CHAPTER - 4 (2) (1).pptx financial cost course about the cost capital integral parts

The cost of capital about integralpartbof investment

1. CHAPTER - 4 THE COST OF CAPITAL Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern. It is used as a discount rate in determining the present value of future cash flows associated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are using different sources of finance, the finance manager must take careful decision with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity of the firm. 1

2. Importance of cost of capital Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern. Importance to Capital Budgeting Decision Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision. Importance to Capital Structure Decision Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure. 2

3. Cont,d Importance to Evolution of Financial Performance Cost of capital is one of the important determining which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm. Importance to Other Financial Decisions Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management. 3

4. Assumptions of Cost of Capital Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts : 1. It is not a cost as such. It is merely a hurdle rate. 2. It is the minimum rate of return. 3. It consists of three important risks such as zero risk level, business risk and financial risk. Cost of capital can be measured with the help of the following equation. K = rj + b + f. Where, K = Cost of capital. rj = The riskless cost of the particular type of finance. b = the business risk premium. f = the financial risk premium. 4

5. What Impacts The Costs of Capitals? Riskiness of earnings The debt to equity mix of the firm Financial soundness of the firm Interest rate levels in US/ global market place Significance of Cost of Capital Cost of capital is useful as a standard for evaluating investment decisions, designing a firm’s debt policy, and appraising the financial performance of top management. Major Types of Cost of Capital (Sources of Capital) The following are some of the major type of cost of capital; Specific cost of capital, Cost of Deb v tt ( Kd ), Cost of Preferred Stock (Kp) Cost of Common Stock ( Ks ) 5

6. The Specific Cost of Capital A firm’s capital is supplied by its creditors and owners . Firms raise capital by borrowing it ( issuing bonds to investors or promissory notes to banks ) or by issuing preferred or common stock. The overall cost of a firms capital depends on the return demanded by each of these suppliers is called the specific cost of capital. Cost Debt ( kd ) When a firm borrows money at a stated rate of interest, determining the cost of debt, kd , is relatively straight forward. Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual or redeemable. 6

7. Cont,d Thus, the after tax cost of debt, kd , is computed as follows: Where: T = Corporate tax rate F = Flotation cost as a percentage of value of debt Ki = investor required rate of return before tax If there is no flotation costs, the Kd can be computed using the formula 7

8. Cont,d Illustration Assume that XYZ company is to issue long term notes, investors will pay Br, 1000 per note when they are issued if the annual interest payment by the firm is Br 100.The firm’s tax rates is 45%, and flotation costs are 2%.calculate the cost of this debt. Solution: kd = = 5.61% Cost of Preferred Stock ( kp ) , The cost of preferred stock ( kp ) is the rate of return investors require on a company’s new preferred stock plus the cost of issuing the stock. Therefore, cost of preferred stock is calculated as follow. 8

9. Cont,d Kp Kp Where: Kp = The cost of the preferred stock issue; the expected return Dp = The amount of the expected preferred stock dividend Pp = the current price of the preferred stock F = the flotation costs per share Illustration Suppose that Midrock Company has preferred stock that pays Br 13 dividend per share and sells for Br 100 per share in the market. Compute the cost of preferred stock. Solution Kp = = = 13%   9

10. Cont,d The Cost of Common Stock (ks) (Cost of Internal Equity) The cost of common stock equity, ks is the rate at which investors discount the expected dividends of the firm to determine its share value. Two techniques for measuring the cost of common stock equity capital are available . One uses the constant growth valuation model (Gordon growth model); T he other uses the capital asset pricing (CAPM ). Using the Constant Growth Valuation Model (the Gordon Growth Model), the cost of common stock, Ks is computed as follows; Po = Where : Po= Value of common stock D1 = Dividend to be received in 1 year Ks = Investors required rate of return g = rate of growth   10

11. Cont,d Solving the model for ks results in the formula for the cost of common stock Ks = Illustration Suppose that IBM industries common stock is selling for $ 40 a share. A next year's common stock dividend is expected to be$4.20 and the dividend is expected to grow at a rate of 5% per year indefinitely. Compute the expected rate of return on IBM’s common stock . Solution : Ks = = 0.105 + 0.5 = 0.155 or 15.5%   11

12. Cont,d A firm may pay dividends that grow at changing rate; it may pay dividends that grow at changing rate; it may pay no dividends at all for the managers of the firm may believe that market risk is the relevant risk. In such cases, the firm may choose to use the capital asset pricing model (CAPM) to calculate the rate of return that investors require for holding company’s common stock according to the degree of non-diversifiable risk present in the stock The CAPM formula for the cost of common stock is; Ks = r f + b ( r m - r f ) 12

13. Cont,d Where:- Ks = the required rate of return from the company’s common stock equity B = Beta coefficient which is an index of systematic risk r f = Risk free rate r m = Return on the market portfolio Illustration Suppose AB industries has a beta of 1.39, the risk free rate as measured by the rate on short term U.S. Treasury bill is 3% and the expected rate of return on the overall stock market is 12%. Given those market conditions find the required rate of return for BATU’S common Stock. 13

