DR D DEEPA-COST OF CAPITAL AND LEVERAGE.pptx

Cost of Capital and Leverage
Cost of Capital
Definition:
The cost of capital is the minimum rate of return a company must earn on its investments to maintain its market value and satisfy its investors. It represents the cost of obtaining funds through equity, debt, or a combination of both.

Types of Cost of Capital:
Cost of Debt (Kd): The interest rate paid on borrowed funds, adjusted for tax benefits.
Cost of Equity (Ke): The return required by shareholders, calculated using models like the Capital Asset Pricing Model (CAPM).
Cost of Preferred Capital (Kp): The fixed dividend paid to preference shareholders.
Weighted Average Cost of Capital (WACC): The overall cost of capital, combining debt and equity in proportion to their use.
Formula for WACC:
�
�
�
�
=
(
�
�
×
�
�
)
+
(
�
�
×
�
�
×
(
1
−
�
�
�
�
�
�
�
)
)
WACC=(
V
E
​
×Ke)+(
V
D
​
×Kd×(1−TaxRate))
Where:

E = Market value of equity
D = Market value of debt
V = Total capital (E + D)
Ke = Cost of equity
Kd = Cost of debt
Importance of Cost of Capital:
Helps in investment decision-making by evaluating new projects.
Affects the capital structure of the firm.
Determines the risk and return expectations of investors.
Leverage
Definition:
Leverage refers to the use of borrowed funds (debt) to increase the potential return on investment. It helps companies amplify earnings but also increases financial risk.

Types of Leverage:
Operating Leverage:

Measures the impact of fixed costs on a company's profitability.
Higher fixed costs lead to higher operating leverage.
Degree of Operating Leverage (DOL) Formula:
�
�
�
=
%
Change in EBIT
%
Change in Sales
DOL=
%Change in Sales
%Change in EBIT
​

Financial Leverage:

Measures the effect of debt financing on earnings per share (EPS).
Higher debt increases financial risk.
Degree of Financial Leverage (DFL) Formula:
�
�
�
=
%
Change in EPS
%
Change in EBIT
DFL=
%Change in EBIT
%Change in EPS
​

Combined Leverage:

The total risk a firm faces, considering both operating and financial leverage.
Degree of Combined Leverage (DCL) Formula:
�
�
�
=
�
�
�
×
�
�
�
DCL=DOL×DFL
Impact of Leverage on Business:
Positive Effect: Higher leverage can increase returns on equity if managed well.
Negative Effect: Excessive debt raises financial risk, leading to bankruptcy if earnings decline.

1. UNIT - 2 COST OF CAPITAL AND LEVERAGE

2. COST OF CAPITAL Meaning: The term cost of capital refers to the minimum rate of return a firm must earn on its investment so that the market value of the company’s equity shares does not fall. Definition: “Cost of capital is the minimum required rate of earning or the cut-off rate of capital expenditure. - Soloman Ezra Characteristics of Cost of capital: Not a cash cost Minimum rate of return Consideration of risk premium

3. CLASSIFICATION OF COST 1. Future cost and Historical Cost: Financial decisions are based on the future costs and not on the historical costs. Historical costs act simply as guides to estimate the future costs. 2. Specific cost and Composite cost: The cost of individual source of capital is referred to as the specific cost. The cost of capital of all the sources combined is termed as composite cost or overall cost. 3. Average cost and Marginal cost: The average cost of capital is the weighted average of the costs of each component of funds employed by the firm. Marginal cost of capital, is the weighted average cost of new funds raised by the firm. For capital budgeting and financing decision, the marginal cost of capital is the most important factor to be considered. 4. Implicit cost and Explicit Cost: The implicit cost is the rate of return associated with the best investment opportunity for the firm. The implicit cost of retained earnings is the rate of return available to the shareholders.

4. FACTORS AFFECTING COST OF CAPITAL General Economic Conditions: Market conditions Firm’s operation and financing decisions Amount of financing IMPORTANCE OF COST OF CAPITAL 1.Capital budgeting decisions 2.Capital structure decisions 3.Other decisions 4.Evaluting financial performance PROBLEMS IN DETERMINATION OF COST OF CAPITAL 1.Conceptual controversies regarding 2.Historical cost and future cost 3.Problems in computation of cost of equity 4.Problems in computation of cost of retained earnings 5.Problems in assigning weights

5. MEASUREMENT/DETERMINATION OF COST OF CAPITAL 1.Computation of component/specific cost of capital 2.Computation of weighted average/composite cost of capital 1.COMPUTATION OF COMPONENT/SPECIFIC COST OF CAPITAL: i . Cost of equity capital ii.Cost of preferred stock/Preference share capital. iii. Cost of debenture iv. Cost of term loan v. Cost of reserves/Retained earnings

