COST OF CAPITAL | Financial Management | The Encyclopedia | Lucky Ali Saifi

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COST OF CAPITAL AND CAPITAL STRUCTURE THEORIES 

Components of Cost of Capital - QS Study
The cost of capital is the company has to pay to various providers of capital. In other words, it can also be defined as the minimum rate of return which must be earned from a project to satisfy the providers of funds.
 If Rs.1,00,000 is required to be invested in a project and the amount is borrowed at 10 % p.a. , the project must earn at least Rs. 10,000 per year to meet the interest obligation on the borrowed funds. So if the project earns less than 10% p.a. with the above financing, the project would be unacceptable.
Further, if the project is financed by more than one source, a single cut off rate example a project involving an investment of Rs. 1,00,000 is financed by two loans, one of Rs.60.000 at 12 % p.a and the other of Rs. 40,000 at 13 % p.a . The required cut off rate would be 12.4% which has been calculated as (0.6 0.12 +0.4 x0.13)x 100

Now the following are the four main sources of funds for the company.
 a. Debentures
b. Preference shares
c. Equity shares
d. Retained earnings

The cost of capital for each of the above has to be different due to differences in the assumption of risks and differences in tax treatment and difference in their expectations. Here the cost of debentures and preference shares are to be calculated following the rate of interest and dividend fixed by the term of issue, whereas the cost of equity will be the rate of earning expected by the equity shareholders. of equity, shareholders depend on market conditions.


A. COST OF DEBT  (Kd) 

(i) When the only rate of interest is given Kd=I(-t)
Where:
I=  rate of interest
t= tax rate in decimal (For 40% use 0.4)

As interest, so the saving in tax has As interest on the debt is tax-deductible we get saving in tax due to payment been deducted from the interest to get the actual cost of capital.

Example-1

 If a 12% debenture is issued and the corporate tax rate is 40 %, Kd will be 12 (1-0.4)=7.2 %

 (ii) Cost of perpetual debt: Kd=1/P (where I =Interest payments and P = Sales proceeds of debt/bond/debenture). If it is tax-deductible, then it will become I(1-t)/P

B. COST OF PREFERENCE SHARES (k):

 Preference shareholders receive a contractual rate of dividends just as debenture holders. But as the dividend on preference shares are not tax-deductible, (1-t) will not be there with interest in the above formulas.

 C. COST OF EQUITY: (k) 

Computation of cost of equity is no fixed financial obligation in equity shares. There is a fixed financial obligation in the case of Debentures and Preference Shares and that obligation is interest and preference dividend. So the cost of equity is based on the expectations of the shareholders and it is always difficult to quantify the expectations. But still, the following formulae are given to compute.

E/P Approach:
 Ke=(EP)x 100 Where El Expected earning per share and P Current market price per share If the price-earnings ratio is given in the question, its reciprocal can be taken as the cost of equity.

CAPM Model: 
CAPM is the most popular method to calculate the cost of equity, It describes the risk required return trade-off for securities. The basic assumption of CAPM relates to
(i) efficiency of capital markets, and
(ii) investor's preferences. It implies that all investors prefer the security that provides the highest return for a given level of risk or the lowest risk for a given level of return,

The risk falls into two categories:

(i)  Diversifiable risks/unsystematic risks and
(ii) Undiversifiable/systematic risks. The unsystematic risks can be eliminated by any investor by investing in a pool of securities, and he is left with only systematic risks. The systematic risk or the risks that cannot be done away with are measured with the market index. The security's relation concerning the market is termed as a beta. Beta is a measure of the volatility of a security's return relative to the returns of the market portfolio.
Ke Rf+B(Rm- Rf)

Beta is calculated as               Cov9(x,y)                      OR                    Cor(x,y) x SD (y)
                                              Variance (x)                                                         SD (x)

 Where x= market portfolio and y= stock

D. COST OF RETAINED EARNINGS: (Kr)

 Retained earning is also a part of equity and it is one of the most important sources of funds. But it is very difficult to find a logically correct cost of this source. So the cost of equity is taken as cost of retained earnings, But logically it should be a little lower than Ke as we don't have to incur any cost to raise this source. Alternatively, t of retained earning may be based on the rate of return that a shareholder can earn if that retained. earning is paid to him as a dividend. If that is given directly in the question we can use that as Kr. The impact of floatation cost is ignored in the computation of Kr as no flotation cost is incurred for this source of funds.

Kr = Ke(1-1-C)
 Where Kr= Cost of retained earnings
Ke= Cost of equity
 T= marginal tax rate
C= Commission, brokerage, etc

 The weighted average cost of capital/Combined cost of capital:
 It is the weighted average of the individual cost of capital as calculated above. Weights are either the market value of the different sources or the book values.

When market values are taken as weights:

In this, the market value of all the sources of capital is taken as weights. Market value can be calculated by taking the total number of shares/debentures outstanding as multiplied with the market price per security as given in the question. One thing must be kept in mind that we must use the market values of all the sources at a time. which if not given book value can be taken as weights which invariably will be given in the question.
 If the market value of equity is taken, then it is not needed to use retained earnings as a source as the MV of equity itself includes the impact of retained earnings.

The marginal cost of capital:
 It is the cost of an additional source of funds raised. If the additional fund is raised by a mixture of debt and equity then the weighted average cost of additional funds is needed to be calculated.

Comparison between the cost of debentures and the cost of equity: 
We all know that risks and returns are directly related. Higher is the risk assumed, greater is the return expected Hence the cost of debentures and cost of equity can not be the same. As we all know that the risk assumed by the equity shareholders is higher than that of debenture holders. Hence, the cost of equity ought to be more than the cost of debentures.
 Capital structure:
Capital structure is the combination of various sources of capital viz, equity shares, preference shares, and debentures in the total capital of the firm. Definitely, this relates to the procurement of funds. But the capital structure of a firm depends upon a lot of factors. Some of those are as follows:

a) Risk
i. Risk of insolvency
ii. Risk of variation in EPS
b) Cost of capital
c) Control
d) Trading on equity
e) Tax considerations
f) Government policy

Optimum capital structure:
 Capital structure is the combination of debentures, preference shares, and equity shares in the total capital of the firm. It is now clearly evident to all of us that the main objective of all the management decision is to increase the wealth of the shareholders. So the optimum capital structure is that combination of debentures, preference shares, and equity shares which optimizes the market price per share. It is difficult to find out optimum debt and equity mix where the capital structure would be optimum to measure a fall in the market value in the equity share on account of an increase in risk due to high debt content. So we should better talk about the "appropriate" capital structure rather than the optimum capital structure as the former sounds more realistic.
 The appropriate capital structure has the following features:
a) Profitability: The most profitable capital structure should aim at minimization of cost of financing and maximization of earning per share
b) Flexibility: The capital structure should be such that the company can raise funds whenever needed c) Conservatism: The debt content should not be too high so that it becomes unbearable.

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