COST OF CAPITAL-Meaning

 Cost of capital of an investor, is equal to return, an investor can fetch from the next best alternative investment. In simple words, it is the opportunity cost of investing the same money in different investment having similar risk and other characteristics.

 From a financing angle, cost of capital is simply the cost which is paid for using the capital. Alternatively, a percentage return on investment that convinces an investor to invest in a particular project or company is the appropriate cost of capital for that investor.

TYPES OF COST OF CAPITAL

1. COST OF DEBT CAPITAL

 Debt is the external source of financing. Cost of debt is simply the interest paid by the firm on debt. But interest paid on debt is a tax-deductible expenditure; hence effective cost of capital is lower than the amount of interest paid.

 Debt may be:

1. Redeemable or
2. Irredeemable.

Redeemable debts are those which will be repaid to the suppliers of debt after a specific period, while irredeemable or perpetual debt is not repaid back to the suppliers of debt, only interest on this is paid regularly.

Methods of calculating redeemable and irredeemable debt have been discussed below:

Cost of Irredeemable Debt or Perpetual Debt:

 Irredeemable debt is that debt which is not required to be repaid during the lifetime of the company. Such debt carries a coupon rate of interest. This coupon rate of interest represents the before tax cost of debt. After tax cost of perpetual debt can be calculated by adjusting the corporate tax with the before tax cost of capital. The debt may be issued at par, at discount or at premium. The cost of debt is the yield on debt adjusted by tax rate.

Symbolically, Cost of Perpetual Debt (Kd) can be calculated using the following formula:

Cost of irredeemable debt (Kd) = I/NP (1 – t)

Where, I = Annual interest payment,

NP = Net proceeds from issue of debenture or bond, and

t = Tax rate.

Cost of Redeemable Debt:

Redeemable Debt is that debt which is repaid after a specific period of time.

The Cost of Redeemable Debt can be calculated by using the following formula:

Kd = Interest (1-t) + (Redeemable value – Net Proceeds/number of years of maturity)  *    100

                    Redeemable Value + Net Proceeds/2

Cost of Preference Share Capital:

Preference share is of two types as well:

Redeemable and irredeemable.

Preference share­holders are entitled to get a fixed rate of dividend if the company earns profit. But dividend payable on preference shares is not a tax-deductible expenditure.

Hence no adjustment for corporate tax is required for computing the cost of preference shares. It is to be noted here that there is no such obligation in regard to preference shares as we find in case of debt. The holders of preference shares only get preferential right as regards payment of dividend as well as return of principal, compared to equity shareholders.

Cost of Irredeemable Preference Share:

Irredeemable preference share is not required to be repaid during the lifetime of the company. Such preference shares carry a rate of dividend, which is the cost of irredeemable preference shares. Since the shares may be issued at par, at premium or at a discount, the cost of preference shares is the yield on preference shares. Cost of irredeemable preference shares is calculated by using the following formula:

 Kp = DP /NP

Where, DP = Preference dividend and

NP = Net proceeds from issue of preference shares.

Cost of Redeemable Preference Shares:

Redeemable preference shares are those that are repaid after a specific period of time. Hence while calculating the cost of redeemable preference shares, the period of preference shares and redeemable value of the preference shares must be given due consideration.

 Like irredeemable preference shares, redeemable preference shares may also be issued at par, discount or at a premium. Moreover there may be floatation costs. So to calculate net proceeds, adjust­ment for floatation cost is necessary. Since it is redeemable the redeemable value may differ from its face value depending on whether the preference shares are redeemed at par, discount or at premium.

The Cost of Redeemable preference share can be calculated by using the following formula:

Kp = Dividend + (Redeemable Value – Net Proceeds/number of years of maturity)      *     100

                     Redeemable Value + Net Proceeds/2

Cost of Equity Capital:

 Cost of equity capital is the cost of using the capital of equity shareholders in the operations. This cost is paid in the form of dividends and capital appreciation (increase in stock price). The computation of cost of equity share capital is one of the controversial issues as it cannot be calcu­lated with a high degree of accuracy, as done with debt and preference shares. Unlike debt and prefer­ence share capital, the holder of equity shares does not get a fixed rate of dividend. The return on equity shares, i.e. dividend, depends solely on the discretion of the management of the company. Moreover, equity shareholders are the last claimants on the assets of the company and hence during repayment they get their principal back after debt and preference shares. In this sense the equity capital has no cost. But this is not true as the objective of a firm is to maximize shareholders’ wealth. Maximization of wealth depends on the market price of shares, which is again related to the dividend paid by the company. Shareholders also expect dividend from their investment. So equity share capital has a certain cost, because without dividend no shareholder will agree to invest in equity shares. Cost of equity share capi­tal is the rate of return that equates the present value of the expected dividends with the market value of share. In other words, it is the minimum rate of return required to keep the market price of shares unaltered. It should be noted here that dividend on equity shares is not tax deductible. So no adjustment for tax is necessary.

Cost of equity share capital is measured by using different approaches:

Dividend approach and Earning approach.

Various methods of measuring cost of equity capital are discussed below:

Dividend Price Approach:

This approach of measuring cost of equity share capital is based on the dividend valuation model. According to this approach cost of equity is the rate of return that the shares are expected to earn in the form of future dividends.

The formula for computation of cost of equity share capital (Ke)  as per Dividend valuation approach is given below:

Ke = D/MP     *   100

Where, D = Dividend per share and

MP = Market price per share.

Note:

In case of new issue, net proceeds per share (NP) shall be used instead of market price. If floatation cost is incurred by the firm during the new issue that should be adjusted to obtain the net proceeds from new issue.

Earning Price Approach:

The formula for computation of cost of equity share capital (Ke)  as per Earning Price  approach is given below:

Ke = EPS/MP     *   100

Where, EPS = Earnings per share and

MP = Market price per share.

Cost of Retained Earnings:

Retained earnings are one of the important internal sources of finance. Profit available to equity can be distributed as dividend; but a proportion of that is distributed and remaining is kept for reinvestment. So retained earnings is the dividend foregone by the equity shareholders. Since equity shareholders are the actual claimants of the retained earnings, the cost of retained earnings, is equivalent to cost of equity. According to this assumption cost of retained earnings (Kr) will be calculated in the same manner as we do with equity.

So Kr = Ke

However in practice, retained earnings are cheaper than the cost of equity capital. If the retained earn­ings are distributed as dividend to equity shareholders, tax on dividends is to be paid by equity share­holders. If they want to reinvest their funds, the company will have to incur expenses as brokerage, commission, etc. Thus cost of retained earnings under this approach can be calculated after making adjustments for tax and expenses for brokerage, commission, etc.

Cost of retained earnings (Kr) = Ke (1 – t) (1 – c)

Where, Ke = Cost of equity,

t = Tax rate of shareholder in alternate source of investment, and

c = Brokerage, commission, etc. of shareholder in alternate source

Capital Asset Pricing Model (CAPM) to calculate cost of equity:

The formula for Cost of Equity Capital:

= Risk-Free Rate + Beta * (Market Rate of Return – Risk-Free Rate)

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Most of the times, WACC is referred as a cost of capital because of its frequent and vast utilization especially when evaluating existing or new projects. Weighted average cost of capital, as the term itself suggests, is the weighted average of all types of capital present in the capital structure of a company. Assuming these two types of capital in the capital structure i.e. equity and debt, the WACC can be calculated by following formula:

= Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt.