companies which
resort to excessive trading on equity because of the risk
factor and to maintain a balance in the capital structure of the
company.
 Operating Leverage
 Operating leverage takes place when a change in revenue produces a
greater change in EBIT. It indicates the impact of changes in sales on
operating income.
 A firm with a high operating leverage has a relatively on EBIT for small
changes in sales. A small rise in sales may enhance profits considerably,
while a small decline in sales may reduce and even wipe out the EBIT.
NO firm likes to operate under conditions of a high operating leverage
as it creates a high risk situation. It is always safe for a firm to operate
sufficiently above the break even point to avoid dangerous fluctuations
in sales and profits.
 The operating leverage is related to fixed costs.
 Operating Lease
• A firm with relatively high fixed costs uses much of its
marginal contribution to cover fixed costs. It is
interesting to note that beyond the break-even point, the
marginal contribution is converted into EBIT. The
operating leverage is highest near the break even point.
• Operating Leverage= Marginal Contribution/EBIT
– Here Marginal contribution = Sales- Variable cost
– Operating Profits = Sales- variable cost- fixed cost

• Degree of operating Leverage= % change in profits

% Change in sales
 Example:
Following is the cost information of a firm:
Fixed cost=Rs. 50,000
Variable Cost= 70% of sales
Sales= Rs. 2,00,000 in the previous year and Rs. 2,25,000 in
current year.

Find out percentage change in sales and operating profits when:

(i) Fixed costs are not there (no leverage)

(ii) Fixed costs are there (leveraged situation)

 Combined Leverage
 Financial leverage is the result of financial decisions.
Operating leverage affects the income which is the
result of production. Combined leverage focuses
attention on the entire income of the concern. The risk
factor should be properly assessed by the management
before using the composite leverage.
 Degree of composite leverage
= Percentage change in EPS/Percentage change in sales
Suggested Readings
• Chandra, Prasanna “Financial Management”, Tata McGraw Hill,
New Delhi
• James C Van Horne, Financial Management, Prentice-Hall, New
Delhi
• Khan M.Y. & Jain P.K, Financial Management, Tata McGraw Hill,
New Delhi
• Pandey I.M “Financial Management”, Vikas Publishing House, New
Delhi
• Reference Material –
• Maheshwari S.N. “Principles of Financial Management”, Sultan
Chand & Sons, New Delhi
• Kulkarni P.V. “Financial Management”, Himalaya Publishing
House, Mumbai
Capital Structure,
 Learning Objectives
 To have understanding about important financial concepts
and analytical tools used in financial decision making process
in an efficient and informative manner

44 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Capital Structure
 Capital structure is the mixture of sources of funds a firm uses
(debt, preferred stock, common stock).
 The amount of debt that a firm uses to finance its assets is
called leverage. A firm with a lot of debt in its capital
structure is said to be highly levered. A firm with no debt is
said to be unlevered.
 Capital structure can be viewed as the permanent financing
the firm represented primarily by long-term debt, preferred
stock, and common equity but excluding all short term
credit.

45 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Capital Structure
 A corporate can finance its business mainly by 2 means
i.e. debts and equity. However, the proportion of each of
these could vary from business to business. A company
can choose to have a structure which has 50% each of
debt and equity or more of one and less of another.
Capital structure is also referred to as financial
leverage, which strictly means the proportion of debt
or borrowed funds in the financing mix of a company.

46 I. M. Pandey, Financial Management, 9th ed., Vikas.

  Debt structuring can be a handy option because the interest
payable on debts is tax deductible (deductible from net
profit before tax). Hence, debt is a cheaper source of
finance. But increasing debt has its own share of drawbacks
like increased risk of bankruptcy, increased fixed interest
obligations etc.
 For finding the optimum capital structure in order to
maximize shareholder’s wealth or value of the firm, different
theories (approaches) have evolved. Let us now look at the
first approach

47
 Capitalization, Capital Structure and
Financial Structure
 Capitalization means the total amount of securities issued by
the company.
 Capital structure means the kinds of securities and
proportionate amount that make up capitalization .
 Financial structure mean all the financial resources of the
firm which includes short term as well as long term

48 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Patterns of capital structure
 Equity Shares only( unlevered firm)
 Equity and preference shares (Levered)
 Equity shares and Debentures (Levered)
 Equity Shares, Preference Shares and Debentures( Levered
firm)

49 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Determinants of capital structure
 Financial Leverage
 Growth and stability of sales
 Cost of capital
 The profitability of the organisation
 Reliable cash flows
 Degree of risk associated with the enterprise
 Management’s risk aversion attitude
 Availability of different kinds of debt instruments
 Attitude of the promoters towards financial and management control
 Cost of flotation
 Legal requirements
 Purpose of financing
 Period of Finance
 Nature and size of the firm
 Corporate Tax Rate
50 I.
 M.Capital
Pandey, Financial Management, 9th ed., Vikas.
Market Conditions
 Net Income Approach Explained
 Net Income Approach was presented by Durand. The theory
suggests increasing value of the firm by decreasing overall
cost of capital which is measured in terms of Weighted
Average Cost of Capital. This can be done by having higher
proportion of debt, which is a cheaper source of finance
compared to equity finance.

51 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Weighted Average Cost of Capital (WACC) is the weighted average costs of
equity and debts where the weights are the amount of capital raised from each
source.

 According to Net Income Approach, change in the financial leverage of a firm

will lead to corresponding change in the Weighted Average Cost of Capital
(WACC) and also the value of the company. The Net Income Approach
suggests that with the increase in leverage (proportion of debt), the WACC
decreases and the value of a firm increases. On the other hand, if there is a
decrease in the leverage, the WACC increases and thereby the value of the firm
decreases.
 For example, equity-debt mix of 50:50, if the equity-debt mix changes to 20:
80, it would have a positive impact on value of the business and thereby
increase
52 I. M.the value
Pandey, Financialper share.9th ed.,Vikas.
Management,
53 I. M. Pandey, Financial Management, 9th ed., Vikas.
 Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are

as follows.
 Increase in debt will not affect the confidence levels of the
investors.
 The cost of debt is less than cost of equity.
 There are no taxes

54 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Market Value –NI Approach
 V=S+D
Where,
V= Total market value of the firm
S=Market value of equity shares
S=Net income/equity capitalization rate(Ke)
D= Market value of Debt
Overall cost of capital or WACC
K o=EBIT/V

55 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Net Operating Income Approach
 This theory is opposite to the net income approach.
According to this approach,change in the capital
structure of a company does not affect the market value
of the firm and the overall cost of capital remains
constant irrespective of the method of financing .
 It implies that the overall cost of capital remains the same
whether the debt equity mix is 50:50, 20:80 or 0:100.
So there is nothing optimal capitals structure and every
capital structure is optimal capital structure.

56 I. M. Pandey, Financial Management, 9th ed., Vikas.

  As per this approach, the market value is dependent on the
operating income and the associated business risk of the
firm. Both these factors cannot be impacted by the financial
leverage. Financial leverage can only impact the share of
income earned by debt holders and equity holders but
cannot impact the operating incomes of the firm. Therefore,
change in debt to equity ratio cannot make any change in
the value of the firm.

57 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Assumption of NOI
 The market capitalizes the value of the firm as a whole
 The business risk remains constant at every level of debt equity
mix
 There are no corporate taxes.
According to NOI approach, the financing mix is irrelevant and it
does not affect the value of the firm.

58 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Value of Firm-NOI Approach
 V= EBIT/Ko
 V= value of a firm
 EBIT= Earning before interest and Tax
 Ko = Overall
cost of capital
 Market value of equity is determined by deducting the
market value of debentures from value of firm.
 S=V-D
 D= Value of debt

59 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Net Operating Income (NOI)
Approach

Cost
ke

ko

kd

Debt

60
 Traditional Approach
 The traditional approach is also known as intermediate
approach, is a compromise between two extremes of net
income approach and NOI approach.
 Stage-1 The value of the firm can be increased initially or cost of
capital can be decreased by using more debt as the debt is a cheaper
source of funds than equity. Thus, optimum capital structure can be
reached by a proper debt –equity mix.
 Stage 2: Beyond a particular point, the cost of equity increase because
increased debt increases the financial risk of the equity shareholders.
The advantage of cheaper debt at this point of capital structure is offset
by increased cost of equity.

61 I. M. Pandey, Financial Management, 9th ed., Vikas.

  Stage 3: At this stage, when the increased cost of
equity cannot be offset by the advantage of low-cost
debt.So, overall cost of capital, increases or rise beyond a
certain point.Even the cost of debt may increase at this
stage due to increased financial risk.

62 I. M. Pandey, Financial Management, 9th ed., Vikas.

 Traditional Approach
 The traditional approach
argues that moderate degree Cost
of debt can lower the firm’s
overall cost of capital and ke

thereby, increase the firm

value. The initial increase in
ko
the cost of equity is more than
offset by the lower cost of
debt. But as debt increases,
shareholders perceive higher kd
risk and the cost of equity
rises until a point is reached at
which the advantage of lower
cost of debt is more than offset Debt
by more expensive equity.

