cost of capital
TRANSCRIPT
CHAPTER 13
COST OF CAPITAL
Chapter 13Cost of Capital
2
CONTENTS
IntroductionOpportunity Cost of CapitalWACC – PreviewCost of Debt– Cost of Redeemable Debt– Cost of Perpetual Debt– Post Tax Cost of Debt– Historical Yields and Current Yields– Treating Floatation Cost and Issue at
Premium/Discount– Which Debts to Consider
Chapter 13Cost of Capital
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CONTENTS
Cost of Preferred CapitalCost of Equity– Dividend Capitalisation Approach– Earning Based Approach– CAPM Based Approach– Cost of External EquityAssigning Weights– Marginal Proportions– Book Value Vs. Market Value ProportionsMarginal Cost of Capital
Chapter 13Cost of Capital
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CONTENTS
Optimal Capital BudgetWACC as Discount Rate & RiskPure Play Approach-– Unlevering & Relevering BetaFactors Affecting Cost of Capital
Chapter 13Cost of Capital
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COST OF CAPITALIntroduction
Cost of capital is an extremely important input requirement for capital budgeting decision. Without knowing the cost of capital no firm can evaluate the desirability of the implementation of new projects. Cost of capital serves as a benchmark for evaluation.
Chapter 13Cost of Capital
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OPPORTUNITY COST OF CAPITAL
The basic determinant of cost of capital is the expectations of the suppliers of capital. The expectations of the suppliers of capital are dependent upon the returns that could be available to them by investing in the alternatives. The returns provided by the next best alternative investment is called opportunity cost of capital. This could serve as basis for cost of capital.
Chapter 13Cost of Capital
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WACC
Besides opportunity cost the cost of capital must also consider1. Business risk 2. Financial risk
There are be many suppliers of capital; predominantly two
1. Debt 2. EquityWACC is a composite figure reflecting cost of each component multiplied by the weight of each component.
WACC = we x re + wp x rp + wd x rdwe = Proportions of equity re = Cost of equity
wp = Proportion of pref capital rp = Cost of preference capitalwd = Proportion of Debt rd = Cost of debt
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COST OF DEBT
Cost of redeemable debt is determined by equating the cash flows of the instrument to its market priceCost of perpetual debt, rd isCost of redeemable debt is
Post tax cost of debt = rd (1-T)
For a bond paying 11% coupon annually and redeemable after three years at Rs 105 that sells for Rs 95 the cost of debt is 10.12% given by
o
td
d
to P
C=ror
rC
=P
∑N
1tN
dt
d
to
)r(1R
)r(1
CP
= ++
+=
3d
3d
2dd )r1(
105)r1(6.0x11
)r1(6.0x11
r16.0x1195
++
++
++
+=
Chapter 13Cost of Capital
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COST OF DEBT
To mobilise debt one has to incur floatation cost which increase the cost of debtWhile computing the cost of debt the claims of the suppliers of long-term debt are only considered.
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COST OF PREFERENCE CAPITAL
Preference capital is in between pure debt and equity that explicitly states a fixed dividend.The dividend has claim prior to that of equity holders. But unlike interest on the debt the dividend on preference capital is not tax deductible.Cost of preference capital , rp is determined by equating its cash flows to market price. There is no adjustment of tax.
∑= +
++
=N
1t N
pt
p
to )r(1
R)r(1
DP
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COST OF EQUITY CAPITAL
Cost of equity capital is most difficult to determine because – It is not directly observable – There is no legal binding to pay any
compensation and – It is not explicitly mentioned
This does not mean that cost of equity is zeroEquity capital is classified as1) Internal: the profits that are not distributed but
retained by the firm in funding the growth, is referred as internal equity and
2) External: equity capital raised afresh to fund, is called external equity
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APPROACHES - COST OF EQUITY
Cost of equity is determined by – Dividend Capitalisation approach – CAPM based approach.Both approaches are driven by market conditions and measure the cost of equity in an indirect mannerThe price to be used in any of the model is the market determined.
Chapter 13Cost of Capital
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DIVIDEND CAPITALISATION APPROACH
Dividend capitalisation approach determines the cost of equity by equating the stream of expected dividends to its market price.For constant dividend cost of equity is equal to
dividend yield.
