Risk / Return

Cost of Capital• Minimum rate of return which a company is expected to

earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price.

• In economic terms there are two approaches to define CoC:

1. It is the borrowing rate of the firm, at which it can acquire funds to finance the proposed project

2. It is the lending rate which the firm could have earned if the firm would have invested elsewhere

CoC is a combined cost of each type of source by which a firm raises funds.

Importance of CoC• Capital Budgeting Decisions• Designing the Corporate Financial Structure• Deciding about the method of financing – in

lieu with capital market fluctuations• Performance of top management• Other areas – eg., dividend policy, working

capital

Basic costs of capital1. Cost of Equity Capital: the cost of obtaining

funds through the sale of common stock.2. Cost of Preference Shares3. Cost of Debt4. Cost of Retained Earnings

Cost of Equity Capital• Ke is defined as the minimum rate of return

that a firm must earn on the equity-financed portion of an investment project in order to leave unchanged the market price of the shares.

• It is the rate at which investors discount the expected dividends of the firm to determine its share value.

• The two approaches to measure ke are i. Dividend valuation approach ii. Capital asset pricing model.

Approaches to measure Ke1. Dividend valuation approach – dividend valuation

model assumes that the value of a share equals the present value of all future dividends that it is expected to provide over an indefinite period.

Ke = (D1/Po) + g; whereD1 = expected dividend per sharePo = net proceeds per share/current market priceg = growth in expected dividendsExample: Expected dividend is Rs.2 in 1st year. Growth

rate expected 4% in perpetuity. What is the cost of equity? Assume market price of share is Rs. 20.

2. Capital Asset Pricing Model approach

• The CAPM explains the behavior of security prices and provides a mechanism whereby investors could assess the impact of proposed security investment on their overall portfolio risk and return. In other words, it formally describes the risk-return trade-off for s

• ke = rf + ß(km – rf);Where,ke = cost of equity capital;rf = the rate of return required on a risk free

asset/security/investmentkm = required rate of return on the market portfolio of

assets that can be viewed as the average rate of return on all assets

ß = the beta coefficient

Formula• ke = rf + ß(km – rf);Where,ke = cost of equity capital;rf = the rate of return required on a risk free

asset/security/investmentkm = required rate of return on the market portfolio of

assets that can be viewed as the average rate of return on all assets

ß = the beta coefficient.

Cost of Preference Capital• They are a hybrid security between debt and

equity. The shareholders are paid a dividend yearly.

kp=dp/P0(1-f); where, dp=constant annual dividend,P0=expected sales price of preference sharef= floatation costs

Cost of Debt• Debt is the cheapest form of long-term debt from the

company’s point of view as:It’s the safest form of investment from the point of view of

creditors because they are the first claimants on the company’s assets at the time of its liquidation. Likewise they are the first to be paid their interest. Another, more important reason for debt having the lowest cost if the tax-deductibility of interest payments.

kd=I(1-T)/SVwhere I is annual interest payment (coupon payment)SV is sale proceeds of bond/debenture.T is tax rate