Cost of Capital; EBIT–EPS Analysis, Capital Gearing/Debt Equity Ratio, Generation of Internal Funds

COST OF CAPITAL

Source of capital may be owner’s equity, debt and retained earnings.A decision to invest in a project depends upon cost of capital of the firm or cut off rate, which is minimum rate of return expected by the investors.

The minimum rate of return will maintain the market value of shares at present level.

The COC/minimum rate or return has direct relation with the risk i.e. higher the risk followed by higher the COC.

Objectives of cost of capital

• Cost of capital is the minimum rate of return that a firm must earn to keep its market value of shares unchanged.
• In case a firm earns at a rate higher than COC, its market value of shares increases.
• In case of firm earns at a rate lower than COC, then market value of shares decreases and wealth maximisation does not take place.

Component  of Cost of Capital

• Return at zero risk level: this component of cost of capital is minimum, which is certain under all circumstances.
• Premium for business risk: It refers the changes in operating profit (EBIT) due to change in sales. The selection of a project of higher risk will increase the cost of capital by way of increase in the expected rate of return of the investors.
• Premium for financial risk: Financial risk is due to debt equity mix, in case of high debt in the total capital structure the financial risk exists. In order to make the payment of interest and principal, such firms need to generate higher operating profits to avoids insolvency.
• The above components of cost of capital can be put under equation: K = ro + b + f, where K, is cost of capital, ro, is return at zero risk level, b, premium for business risk and f, premium for financial risk.

Importance of cost of capital

• A firm’s cost of capital is important from both the angles of planning for capital budgeting and capital structure decisions.
• Capital budgeting decisions: Under this cost of capital is used as discount rate on the basis of that firm’s future cash flows are discounted to find out their present values. That is why cost of capital is very essential for financial appraisal of new capital expenditure proposals. So, the cost of capital is be correctly determined otherwise the decision would be irrational. This is because the firm must at least earn at a rate equal to COC to ensure break even point.
• Capital structure decisions: The finance manager must raise the funds from the different sources in a way that it minimises the cost and risk factor. The cost of debt may be cheaper because of tax benefits, but a slight fall in earning capacity of the firm may bring the firm near to cash insolvency.
• Therefore, cost of each source of funds is carefully considered and compared with the risk involved with it.

Classification of cost of capital

• Explicit cost: It is the discount rate that equates the PV of funds received by the firm net of underwriting cost with the PV of expected cash outflows.
• Implicit cost: it is the opportunity cost for the firm and its shareholders to be foregone in case of project under consideration is accepted.
• Future cost: It refers to projected cost of funds to finance the project.
• Historical cost: It is the cost which has been has been already incurred for financing a project. It can be useful in projecting the future costs when compared with standard cost.
• Specific cost: The cost of each component of capital i.e. equity, preference share and debenture is known is specific cost.
• Combined cost: overall cost of capital of all sources of finance is combined cost.
• Average cost: It is the weighted average cost of capital of each component of capital in the total capital.
• Marginal cost: It is the WACC of new funds raised by the firm. For capital structure and financing decisions the marginal cost of capital is the most important factor to be considered. So, it the cost which is based on the funds raised afresh.

Approaches of cost of capital

Traditional approach: As per this a firm’s cost of capital depends upon the method and level of financing or say its capital structure. Therefore, a firm can increase or decrease its WACC by increasing or decreasing its debt- equity mix. It results because, generally the cost of debt is cheaper than equity and interest is allowed as an expense before calculation of tax, whereas the dividend is not allowed as an expense before such calculation of tax rather it is a distribution of profits.

Modigliani and Miller approach: As per them the cost of capital is independent of method and level of financing & capital structure. This means that WACC does not change if debt equity mix is changed.

Assumptions under this approach:

• perfect capital market.
• no retained earning means dividend payout ratio is 100%.
• firms can be grouped under homogeneous classes, where same return under identical risk. iv) No taxes

After going through all assumptions the M&M approach seems not to be practical as traditional theory.