6. I. COST OF EQUITY CAPITAL Dividend yield method or dividend/ Price ratio method Dividend yields plus growth in dividend method Earning yield method Earning growth method Realised yield method Capital asset pricing method II COST OF PREFERENCE SHARE CAPITAL/COST OF PREFERRED STOCK III COST OF DEBENTURE Debts issued at par Debts issued at a discount or premium IV COST OF TERM LOAN V COST OF RESERVES/RETAINED EARNINGS

7. 2.Computation of weighted average/composite cost of capital Meaning: Weighted average cost of capital is defined as weighted the average cost of various sources of financing. Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. Steps to compute composite/weighted average cost of capital: The computation of the overall cost of capital( represented symbolically by Ko involves the following steps. Assigning weights to specific costs Multiplying the cost of each of the sources by the appropriate weights Dividing the total weighted cost by the total weights.

8. SYSTEMS OF WEIGHTING 1.Historical or existing cost i . Book value weights: Book value weights are base on the values found in the balance sheet. Merits: a. the calculation of book value weights is very simple. b. It is fairy and stable ii. Market value weights: The weighting, is equal to the market value of that source of capital divided by the market valued of all sources of long-term capital employed by the firm. Merits: a. Maintain the market value of the firm b. It is valid to measure minimum rate of return required by investors.

9. SYSTEMS OF WEIGHTING Demerits: a. Market values may not be obtainable when the firm is not listed or when the securities of the firm are not traded. b. Market values may be distorted when the security prices influenced by speculative forces. 2. Marginal weights: The firm raises capital marginally to make a marginal investment in new projects, the marginal cost of capital should be calculated. Factors affecting weighted average cost of capital: Factors the firm cannot control: The most important factors that are beyond a firm’s direct control are: I Level of interest rates: II Tax rates Factors the firm can control: A firm can directly affect its cost of capital through its capital structure policy, its dividends policy, and its investments policy. I Capital structure policy II Dividend policy III Investment policy

10. Advantages of weighted average cost of capital Straight-forward and logical Builds on individual debt and equity components Accurate in periods of normal profits Accurate when the debt level is reasonable DISADVANTAGES OF WEIGHTED AVERAGE COST OF CAPITAL 1.Determining the weights 2.Choice of capital structure 3.Other limitations i . When the dividend policy of the company is being changed ii. When the growth objective of the company are being changed iii. When the company is trying to bring about radical changes in its debt policy.

11. LEVERAGE Definition: “Leverage is the ratio of the net rate of return on shareholders equity and the net rate of return on total capitalization”. Types of Leverage: 1.Operating leverage: The leverage associated with investment(asset acquisition) activities is referred to as operating leverage. 2.Financial leverage: The leverage associated with financing activities is called financial leverage. 3.Composite leverage: The combination of both is composite leverage.

12. Characteristics of operating leverage Related to fixed costs Highest operating leverage near break-even point. Uses Or Significance Of Leverage Measurement Of Operating Risk Measurement Of Financial Risk Managing Risk Designing Appropriate Capital Structure Mix Increase Profitability

13. IMPACT OF MARKET CONDITIONS ON OPEARATING LEVERAGE Times of rising prices of inflation Normal conditions Impact of technology FINANCIAL LEVERAGE: Financial leverage is also known as trading on equity. It is defined as below: “Financial leverage may be defined as percentage return on equity to the percentage return on capitalisation.” – Walter CHARATERISTICS OF FINANCIAL LEVERAGE: Concerned with liabilities side of the balance sheet Related to fixed cost of capital Financial risk MEASURES OF FINANCIAL LEVERAGE: 1.Debt ratio 2.Debt-equity ratio 3.Interest coverage ratio

14. LIMITATIONS OF FINANCIAL LEVERAGE 1.Financial leverage as double edged sword 2. Beneficial only to companies having stability of earnings 3.Increase risk and rate of interest 4.Restrictions from financial institutions

15. DIFFERENCES BETWEEN OPERATING AND FINANCIAL LEVERAGE Basis of difference Operating leverage Financial leverage Objective The objective is to magnify the effect of changes in sales on operating profit The objective is to magnify the effect of changes in operating profits on earnings per share Relationship It establishes relationship between operating profit and sales It establishes relationship between operating profits and return on equity. Measurement Operating profit Return to equity shareholders Effect on income It affects profit before interest and tax It affects profit after interest and tax Risk It involves operating risk It involves financial risk Decision It is concerned with investment decision It is concerned with financial decision Stage It is described as first stage of leverage It is described as second stage of leverage

16. COMPOSITE LEVERAGE Composite leverage, thus, expresses the relationship between revenue of accounting sales and the taxable income.