IV Unit Finance - Cost of Capital Cost of Capital For...

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Unformatted text preview: Cost of Capital Cost of Capital For Investors the rate of return on a security is a benefit of investing. For Firm it is the rate of return for raising funds that are needed to operate the firm. In other words, the cost of obtaining funds is the firm’s cost of capital. How can the firm raise capital? Bonds Preferred Stock Common Stock Each of these offers a rate of return to investors. This return is a cost to the firm. “Cost of capital” actually refers to the weighted cost of capital - a weighted average cost of financing sources. significance Acceptance criterion in capital budgeting Determinant of capital mix Evaluating financial performance (actual profitability is compared to the actual cost of capital ) Helps to take other financial decision s ( dividend policy, Capitalization of profits, working capital etc ) The Weighted Cost of Capital To calculate the firm’s weighted cost of capital, first calculate the costs of the individual financing sources: Cost of Debt Cost of Preferred Stock Cost of Common Stock Cost of Debt For the issuing firm, the cost of debt is: the rate of interest payable on debt. flotation costs (any costs associated with issuing new bonds), and Taxes. Tax effects of financing with debt EBIT - interest expense EBT - taxes (34%) EAT Now, suppose the firm pays Rs50,000 in dividends to the stockholders without debt 400,000 0 400,000 (136,000) 264,000 -- 50000 214000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231000 Example: Tax effects of financing with debt without debt EBIT 400,000 - interest expense 0 EBT 400,000 - taxes (34%) (136,000) EAT 264,000 - dividends (50,000) Retained earnings 214,000 with debt 400,000 (50,000) 350,000 (119,000) 231,000 0 231,000 Cost of irredeemable debt kd = I/NP Post tax Kdt= I(1-t) /NP (or) kd (1-t) Pretax Kd= I/NP Eg ; 12% debt of Rs 100/- each .50% tax .what is Kd? Kd = 12/100 = 0.12 = 12% ( interest rate = cost) Kdt = 12(1-0.50)/100 = 0.06 = 6% ( cost will be less than interest rate) 2. 15 % ,Debentures of Rs 100/- each for Rs 10,00,000/- ,t=35%; i) Issued at Par value ii) Issued at 10%Premium iii) Issued at 10%Discount Find out kd before and after tax? 3A. X ltd issues 50000 8%Dedentures at par .Tax rate applicable is 50%. 3B. Y Ltd issued 50000, 8% debentures at a discount of 5%. TR is 60% 3C.Bltd issued 100000 9% at a premium of 10%. The cost of flotation is 2%. TR is 60%. Find cost of debt. Cost of redeemable debt: debt is issued to be redeemed after a certain period I(1-t)+1/n(RV-NP) ½(RV+NP) A company issues 1000000, 10% redeemable debentures at a discount rate of 5%. The cost of flotation is 30000. The debentures are redeemable after 5 years. Calculate before tax and after tax cost of debt assuming a tax rate of 50% A 5 year Rs 100 debenture of a firm can be sold for a net price of 96.5.The coupon rate of interest is 14% P.a and the debenture will be redeemed at 5% premium on maturity. The firm’s tax rate is 40%. Compute after tax cost of debenture. BE company issues Rs100/- par value of debentures carrying 15% interest. The debentures are repayable after a period of 7 years at face value. The cost of issue is 3% and tax is 35%.What is Kd? Example: Cost of Debt Prescott Corporation issues a Rs1,000 par, 20 year bond paying the market rate of 10%. Coupons are annual. The bond will sell for par since it pays the market rate, but flotation costs amount to Rs50 per bond. What is the pre-tax and after-tax cost of debt for Prescott Corporation? Pre-tax cost of debt: 950 = 100(PVIFA 20, kd) + 1000(PVIF 20, kd) using the calculator, kd = 10.61%. So, a 10% bond costs the firm After-tax cost of debt: only 7% (with Kd = kd (1 - T) flotation costs) Kd = .1061 (1 - .34) since the interest Kd = .07 = 7% is tax deductible. Cost of Preferred Stock A fixed rate of dividend is payable on preference shares Cost on Preference capital is the return expected by the investors. kp = D NPo = Cost of irredemable preference shares KP= D/ Np Dividend/ Net price Cost of redemable preference shares D+ 1/n(RV- NP) ½(RV+NP) Cost of irredemablePreferred If Prescott Corporation issues preferred stock, it will pay a dividend of Rs8 per year and should be valued at Rs75 per share. If flotation costs amount to Rs1 per share, what is the cost of preferred stock for Prescott? 