Computation of COC

Cost of Debt: Issued at par and debt is perpetual, means not redeemable.

Kd = R(1-T), where Kd is the cost of debt, T is the tax rate and R is the rate of interest. This cost after tax is used only where EBIT is equal to or more than interest, but in case if the EBIT is negative or less than interest, then the interest rate is to be calculated before adjusting tax rate only.

Cost of preference capital

Though it is not legally binding on the firm to pay the dividends on preference shares but it is generally paid whenever the firm makes the sufficient profits. This can lead to serious situation for equity shareholders since under certain circumstances the preference shareholders resume legal rights to participate  in AGM in the event of failure of their dividends. On account of these reasons the cost of preference capital is also computed like debentures.

Cost of equity capital

Since there is no legal binding on the firm to pay dividends on equity shares, so many people think that there is no cost of equity capital. But it is not true as the equity share holders make investments in equity in the expectation of dividends. The firm also does not have such intention of not paying the dividends to shareholders. Therefore, the market price of shares depend on the return expected by the shareholders.

The cost external equity or new issue of equity shares: This is difficult proposition since shareholders as a class are difficult to predict or quantify. Many authors have different approaches and explanations. Some approaches to calculate the cost of equity.

Dividend price approach: cost of equity will be that rate of dividend which shall maintain the present market price of shares. It ignores the retained earnings which has equally impact on the market price of shares.

The cost of new equity can be calculated as follows: Ke = D/NP, Ke is cost of equity capital, D is dividend per equity share and NP is net proceeds of an equity share.

 In case of an existing equity share, it is appropriate to calculate the cost of equity on the basis of market price of the share.

Dividend price and growth approach: In this the calculation of dividend and an expected growth rate is taken into consideration Ke = D/NP + g, the g here the estimated growth rate.

It is to be noted in case of existing shares in the above formula where  replace the net proceeds by market price of the shares.

Earning price approach: As per this it is the EPS (earning per share) which determine the market price of share.

Cost of retained capital

Many people think that retained earnings do not have any cost and are absolutely free. The opportunity cost of retained earnings may be taken as cost of retained earnings. It is equal to that the shareholders could have earned by placing these funds in alternative investments. In actual life shareholders have to pay tax on the dividend received and incur brokerage cost for making investment, so funds available with shareholders are less what they would have been with the company. On account of this the cost of retain earnings to the company would always be less than the cost of new equity shares.

Adjustments made for ascertaining the cost of retained earnings: i) income tax ii) Brokerage cost. The opportunity cost of retained earnings to shareholders is rate of return that they can obtain the net dividends (after tax & brokerage adjustments) in alternative opportunity of equal quality. Kr =Ke(1-T)(1-B), B is brokerage cost, T is tax rate and Ke  is cost of equity.

Weighted average cost of capital

• It is also called overall cost of capital and calculated as follows:
• Calculate the cost of each source of specific fund. This involves the determination of cost of debt, preference share and cost of equity separately.
• Assigning weights to specific costs. This involves the determination of proportion of each source of funds in the total capital structure.

WACC Assigning weights to specific costs

• Marginal weights method: In this method weights are assigned on the logic that our concern is with new or incremental capital not with the capital raised in the past. If the weights are assigned on different basis then the WACC shall be different. It suffers from one limitation that it does not consider long term affect of current financing.
• Historical cost method: As per this weights are assigned on the basis of funds already employed.

GENERATION OF INTERNAL FUNDS

In the theory of capital structure, internal financing is the name for a firm using its profits as a source of capital for new investment, rather than a) distributing them to firm’s owners or other investors and b) obtaining capital elsewhere. It is to be contrasted with external financing which consists of new money from outside of the firm brought in for investment. Internal financing is generally thought to be less expensive for the firm than external financing because the firm does not have to incur transaction costs to obtain it, nor does it have to pay the taxes associated with paying dividends. Many economists debate whether the availability of internal financing is an important determinant of firm investment or not. A related controversy is whether the fact that internal financing is empirically correlated with investment implies firms are credit constrained and therefore depend on internal financing for investment.