Cost of Capital

COST OF CAPITAL

Cost of capital is a decisive factor in financial decision-making. W measure and compare the cost of capital in deciding the capital structure of the company so as to earn a fair return to the owner an at least a fair return to the contributors. In recent years, it has received a considerable attention from both theorists and practitioners. Two major schools of thought have emerged having basic differences on the relevance of the concepts but both concepts are based on optimal policy. One school of thought is of the opinion that the cost of capital of a firm is constant and it is quite independent of the method and the level of financing. If we follow this concept, it means that financial planning is no problem. Under thus concept, optimal policy is the investment that equates the marginal return on investment with tis cost of capital. The opposite view is that cost of capital is not constant and varies with the method and level of financing.

Importance of Cost of Capital in Decision Making

The concept of cost of capital is a very important concept in financial management decision making. The concept, is however, a recent development and has relevance in almost every financial decision making but prior to that development, the problem was ignored or by-passed.

The progressive management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions.

(1) Capital Budgeting Decision. Cost of capital may be used as the measuring road for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing. In various methods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management. It measures the financial performance and determines the acceptability of all investment opportunities.

(2) Designing the Corporate Financial Structure. The cost of capital is significant in designing the firm's capital structure. The cost of capital is influenced by the chances in capital structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. He may try to substitute the various methods of finance in an attempt to minimise the cost of capital so as to increase the market price and the earning per share.

(3) Deciding about the Method of Financing. A capable financial executive must have knowledge of the fluctuations in the capital market and should analyse the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, he may ave a better choice of the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the considerations of relating control and of avoiding risk.

(4) Performance of Top Management. The cost of capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitabilities of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds.

(5) Other Areas. The concept of cost of capital is also important in many others areas of decision making, such as dividend decisions, working capital policy etc.

Relevant Costs

The following costs are relevant costs, closely associated with the problem of cost of capital

(1) Marginal Cost of Capital or Explicit Cost. The current rate of interest on long term debts or current rate of return is treated as the marginal cost of capital. Marginal cost or explicit cost tends to increase proportionately as the amount of debt increases.

(2) Implicit Cost or Real Cost. The explicit cost includes only the cost of capital to be paid and ignores the other factors such as risks involved, flexibility and leverage. Characteristics which are adversely affected with an increase in debt contents in its capital costs may be determined by taking these factors into consideration. The real cost of raising debt is, therefore, a substantially higher than explicit cost.

(3) Future Cost and Historical Cost. For decision making purposes, future costs are relevant and the financial decision making is no exception. We always consider the projects, expected internal rate of return and compare it with the expected (future) cost of capital while making capital expenditure decision. Similarly, we plan to minimise the future cost of capital at the time of designing a capital structure-cost incurred in the past (Historical cost) cannot be minimized. Historical costs help in predicting the future costs and provide an evaluation of the past performance when compared with standard costs.

(4) Specific Cost and Inclusive Cost or Average Cost. Specific cost, of capital is associated with a specific component of capital structure, e.g., cost of debentures, cost of preference shares etc. In affiancing decisions involving alternatives which may not affect the capital structure (Selection of two alternative debentures of similar size) specific cost should be used as the criterion for decision making. Inclusive cost or average of various specific cost of different components of various sources at a given time. This cost is relevant in investment decisions of the funds of the firm were firm employs a mix of various sources.

(5) Spot Costs and Normalized Costs. Spot costs represent those costs prevailing in the market at a certain time. This cost is considered in financing decisions involving alternative appraisal. Normalized costs indicate an estimate of cost by some averaging process from which cyclical element is removed. These are normally used in taking investment decisions.

(6) Opportunity Costs. The opportunity cost is the rate of return the shareholder forgoes by not putting the funds elsewhere. Keeping in mind the shareholders interest, this cost is used while making the investment decisions to determine the cut-off point of the project.

(7) Combined Cost. The combined or composite cost of capital is an aggregate of the cost of capital from all sources, i.e., debt, equity and preference capital. In other words, it is weighted cost of capital. This is relevant in capital expenditure decisions as an acceptance criterion. It is the overall mix of financing over time which is important in valuing firm as an ongoing overall entity.

Mode of Measuring Cost of Capital

 In making investment decisions, cost of different types of capital is measured and compared. The source, which is the cheapest, is chosen and capital is raised.

