This extra money paid is said to be the cost of using capital and is called the cost of capital. This cost of capital expressed as a rate is used to discount/compound the cash flow or stream of cash flows. The cost of capital is important to arrive at the right amount and helps the management or an investor to make a right decision.
The estimated benefits (future cash flows) from available investment opportunities (business or project) are converted into the present value of benefits by discounting them with the relevant cost of capital. Here capital costs are used to arrive at the present value of costs and benefits received. The cost of capital in this case would be 9% interest that could have been earned by not investing the deposit for the business purposes.
Two factors considered in determining the cost of capital are: ii) Reciprocity of the financing used. The cost of debentures that are not redeemed by the issuer of the debenture are known as non-redeemable debentures. The cost of repayable debt (Kd) is also calculated by discounting the relevant cash flows using the internal rate of return (IRR). The concept of IRR is discussed in the chapter – Investment Decisions).
The above cash flows of all five years will be discounted by the cost of capital.
Cost of Convertible Debenture
COST OF PREFERENCE SHARE CAPITAL
Cost of Redeemable Preference Shares
Cost of Irredeemable Preference Shares
COST OF EQUITY SHARE CAPITAL
- Dividend Price Approach
- Earning/ Price Approach
- Realized Yield Approach
- Capital Asset Pricing Model (CAPM) Approach
Constant Growth Dividend Price Approach: Under this approach, the rate of dividend growth remains constant. Accordingly, the cost of equity capital will be based on the expected earnings of a company. Thus, if an investor expects the company in which he is to subscribe for shares to have at least 20% earnings, the cost of equity share capital can be interpreted on this basis.
Since earnings practically do not remain constant and the price of equity shares is also directly affected by the growth rate in earnings. The calculation of 'g' (the growth rate) is an important factor in calculating the cost of equity share capital. It can be calculated as below: r = rate of return on fund invested b = earnings retention ratio/rate*.
It calculates the equity value based on historical records of dividends actually realized by shareholders. Although this approach provides a single mechanism for calculating the cost of equity capital, it makes unrealistic assumptions such as the risks faced by the firm remain the same; shareholders continue to expect the same rate of return; and the shareholders' opportunity cost of reinvestment (rate) is equal to the realized return. We know that according to the realized return approach, the cost of equity is equal to the realized rate of return.
Therefore, it is important to calculate the internal rate of return through trial and error. The relationship between risk and return of various securities. Therefore required rate of return = risk free rate + risk premium. Despite these shortcomings, the CAPM is useful in calculating the cost of equity capital even when the firm is suffering losses.
The basic factor for determining the cost of equity capital is the measurement of investors' expectations regarding the ownership shares of a particular company. Therefore, the whole question of determining the cost of equity shares depends on factors that affect the expectations of a certain group of investors in a company of a certain risk class. Calculate the cost of equity of H Ltd., whose risk-free rate of return is 10%.
COST OF RETAINED EARNINGS
The cost of retained earnings is often used interchangeably with the cost of equity, since cost of retained earnings is nothing but the expected return of the shareholders from the investment in shares of the company. However, sometimes the cost of retained earnings remains below the cost of equity due to savings in operating costs and the existence of personal taxes. Flotation costs: The new issue of a security (debt or equity) involves some expenses in the form of underwriting or brokerage fees, legal and administrative costs, registration fees, printing expenses, etc.
Liquidation costs are adjusted to yield net proceeds for calculating the cost of capital.
EFFECTIVE INTEREST RATE (EIR) METHOD
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Thus, a weighted average technique can be used in an almost marginal way to evaluate a proposed investment project, such as the construction of a new building. Thus, the weighted average cost of capital is the weighted average of the after-tax costs of the individual components of the firm's capital structure. That is, the after-tax cost of each debt and equity is calculated separately and added together to an overall cost of equity.
Calculate the total capital from all the sources
Calculate the proportion (or %) of each source of capital to the total capital
Multiply the proportion as calculated in Step 2 above with the respective cost of capital
Aggregate the cost of capital as calculated in Step 3 above. This is the WACC
Choice of weights
While using BV, reserves such as share premium and retained earnings are included in the BV of equity, in addition to the nominal value of share capital. Here, the value of equity will generally not reflect historical asset values, as well as the future prospects of an organization. While using MV, reserves such as share premium and retained earnings are ignored as they are in effect included in the value of equity.
It represents existing conditions and also takes into account the effects of changing market conditions and current prices of various securities. Similarly, in the case of debt, it is better to use MV instead of the BV of the debt, although the difference may not be very significant.
MARGINAL COST OF CAPITAL
Below is the earnings per share trend over the past ten years, which is expected to continue in the future. The company has issued new bonds with an interest rate of 16% and the current market price of the bond is '96. New share of stock (consuming new equity from retained earnings) (B) Calculate the marginal cost of capital if no new shares are issued.
How much can be spent on capital investments before new common shares must be sold.
SUMMARY
TEST YOUR KNOWLEDGE
Calculation of Weighted Average Cost of Capital (WACC)
