Monday, 8 July 2013

measuring of cost of capital

How is the cost of capital measured?

Cost of capital is measured in terms of weighted average cost of capital. In this the total capital value of a firm without any outstanding warrants and the cost of its debt are included together to calculate the cost of capital.

To calculate the company's weighted cost of capital, first the calculation of the costs of the individual financing sources:

Cost of Debt Cost of Preference Capital, Cost of Equity Capital, and cost of stock capital take place and the formula is given as:-

WACC= Wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. Stock)< /STRONG> 

measuring of cost of capital


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 t 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 cos 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:-

                           Kd = (1 – T) R.

Here:                  Kd = 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
                        Kp =  -----
                                    P
Here:             Kp = 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
                Kp = ------------- 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 an 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 prise-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 shareholders 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 – Ti) D
                    Kr =     -------------
                                (1 – To) P

Here :      Ti = Tax rate applicable to individual
               To = 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.

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