Now the problem is how to measure the cost of different sources of capital. In fact, there is no exact procedure for measuring the cost of capital. It is based largely on forecasts and is subject to various margins of error. While computing the cost of capital care should be taken about such factors as the needs of the company, the conditions under which it is raising its capital, corporate policy constraints and level of expectation. In fact, a company raises funds from different sources, and therefore, composite cost of capital can be determined after specific cost of each type of fund has been obtained. It is therefore, necessary to determine the specific cost of ea source in order to determine the minimum obligation of a company, i.e., composite cost of raising capital.

In order to determine the composite cost of capital, the specific costs of different sources of raising funds are calculated in the following manner:-


(1) Cost of Debt. In measuring cost of capital, the cost of debt should be considered first. In calculating cost of debt, contractual cost as well as imputed cost should be considered. Generally, the cost of debt (Debentures and long-term debts) is defined in terms of the required rate of return that the debt-investment must yield to protect the share holders' interest. Hence cost of debt is the contractual interest rate adjusted further for the tax-liability of the firm. As per Formula:-

                           K_d = (1 – T) R.

Here:                  K_d = Cost of debt capital

                          T = Marginal tax rate applicable to the company.

                          R = Contractual interest rate.

Suppose, a company issues 9 % debentures. Its marginal tax rate is 50 %. The effective cost of these debentures will be as follows :-


                              K = (1- 50) X 9

or                          K = .50 X 9 = 4.50 %

As because of the tax deductibility of interest, it is customary to compute the cost of borrowed funds as an after tax-rate of interest.

When more debt finance is used, the cost of debt is likely to increase above the actual rate of interest on account of two accounts- (a) The contractual rate of interest will rise; and (b) hidden cost of borrowing will also be taken into account. In this way, real cost of debt will be higher, if company relies more and more on debt finance. If it were not so, the management would always finance by this source of capital.

(2) Cost of Preference Shares. Preference shares are the fixed cost bearing securities. The rate of dividend is fixed well in advance at the time of their issue. So, the cost of capital of preference shares is equal to the ratio of annual dividend income per shares to the net proceed. The ratio is called current dividend yield. The formula for calculating the cost of preference share is:-

                                     R
                        K_p =  -----
                                    P

Here:             K_p = Cost of preferred capital

                     R = Rate of preferred dividend.

                     P = Net Proceeds.

For example, suppose a company issues 95 preference shares of Rs. 100 each at a premium of Rs. 5 per share. The issue expenses per share comes to Rs. 3 . The cost of preference capital shall be calculated as under :-

                                9                 9
                K_p = ------------- or ------- = 8.82 %
                         100 + 5 – 3    102

The cost of preference share capital is not be adjusted for taxes, because dividend on preference capital is paid after taxes as it is not tax deductible. Thus, the cost of preference capital is substantially greater than the cost of debt.

(3) Cost of Equity Shares. The calculation of equity capital cost is not an easy job and raises a host of problems. Its purpose is to enable the management to make decisions in the best interest of the equity holders. Generally the cost of equity capital indicated the minimum rate which must be earned on projects before their acceptance and the raising of equity funds to finance those projects several models have been proposed. Most not-able among them are the models of Ezra Solomon, Myren J. Gordon, James E. Walter, and the team of Modigliani and Miller.

Here are four approaches for estimating cost of equity capital.

(A) D/P Ratio or Dividend /Price Ratio. The approach is based on the thinking that what the investors expect when they put in their savings in the company. It means that the investor arrives at the market price for a share by capitalizing the expected dividend at a normal rate of return. Through this approach is simple, but it suffers from two serious weaknesses- (a) It ignores the earnings on company's retained earnings which increases the rate of dividend in equity shares and (b) it ignores the fact that price rise of shares may be due to the retained earnings also and not on account of only high rate of dividend.


(B) Earnings Price (E/P) Ratio Approach. The E/P ratio assumes tat shareholders capitalize a stream of uncharged earnings by the capitalisation rate of earnings/price ratio in order to evaluate their holdings. The advocates of this approach, however, differ on the earnings figure and market price. Some use the current earnings and current market price for determining the capitalisation rate while others recommend average earnings and average market price over some period in the past. This approach also has three main limitations:- (i) all earnings are not distributed among the shareholders in the form of dividend, (ii) earnings per share cannot be assumed to be constant as this approach emphasizes, and (iii) share price does not remain constant because investments in retained earnings result in increase in market price of share.


(C) Dividend/Price + Growth Rate of Earning (D/P + g) Approach. This approach emphasizes what the investor actually receives, i.e., dividend + the rate of growth (g) in dividend. The growth rate in dividend is assumed to be equal to the growth rate in earnings per share. In other words, if the earnings per share increased at a rate of 5 %, of the dividend per share and market price per share should also be increased at a rate of 5 %. This approach is considered to be the best conceptual measure of the cost of new capital that ensures the optimum capital budgeting decisions. It is claimed that it will give an accurate estimate of return which the shareholders will actually realize only if the future price-earnings ratio and the current price-earnings ratio are the same and the dividend and the earnings grow at the same rate. It may be noted that removal of these assumptions will affect the validity of the approach. The main difficulty in this approach is to determine the rate of growth of price appreciation expected by a shareholder when he is willing to pay a certain price for a current dividend.


(D) Realized Yield Approach. In case where future dividend and the sale price are uncertain, it is very difficult to estimate the rate of return on investment. In order to remove this difficulty, it is suggested the cost of capital. Under this approach, the Realized yield is discounted at the present value factor and then compared with the value of investment. For example, suppose an investor purchased one share of ABC Ltd. at Rs. 240/- on January 1, 1970 and after holding it for 5 years, sold the share at Rs. 300. During this period of five years, he received a dividend of Rs. 14, Rs. 14, Rs. 14.50 and Rs. 14.50. respectively. His rate of return on discounted case flow, as computed below comes to nearly 10 %.

Year	Dividend	Sale Price	Discount factor	Jan. 1970
			@ 10 %	Value
1970 (ending)	14.00		.909	12.7
1971 ( ending)	14.00		.826	11.6
1972 (ending)	14.50		.751	10.9
1973 (ending)	14.50		.683	9.9
1974 (ending)	14.50		.621	9.0
1975 (beginning)	-	300	.621	189.3
				240.4

Thus @ 10 % it equates initial investment price to dividend and sale price.

The advocates of this approach suggest that the past behaviour will be materialized in future and the historic Realized rate of return would be an appropriate indicator of prospective investor's required future rate of return. We can easily remove the cyclical fluctuations in return by averaging the Realized yield and may determine the central tendency. This approach also suffers from some serious assumptions.

(4) Cost of Retained Earnings. Some regard that cost of retained earnings is nil but it is not so. Retained earnings also have opportunity cost which can be computed well. The opportunity cost of retained earnings in a company is the rate of return the shareholder forgoes to determine the cut off point. Opportunity cost of retained earnings to the shareholders is the rate of return which they can get by investing the after tax dividends in the other alternative opportunities. It can be expressed as-

                                 (1 – T_i) D
                    K_r =     -------------
                                (1 – T_o) P

Here :      T_i = Tax rate applicable to individual

               T_o = Capital gain tax

               D = Dividend

               P = Price of the share.

(5) Cost of Depreciation Funds. Depreciation funds though appear to be cost-less but this is not so. Their cost too, like cost of retained earnings, are calculated on the basis of opportunity cost to the shareholder. If an internal projects cannot earn the rate that the equity shareholders can obtain by investing the funds elsewhere, money should be distributed to equity shareholder s liquidating dividend.

Meaning of Cost of Retained Earnings

The company is not to pay any dividends on retained earnings, it is therefore, observed that this source of finance is cost free.

This view seems to be based on the assumption that the company is a separate entity from its shareholders and it pays nothing to the shareholders to withhold these earnings. But this view is not correct. Retained earnings involve an opportunity cost. The opportunity cost of retained earnings is the dividend foregone by the shareholders by not putting funds elsewhere. Thus cost of Retained earnings is the return expected by the company.

From shareholders' point of view, the opportunity cost of Retained earnings is the rate of return that they can obtain by putting after tax dividend in some other securities of equal qualities, if earnings are paid to them as dividend in cash. And individual pays income tax on dividend hence he would only be able to invest the amount remained after paying individual income tax on such earnings. The value of his shares would also be increased in the market by an amount which after making provisions for any tax on capital gains, is equal to the net dividend he would have received after tax. It shows that necessary adjustments should be made for individual income tax and capital gain tax on such expected earnings to the shareholders in determining the opportunity cost to them. This can be expressed as follows-

                          (1 – T_i) D
               K_r =   -------------
                         (1 – T_o) P

Here :            K_r = Cost of retained earnings

                     T_i = Marginal income tax-rate applicable to an individual

                     T_o = Capital gain tax

                     D = Dividends per share

                     P = Price of share.

Meaning of Weighted Average Cost of Capital

A company has to employ owner's funds as well as creditors' funds to finance its project so as to make the capital structure of the company balanced and to increase the return to the shareholders.

The total cost of capital is the aggregate of costs of specific capitals. In financial decision making, the concept of composite cost is relevant. The composite costs of capital is the weighted average of the cost of various sources of funds, weights being the proportion of each source of funds in the capital structure. It should be remembered, tat it is weighted average, and not the simple average, which is relevant in calculating the overall cost of capital. The composite cost of all capital lies between the leas t and the most expensive funds. This approach enables the maximizations of corporate profits and the wealth of the equity shareholders by investing the funds in a project’s earnings in excess of the cost of its capital-mix.

