Finance Aspect-cost of capital

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COST OF CAPITAL - DEFINITIONS

Cost of capital is one rate of return the capital funds used should produce to justify

their use within the firm.

i) According to Solomon Ezra, the cost of capital is the minimum required rate

of earnings of the cut off rate for capital expenditure.

ii) In the words of Haley and Schall, in a general sense, cost of capital is any

discount rate used to value cash streams.

iii) According to James C. Vanhorne, the cost of capital represents a cut off rate

for the allocation of capital investment of projects. It is the rate of return on a

project that will have unchanged the market price of the stock.

COST OF CAPITAL – SIGNIFICANCE

The determination of the firm's cost of capital is important from the point of view of

both capital budgeting as well as capital structure planning decisions.

i) Capital budgeting decisions. In capital budgeting decisions, the cost of

capital is often used as a discount rate on the basis of which the firm's future

cash flows are discounted to find out their present values. Thus, the cost of

capital is the very basis for financial appraisal of new capital expenditure

proposals. The decision of the finance manager will be irrational and wrong in

case the cost of capital is not correctly determined. This is because the

business must earn least at a rate which equals to its cost capital in order to

make at least a break-even.

ii) Capital structure decisions. The cost of capital is also an important

consideration in capital structure decisions. The finance manager must raise

capital from different sources in a way that it optimises the risk and cost

factors. The sources of funds which have less cost involve high risk. Raising

of loans may, therefore, be cheaper on account of income tax benefits, but it

involves heavy risk because a slight fall in the earning capacity of the

company may bring the firm near to cash insolvency. It is, therefore,

absolutely necessary that cost of each source of funds is carefully considered

and compared with the risk involved with it.

In order to compute the overall cost of capital, the manager of funds has to

take the following steps:

i) To determine the type of funds to be raised and their share in the total

capitalization of the firm.

ii) To ascertain the cost of each type of funds.

iii) To calculate the combined cost of capital if the firm by assigning weight to

each type of funds in terms of quantum of funds so raised.

COST OF PREFERENCE SHARE CAPITAL

A security sold in a market place promising a fixed rupee return per period is

known as a preference share or preferred stock. Dividends on preferred stock are

cumulative in the sense that if the firm is unable to pay when promised by it, then

these keep on getting accumulated until paid, and these must be paid before dividends

are paid to ordinary shareholders. The rate of dividend is specified in case of

preference shares. Preference shares are of two kinds: the redeemable and

irredeemable preference shares. In case of redeemable preference shares the period of

repayment is specified, while for irredeemable ones this is not done.

The important difference in the true cost of debentures and preference shares

must be noted. Interest on debentures is considered as an expense by tax authorities

and is, therefore, deducted from company's income fortax purposes. That is why the

true cost of debentures is the after tax cost. On the other hand, the dividends are paid

to preference shareholders after the company has paid tax on its income (including

that portion of income which is to be paid to preference shareholders). Therefore, the

true cost of preference capital is the before tax cost which may be found as :

Cp (before tax) = Rate of dividend [ 1 / (1 – corporate tax rate)] x 100

For example, if dividend rate is 10% and a corporate tax 65%, the cost of

preference capital is:

Cp = 0.10 [1 / (1 – 0.65)] x 100 = 28.6%.

COST OF EQUITY CAPITAL

Cost of this source of capital is very difficult to measure. Many methods have

been suggested, but no method is clearly the best. Here, three popular approaches for

estimating cost of equity capital are presented. Like preference capital, cost of equity

capital is also calculated before-cost, as tax does not affect this cost.

Method I. The Risk-Free Rate Plus Risk Premium.

Since the equity holders are paid only after the debt servicing is done, it is

generally found that investment is equity is riskier in than investment in bonds.

Therefore, an investor will demand a return on equity (re) which will consist of: (i) a

risk free return usually associated with return on government bonds, plus (ii) a

premium for additional risk. There are two sources of risk which affect the risk

premium:

(1) The additional risk undertaken by investing in private securities rather than

government securities.

(2) The risk of buying equity stock rather than bond of a private firm.

The first type of risk is calculated by taking a difference between the interest

on firm's bonds and on government bonds. For the second type of risk, a rule of

thumb is used. Based on their judgement, the financial analysts have come to believe

that the return on firm's equity is about 3 to 5 per cent more than that on the debt. We

may take its mid-point (i.e., 4 per cent) as an estimate of premium for second type of

risk. Now, suppose risk free rate is 10 per cent and firm's bond yield 15 per cent, the

total risk premium (p) can be calculated as:

p = (0.15 – 0.10) + 0.04 =0.09

The firm's cost of equity capital (Cg) (which is the sym of risk-free return plus

premium for additional risk) would, therefore, be

Ce = 0.10 + 0.09 = 0.19, or 19 per cent.

Method II. Dividend Valuation Method.

This is also known as Dividend Growth Model. The underlying logic of this

method is the same as the internal rate of return method of evaluating investments.

According to this method, the cost of equity capital is that discount rate which equates

the current market price of the equity (P) with the sum of present value of expected

dividends. That is,

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COST OF CAPITAL - DEFINITIONS Cost of capital is one rate of return the capital funds used should produce to justify their use within the firm. i) According to Solomon Ezra, the cost of capital is the minimum required rate of earnings of the cut off rate for capital expenditure. ii) In the words of Haley and Schall, in a general sense, cost of capital is any discount rate used to value cash streams. iii) According to James C. Vanhorne, the cost of capital represents a cut off rate for the allocation of capital investment of projects. It is the rate of return on a project that will have unchanged the market price of the stock. COST OF CAPITAL – SIGNIFICANCE The determination of the firm's cost of capital is important from the point of view of both capital budgeting as well as capital structure planning decisions. i) Capital budgeting decisions. In capital budgeting decisions, the cost of capital is often used as a discount rate on the basis of which the firm's future cash flows are discounted to find out their present values. Thus, the cost of capital is the very basis for financial appraisal of new capital expenditure proposals. The decision of the finance manager will be irrational and wrong in case the cost of capital is not correctly determined. This is because the business must earn least at a rate which equals to its cost capital in order to make at least a break-even. ii) Capital structure decisions. The cost of capital is also an important consider ...
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