For constant growth of dividend at ‘g’ Yield Dividend
PDr or ;
rDP Then
D......DDD . i.e constant is dividend if
...................)r(1
D)r(1
D)r(1
D)r(1
DP
0e
e0
321
4e
43
e
32
e
2
e
10
===
====
++
++
++
+=
g+D=r or ; D=P then
...................)r+(1g)+(1D+
)r+(1g)+(1D+
)r+(1g)+(1D+
)r+(1D=P
1
4e
31
3e
21
2e
1
e
10
Pg-r 0e
e0
Chapter 13Cost of Capital
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COST OF EQUITY – PE APPROACH
Earnings based approach, as manifested by Dividend Capitalisation Approach equates the value as
Under the special case when the firm uses the earnings at the same rate as expected by shareholders earnings based approach measures the cost of equity as
bxk-rb)-x(1E=
g-rD=P
e
1
e
10
0
1e
e
10
e
1
e
10
PE=r or
rE=P k;=b whenAnd
bxk-rb)-x(1E=
g-rD=P
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COST OF EQUITY –CAPM APPROACH
CAPM based determination of cost of equity considers the risk characteristics that dividend capitalisation approach ignores.Determinants of cost of equity under CAPM based approach include three parameters; – the risk free rate, rf– the market return, rm and – β, as measure of risk
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COST OF EQUITY –CAPM APPROACH
β,the primary determinant of risk governs the cost of equity.
re = rf + β x (rm – rf)
Cost of Equityre
rm
Risk Premium(rm-rf)β
rf
β = 1 Risk, β
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COST OF EQUITY –DDM Vs CAPM APPROACH
CAPM based determination of cost of equity is regarded superior as– it relies on the market information and – incorporates risk– it need not know the dividend policy.
Dividend capitalisation approach – does not consider risk of the dividend – has assumption of constant pay out
ratio.
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COST OF INTERNAL AND EXTERNAL EQUITY
There are three major differences in the INTERNAL and EXTERNAL equity – Existence of flotation cost– Under utilisation of external equity– Under pricing of fresh capital
If floatation cost is 5% of the issue price and cost of internal equity determined either through DDM or CAP-M is 16% then the cost of fresh equity shall be 16.84% (16/0.95).
g+PD
f)-(11=
f)-(1equity internal of Cost= equity external for r
0
1e
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ASSIGNING WEIGHTS
After cost of each component is determined they need to be multiplied by the respective proportions to arrive at WACC. The proportions may be based on 1) marginal 2) book value or 3) market value
The weights based on the target capital structure are most appropriate though the current capital structure may not conform.
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BOOK VALUES vs MARKET VALUES
The weights for computation of WACC can either be based on
book values or market values
Though book value weights appear convenient and practical it lacks conviction ignoring current trends.Use of market value based weights is technically superior reflecting the current expectations of investors.
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MARGINAL COST OF CAPITAL
WACC as discount rate, implies that acceptance of projects do not alter the existing capital structure.When project is large compared to the existing operations, the capital structure as well as the cost of each component would more likely increase.Lenders tend to raise cost with the quantum, so could be the case with equity suppliers.In such cases WACC is inappropriate as hurdle rate. Marginal (incremental) cost of capital is more appropriate.
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OPTIMAL CAPITAL BUDGET
In practice Marginal Cost of Capital must be used in determination of the optimal capital budget. Marginal cost of capital governs the value addition.Incremental benefits must exceed incremental cost.The capital expenditure level at which incremental benefits are equal to the incremental cost is “Optimal capital budget”.
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WACC and RISK
The discount rate for the project must be appropriate to its risk. In most cases WACC adequately represents the risk since most projects selected by the firms belong to the line of activity. Where project has substantially different risk profile blind use of WACC as discount rate may cause
1.erroneous acceptance of riskier project due to lower discount rate or
2.erroneous rejection of less risky project due to higher discount rate.
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PURE PLAY APPROACHAdjusting for Risk
Risk-adjusted WACC must be used as discount rate for the cash flow. Most popular method to incorporate such risk is called a pure-play approach,– identifying a firm that most resembles the
risk profile of the new project. – beta of the firm is adjusted for its
leverage to find an all equity beta, called unlevering and then
– re-adjusting for the proposed capital structure of the project, called relevering.
– The value of β so arrived is used in calculating the WACC.