Weighted average, as the name implies, is an average of the costs of specific source of Capital employed in a business, properly weighted by the proportion, they hold in the firm's capital structure.

Weighted Average, How to Calculate?

Though the concept of weighted average cost of capital is very simple, yet there are so many problems in the way of its calculations.

Its computation requires two steps.

(i) Computation of weights to be assigned to each type of funds, and

(ii) Assignment of cost to various sources of capital.

Once these values are known, the calculation of weighted average cost becomes very simple. It may be obtained by adding up the products of cost of all types of capital multiplied by their appropriate weights.

Capital Structure

Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisions-

1. Type of securities to be issued are equity shares, preference shares and long term borrowings( Debentures).
2. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into two-
1. Highly geared companies- Those companies whose proportion of equity capitalization is small.
2. Low geared companies- Those companies whose equity capital dominates total capitalization.

For instance - There are two companies A and B. Total capitalization amounts to be Rs. 20 lakh in each case. The ratio of equity capital to total capitalization in company A is Rs. 5 lakh, while in company B, ratio of equity capital is Rs. 15 lakh to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company.

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans.
4. Choice of investors- The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.
5. Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in period of boons and inflation, the company’s capital should consist of share capital generally equity shares.
6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.
9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

Determining the Type of Capital Structure

The next step or the problem in calculating the weighted average cost is the selection of capital structure from which the weights are obtained.

There may be several possibilities

(a) Current capital structure either before or after the projected new financing

(b) Marginal capital structure, i.,e., proportion of various types of capital in total of additional funds to be raised at a certain time

(c) optimal capital structure. All may agree that firms do seek optimum capital structure, i.e., the capital structure that minimizes the average cost of capital.

Unless we have reasons to believe that the current structure deviates substantially from the optimum capital structure, we may assume that the current capital structure is the optional capital structure and use it in the assignment of weights. The marginal capital structures is irrelevant here.

Characteristics of a sound financial plan

The success of a business very much depends upon a financial plan (capital plan) based upon certain basic principles of corporation finance.

The essential characteristics of an ideal capital plan may briefly be summarised as follows:-

(1) Simplicity. The capital plan of a company should be as simple as possible. By 'simplicity' we mean that the plan should be easily understandable to all and it should be free from complications, and/or suspicion-arising statements. At the time of formulating capital structure of a company or issuing various securities to the public, it should be borne in mind that there would be no confusion in the mind of investors about their nature and profitability.

(2) Foresight. The planner should always keep in mind not only the needs of 'today' but also the needs of 'tomorrow' so that a sound capital structure (financial plan) may be formed. Capital requirements of a company can be estimated by the scope of operations and it must be planned in such a way that needs for capital may be predicted as accurately as possible. Although, it is difficult to predict the demand of the product yet it cannot b an excuse for the promoters to use foresight to the best advantage in building the capital structure of the company.

(3) Flexibility. The capital structure of a company must be flexible enough to meet the capital retirements of the company. The financial plan should be chalked out in such a way that both increase and decrease in capital may be feasible. The company may require additional capital for financing scheme of modernisation, automation, betterment of employees etc. It is not difficult to increase the capital. It may be done by issuing fresh shares or debentures to the public or raising loans from special financial institutions, but reduction of capital is really a ticklish problem and needs statesman like dexterity.

(4) Intensive use. Effective use of capital is as much necessary as its procurement. Every 'paisa' should be used properly for the prosperity of the enterprise. Wasteful use of capital is as bad as inadequate capital. There must be 'fair capitalisation' i.e., company must procure as much capital as requires nothing more and nothing less. Over-capitalisation and under capitalisation are both danger signals. Hence, there should neither be surplus nor deficit capital but procurement of adequate capital should be aimed at and every effort be made to make best use of it.

(5) Liquidity. Liquidity means that a reasonable amount of current assets must be kept in the form of liquid cash so that business operations may be carried on smoothly without any shock to therm due to shortage of funds. This cash ratio to current ratio to current assets depends upon a number of factors, e.g., the nature and size of the business, credit standing, goodwill and money market conditions etc.

(6) Economy. The cost of capital procurement should always be kept in mind while formulating the financial plan. It should be the minimum possible. Dividend or interests to be paid to share holder (ordinary and preference) should not be a burden to the company in any way. But the cost of capital is not the only criterion, other factors should also be given due importance.