8.00 == 10.81% 74.00 A company issues 10000, 10% preference shares of Rs.100 each. Cost of issue is Rs 2 per share. Calculate cost of preference capital if these shares are issued A) at par B) at a premium of 10% C) at discount of 5% Cost of redeemablePreferred A company issues 10000, 10% preference shares of Rs100 each redeemable after 10 years at a premium of 5%. . Cost of issue is Rs 2 per share. Calculate cost of preference capital. 100000+1/10 (1050000-980000) ½(1050000+ 980000) = 10.54% Cost of Common Stock There are 2 sources of Common Equity: 1) Internal common equity (retained earnings), and 2) External common equity (new common stock issue) Do these 2 sources have the same cost? Cost of Internal Equity Retained earnings do not involve any cost because a firm is not required to pay dividends on retained earnings. However the shareholders expect a return on retained profits. Retained earnings accrue to a firm only because of some sacrifice made by the shareholders in not receiving the dividends out of available profits. SO Kr may be considered as the return which the existing shareholders can obtain by investing the after tax dividends in alternative opportunities. Thus it is the opportunity cost of divedends foregone by the shareholders. Kr = D NP +g Cost of Equity 1) Dividend Growth Model Ke = D1 + g NPo 2) Capital Asset Pricing Model (CAPM) ke = krf + b ( km - krf ) Rf= rate of return on risk free investment Km= required return on market portfolio of assets. B= beta co efficient. Dividend Growth Model A)A company plans to issue 1000 new shares of Rs100 each at par. The floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares. B) If the current market price of an equity share is Rs 150. Calculate the cost of existing equity share capital A) 10 95 + 5% = 15.53% B) 10 150 + 5% === 11.67% Weighted Cost of Capital The weighted cost of capital is the weighted average cost of all of the financing sources. Weighted Cost of Capital Source Cost debt 20% preferred common 670%% 10% 16% Capital Structure 10% Weighted Cost of Capital (20% debt, 10% preferred, 70% common) Weighted cost of capital = .20 (6%) + .10 (10%) + .70 (16) = 13.4% A firm’s after tax cost of capital of specific sources is as follows Cost of debt- 8% Cost of preference shares -14% Cost of equity-17% The capital structure of the firm as – debt---------------------- 3,00,000 Preference capital------ 2,00,000 Equity -------------------- 5,00,000 Total 10,00,000 Red Rock Limited requires Rs. 200 . crore of external financing for which it is considering two alternatives: Alternative A : Issue of 1.6 crore equity shares of Rs 10 par at Rs. 125 each. Alternative B : Issue of Rs.200 crore of debentures carrying 8 percent interest rate.What is the EPSEBIT indifference poin A firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. It need Rs 6,000,000 to finance a proposed project and is considering two options: Sell 200,000 shares of common stock at Rs 30 per share or Borrow $6,000,000 by issuing 10% bonds. If the expected EBIT is Rs 20, 00,000/-, Find out the Breakeven EBIT of the two financing plans Red Rock Limited requires Rs. 200 . crore of external financing for which it is considering two alternatives: Alternative A : Issue of 1.6 crore equity shares of Rs 10 par at Rs. 125 each. Alternative B : Issue of Rs.200 crore of debentures carrying 8 percent interest rate.What is the EPSEBIT indifference poin A firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. It need Rs 6,000,000 to finance a proposed project and is considering two options: Sell 200,000 shares of common stock at Rs 30 per share or Borrow $6,000,000 by issuing 10% bonds. If the expected EBIT is Rs 20, 00,000/-, Find out the Breakeven EBIT of the two financing plans Capital structure Decision Capital structure Decision / Financing Decision How can we assets? finance the firm’s Balance Sheet Current Current Liabilities Assets Long term Debt and Preference Fixed Assets Shareholders’ Equity Financial structure Balance Sheet Current Current Liabilities Assets Debt Preference Fixed Assets Shareholders Equity Capital structure Capital structure refers to the composition of its capitalization and it includes all long term capital sources. Capitalisation refers to the total amount of securities issued by a company. Financial structure means the entire liabilities side of the balance sheet. Financial structure Capital sturucture Long term and short term funds Only long term Entire liabilities Long term only Not important in determination of value of firm important in determination of value of firm Objectives of Capital Structure Maximize the value of the firm. Minimize the overall cost of capital . Optimum capital structure OPTIMUM CAPITAL STRUCTURE Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum. Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the maximum value of the firm. Planning the Capital Structure Important Considerations Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and market price per share. Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on interest & no benefit on dividends. Risk: insolvency risk associated with high debt component. Control: avoid dilution of management control Flexible: altering capital structure without much costs & delays, to raise funds whenever required. Capacity: ability to generate profits to pay interest and principal Capital Structure Theories There is a relationship among the capital structure, cost of capital and value of the firm. The aim of effective capital structure is to maximize the value of the firm and to reduce the cost of capital. The following theories explains the relationship between capital structure, cost of capital and value of the firm. Net Income (NI) Approach suggested by the Durand. The capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well as the total value of the firm. According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm. Net income approach is based on the following three important assumptions: 1. There are no corporate taxes. 2. The cost debt is less than the cost of equity. 3. The use of debt does not change the risk perception of the investor. Net Income Approach Cost of Capital The low cost of debt reduces the cost of capital. ke ke ko kd kd financial leverage Net Income Approach The total market value of a firm V= S+D Ko = EBIT V A) Net Income Approach (NI) Particulars EBIT (-) Interest EBT Ke Value of Equity (EBT / Ke) Value of Debt Total Value of Firm WACC (EBIT / Value) * 100 case 1 case 2 case 3 200,000 30,000 170,000 200,000 42,000 158,000 200,000 12,000 188,000 10% 1,700,000 10% 1,580,000 10% 1,880,000 500,000 700,000 200,000 2,200,000 2,280,000 2,080,000 9.09% 8.77% 9.62% Net Operating Income (NOI) Approach Suggested by Durand Capital Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital structure changes. According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market price of shares as well as the overall cost of capital. Assumptions; The overall cost of capital remains constant; There are no corporate taxes; Business risk remains constant at every level of debt- equity mix . NOI approach ke The cost of capital does ke not change. Leverage has no effect on the cost of capital and therefore, it has no effect on the value of the firm. ko kd kd Cost of Capital financial leverage Modigliani and Miller Approach Modigliani and Miller approach states that the financing decision of a firm does not affect the market value of a firm in a perfect capital market. In other words MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital structures of the firm. Modigliani and Miller approach is based on the following important assumptions: • There is a perfect capital market. • There are no retained earnings. • There are no corporate taxes. • The investors act rationally. • The dividend payout ratio is 100%. • The business consists of the same level of business risk. MM Model proposition – Value of a firm is independent of the capital structure. Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the appropriate rate (i.e. WACC). Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt = Expected EBIT Expected WACC MM Model proposition – As per MM, identical firms (except capital structure) will have the same level of earnings. As per MM approach, if market values of identical firms are different, ‘arbitrage process’ will take place. In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms. Levered Firm Value of levered firm = Rs. 110,000 Equity Rs. 60,000 + Debt Rs. 50,000 Kd = 6 % , EBIT = Rs. 10,000, Investor holds 10 % share capital Un-Levered Firm Value of un-levered firm = Rs. 100,000 (all equity) EBIT = Rs. 10,000 and investor holds 10 % share capital Return from Levered Firm: Investment 10% 110, 000 50 , 000 10% 60, 000 6 , 000 Return 10% 10, 000 6% 50, 000 1, 000 300 700 Alternate Strategy: 1. Sell shares in L: 10% 60,000 6,000 2. Borrow (personal leverage): 10% 50,000 5,000 3. Buy shares in U : 10% 100,000 10,000 Return from Alternate Strategy: Investment 10,000 Return 10% 10,000 1,000 Less: Interest on personal borrowing 6% 5,000 300 Net return 1,000 300 700 Cash available 11,000 10,000 1,000 Modigliani and Miller Approach Modigliani and Miller recognized that the value of the firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose. Thus the optimal capital structure can be achieved by maximizing the debt mix in the equity of a firm. Traditional Approach The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm. Traditional approach (‘intermediate approach’) is a compromise between these two extreme approaches. Traditional approach confirms the existence of an optimal capital structure; where WACC is minimum and value is the firm is maximum. As per this approach, a best possible mix of debt and equity will maximize the value of the firm. The approach works in 3 stages – Value of the firm increases with an increase in borrowings (since Kd < Ke). As a result, the WACC reduces gradually. This phenomenon is up to a certain point. At the end of this phenomenon, reduction in WACC ceases and it tends to stabilize. Further increase in borrowings will not affect WACC and the value of firm will also stagnate. Increase in debt beyond this point increases shareholders’ risk (financial risk) and hence Ke increases. Kd also rises due to higher debt, WACC increases & value of firm decreases Cost ke ko kd Debt Capital Structure Management EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S Capital Structure Management EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS EPS == (EBIT (EBIT -- I)(1 I)(1 -- t)t) -- PP SS I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding. EBIT-EPS Example Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: Sell 2,00,000 shares of common stock at $30 per share, Borrow $6,000,000 by issuing 10% bonds. If we expect EBIT to be $2,000,000: Financing stock debt EBIT 2,000,000 2,000,000 - interest 0 (600,000) EBT 2,000,000 1,400,000 - taxes (40%) (800,000) (560,000) EAT1,200,000 840,000 # shares outst. 1,000,000 800,000 EPS $1.20 $1.05 If we expect EBIT to be $4,000,000: Financing stock debt EBIT 4,000,000 4,000,000 - interest 0 (600,000) EBT 4,000,000 3,400,000 - taxes (40%) (1,600,000) (1,360,000) EAT2,400,000 2,040,000 # shares outst. 1,000,000 800,000 EPS $2.40 $2.55 If EBIT is $2,000,000, common stock financing is best. If EBIT is $4,000,000, debt financing is best. So, now we need to find a breakeven EBIT where neither is better than the other. EPS 3 If we choose stock financing: stock financing 2 1 0 EBIT $1m $2m $3m $4m EPS 3 If we choose bond financing: bond financing 2 1 0 EBIT $1m $2m $3m $4m Breakeven EBIT EPS 3 bond financing stock financing 2 1 0 EBIT $1m $2m $3m $4m Breakeven Point: Set 2 EPS calculations equal to each other and solve for EBIT: Stock Financing (EBIT-I)(1-t) - P S = Debt Financing (EBIT-I)(1-t) - P S Breakeven Point: Stock Financing (EBIT-I)(1-t) - P = S Debt Financing (EBIT-I)(1-t) - P S (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800,000+200,000 800,000 To refresh your algebra…. Stock Financing .6 EBIT = 1 .48 EBIT = .12 EBIT = Debt Financing .6 EBIT - 360,000 .8 .6 EBIT - 360,000 360,000 EBIT = $3,000,000 Breakeven EBIT EPS 3 bond financing For EBIT up to $3 million, stock financing is best. stock financing 2 1 0 EBIT $1m $2m $3m $4m Breakeven EBIT EPS 3 bond financing For EBIT up to $3 million, stock financing is best. 2 stock financing For EBIT greater than $3 million, debt financing is best. 1 0 EBIT $1m $2m $3m $4m Team Problem: Plan A- all equity: We will start a new firm by selling 1,200,000 shares at $10 per share. Plan B- levered: issue $3.5 million in 9% debt and finance the rest with equity at $10 per share. a) Breakeven EBIT: Stock Financing (EBIT-I) (1-t) - P = S EBIT-0 (1-.50) 1,200,000 Levered Financing (EBIT-I) (1-t) - P S = (EBIT-315,000)(1-.50) 850,000 EBIT = $1,080,000 Analytical Income Statement Stock Levered EBIT 1,080,000 1,080,000 I 0 (315,000) EBT 1,080,000 765,000 Tax (540,000) (382,500) NI 540,000 382,500 Shares 1,200,000 EPS .45 .45 850,000 b) Breakeven EBIT levered financing EPS .65 stock financing .45 .25 0 EBIT $.5m $1m $1.5m $2m Breakeven EBIT For EBIT up levered to $1.08 m, stock EPS financing stock financing .65 financing is best. .45 .25 0 EBIT $.5m $1m $1.5m $2m Breakeven EBIT For EBIT up levered to $1.08 m, stock EPS financing stock financing .65 financing is best. For EBIT greater than $1.08 m, .45 the levered plan is best. .25 0 EBIT $.5m $1m $1.5m $2m Leverage Leverage Leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders. Leverage Operating Leverage Financial Leverage Combined Leverage Operating Leverage This is associated with investment activities. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Op...
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