63 I. M. Pandey, Financial Management, 9th ed., Vikas.

 MM Approach
 MM approach has two version –MM I & MM II
 Assumptions
 There are no corporate taxes
 There is a perfect market
 Investor act rationally
 The expected earnings of all firms have identical risk characteristics
 The cut off point of investment in a firm is capitalization rate.
 Risk to investors depends upon the random fluctuations of expected
earnings.
 All earnings are distributed to the shareholders.

64 I. M. Pandey, Financial Management, 9th ed., Vikas.

 MM Approach
 This approach was devised by Modigliani and Miller
during 1950s. The fundamentals of Modigliani and Miller
Approach resemble to that of Net Operating Income
Approach. Modigliani and Miller advocates capital
structure irrelevancy theory. This suggests that the
valuation of a firm is irrelevant to the capital structure of
a company. Whether a firm is highly leveraged or has
lower debt component in the financing mix, it has no
bearing on the value of a firm

65 I. M. Pandey, Financial Management, 9th ed., Vikas.

  Modigliani and Miller Approach further states that the
market value of a firm is affected by its future growth
prospect apart from the risk involved in the investment. The
theory stated that value of the firm is not dependent on the
choice of capital structure or financing decision of the firm.
If a company has high growth prospect, its market value is
higher and hence its stock prices would be high. If investors
do not see attractive growth prospects in a firm, the market
value of that firm would not be that great.

66 I. M. Pandey, Financial Management, 9th ed., Vikas.

 MM Approach Without Tax:
Proposition I
 Proposition 1: With the above
assumptions of “no taxes”, the
capital structure does not
influence the valuation of a firm.
In other words, leveraging the
company does not increase the
market value of the company.

67 I. M. Pandey, Financial Management, 9th ed., Vikas.

 MM with Corporate Taxes
The real world is somewhat different from that
created for the purposes of MM's original 1958
model. One of the most significant differences is
that individuals and companies do have to pay
taxes.
MM corrected for this assumption in their 1963
version of the model – this changes the analysis
dramatically. Most tax regimes permit companies
to offset the interest paid on debt against taxable
profit.The effect of this is a tax saving which
reduces the cost of debt capital.
68
 The introduction of taxation brings an additional advantage
to using debt capital: it reduces the tax bill. Now value rises
as debt is added to the capital structure because of the tax
benefits (or tax shield).
The WACC declines for each unit increase in debt so long as
the firm has taxable profits. This argument can be taken to
its logical extreme, such that WACC is at its lowest and
corporate value at its highest when the capital of the
company is almost entirely made up of debt.

69 I. M. Pandey, Financial Management, 9th ed., Vikas.

  Value of Unlevered Firm:
(Vu)= EBIT / Ko (1-t)

Where
EBIT= Earning before interest and tax
Ko = Overall Cost of Capital

 Value of levered Firm:

(VL)= Vu + tD

Where
VL = Value of levered Firm
t = rate of tax
D = Quantum of Debt used in the mix
70
 MM with Taxes


71 I. M. Pandey, Financial Management, 9th ed., Vikas.

Suggested Readings
 Chandra, Prasanna “Financial Management”, Tata McGraw Hill, New
Delhi
 James C Van Horne, Financial Management, Prentice-Hall, New Delhi
 Khan M.Y. & Jain P.K, Financial Management, Tata McGraw Hill, New
Delhi
 Pandey I.M “Financial Management”, Vikas Publishing House, New Delhi
 Reference Material –
 Maheshwari S.N. “Principles of Financial Management”, Sultan Chand &
Sons, New Delhi
 Kulkarni P.V. “Financial Management”, Himalaya Publishing House,
Mumbai
Suggested Readings
• Chandra, Prasanna “Financial Management”, Tata McGraw Hill, New
Delhi
• James C Van Horne, Financial Management, Prentice-Hall, New Delhi
• Khan M.Y. & Jain P.K, Financial Management, Tata McGraw Hill, New
Delhi
• Pandey I.M “Financial Management”, Vikas Publishing House, New Delhi
• Reference Material –
• Maheshwari S.N. “Principles of Financial Management”, Sultan Chand &
Sons, New Delhi
• Kulkarni P.V. “Financial Management”, Himalaya Publishing House,
Mumbai
Suggested Readings
 Chandra, Prasanna “Financial Management”, Tata McGraw Hill, New
Delhi
 James C Van Horne, Financial Management, Prentice-Hall, New Delhi
 Khan M.Y. & Jain P.K, Financial Management, Tata McGraw Hill, New
Delhi
 Pandey I.M “Financial Management”, Vikas Publishing House, New Delhi
 Reference Material –
 Maheshwari S.N. “Principles of Financial Management”, Sultan Chand &
Sons, New Delhi
 Kulkarni P.V. “Financial Management”, Himalaya Publishing House,
Mumbai