14. Cont,d Ks = r f + b ( r m -r f ) = 3% + 1.39 (12%-3%) = 3% + 1.39 (9%) 0.1551 or 15.5 %   14

15. WEIGHTED AVERAGE COST OF CAPITAL (WACC) In the above we have seen how to compute the cost of capital for each individual source of capital. The specific cost of capital is used in evaluating an investment proposal to be financed by a particular capital source. Practically, however, investments are financed by two or more sources of capital. In such a situation, we cannot make use of the individual cost of capital. Rather we should use the average cost of capital employed by the firm . The firm’s capital structure is composed of debt, preferred stock, common stock, and retained earnings. Each capital source accounts to some portion of the total finance. But the percentage contribution of one source is usually different from another. So we must compute the weighted average cost of capital rather than the simple average. 15

16. WEIGHTED AVERAGE COST OF CAPITAL (WACC) The weighted average cost of capital (WACC) is the weighted average of the individual costs of debt, preferred stock and common equity (common stock and retained earnings). It is also called the composite cost of capital. The computation of the overall cost of capital ( Ko ) involves the following steps . (a) Assigning weights to specific costs. (b) Multiplying the cost of each of the sources by the appropriate weights. (c) Dividing the total weighted cost by the total weights. If the weights of the component capital sources are all given, the weighted average cost of capital can be computed as: WACC = WdKdt + WpsKps + WceKs 16

17. Weighted Average Cost of Capital Where: WACC = the weighted average cost of capital Wd = The weight of debt Wps = the weight of preferred stock Wce = the weight of common equity Kdt = the after – tax cost of debt Kps = the cost of preferred stock Ks = the cost of common equity The WACC is found by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure. Weights of the individual capital sources can be calculated based on their book value or market value. 17

18. Weighted Average Cost of Capital To illustrate the computation of the WACC, look at the following example. Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted average cost of capital. The book and market values of the amounts as well as specific after-tax costs are shown in the following table for each source of capital . Source of capital Book value Market value Specific cost Debt Preferred stock Common equity Total Br. 1,050,000 84,000 966,000 Br. 2,100,000 Br. 1,000,000 125,000 1,375,000 Br. 2,500,000 5.3% 12.0 16.0 18

19. Weighted Average Cost of Capital Required: Calculate the firm’s weighted average cost of capital using: book value weights market value weights Total book value = Br. 2,100,000 Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000 _ = 0.04; Wce = Br. 966,000 = 0.46 Br. 2,100,000 Br. 2,100,000 Br. 2,100,000 WACC = WdKdt + WpsKps + WceKs = 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%) = 2.65% + 0.48% + 7.36% = 10.49% 19

20. Cont,d The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all projects so long as they earn a return greater than or equal to 10.49% . 2) Total Market value = Br. 2,500,000 Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55 Br. 2,500,000 Br. 2,500,000 Br. 2,500,000 WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%) = 2.12% + 0.60% + 8.80% = 11.52% If the market value weights are used, Muna should accept all projects with a minimum rate of return of 11.52% 20

21. marginal cost of capital (mcc) As a firm tries to have more new capital, the cost of each birr will rise at some point. Thus, the marginal cost of capital (MCC) is the cost of obtaining additional new capital. Technically speaking, the MCC is the weighted average cost of the last birr of new capital obtained. So the concept of marginal cost of capital is discussed in the context of the weighted average cost of capital. As a firm raises larger and larger amounts of capital, the weighted average cost of capital also rises. But the question would be at what point the firm’s costs of debt, preferred stock, and common equity as well as WACC increase? As you raise more and more money, the cost of each additional dollar of new capital may increase. The reasons are the flotation costs and the demand for the security representing the capital to be raised. 21

22. marginal cost of capital (mcc) Example: If the firm issues br. 1,500,000 of new debt, the first br. 1,000,000 costs 5% per year and the next br. 500,000 costs 6% per year . Suppose the firm raises capital in the proportions of 40% debt and 60% equity and raises br. 2,000,000 of new capital comprising br. 800,000 debts and br. 1,200,000 common stock. Looking at the schedules, we see the cost of debt is 5% up to the first br. 1,000,000 of debt . However, the cost of equity changes once we have raised br . 1,000,000: The first br. 1,000,000 of equity costs 9% and the additional br. 200,000 costs 10%. The cost of capital of the first br. 2,000,000 of new capital is : 22

23. Cont,d The cost of capital of the first br. 2,000,000 of new capital is: *0.05 = Debt= 0.020 2. * 0.09 = Equity @ 9% = 0.045 3. * 0.10 = equity @ 10%= 0.010 Therefore, 0.020+ 0.045+ 0.010= 0.075 or 7.5% The average cost of raising a birr of capital for the first br.2, 000,000 of capital is 7.5%. The marginal cost of capital for the first br.1, 800,000 is: Marginal cost of capital for the first br.1, 800,000   23

24. Cont,d Br.720 , 000 * 0.05 + br . 1,080,000 * 0.09 = 7.4 % per year. Br.1, 800,000 br.1, 800,000 Marginal Cost of Capital and Shareholder Wealth Maximization Maximizing shareholder wealth means in terms of making investment and financing decisions . To maximize shareholder wealth we must invest in a project until the marginal cost of capital is equal to its marginal benefit . What is the benefit from an investment? It is the internal rate of return —also known as the marginal efficiency of capital. If we begin by investing in the best projects (those with highest returns), and then proceed by investing in the next best projects, and so on, the marginal benefit from investing in more and more projects declines. 24

25. Cont,d Also, as we keep on raising funds and investing them, the marginal cost of funds increases. To maximize shareholders’ wealth, we should invest in projects to the point where the increasing marginal cost of funds is equal to the marginal benefit from our investment. 25