In financial management, the Cost of capital represents the minimum return a company must earn to satisfy its stakeholders. Think of it as the benchmark that guides investment decisions, this is a vital topic because it underpins financial decision-making and influences a firm’s capital structure.
Let’s break down each component of the cost of capital, step by step, with formulas, examples, and practical insights.
Key Takeaways:
Cost of capital is the rate of return a firm must earn on its investments to maintain its market value and satisfy its investors.
Key components include:
Cost of Debt (Kd): The effective rate a company pays on its borrowed funds.
Cost of Preference Shares (Kp): The return required by preference shareholders.
Cost of Retained Earnings (Ke): The opportunity cost of reinvesting earnings.
Cost of Equity (Ke): The return expected by equity shareholders, calculated using methods like Dividend Price Approach, Earnings Price Approach (with and without growth), and Capital Asset Pricing Model (CAPM).
A deep understanding of these components is crucial for UGC NET aspirants.
Cost of Debt (Kd)
Definition: The cost of debt is the effective interest rate a company pays on its borrowed funds.
Formula:
Kd (after tax) = (Interest Expense / Net Proceeds from Debt) × (1 - Tax Rate)Key Points:
Interest is tax-deductible, which reduces the actual cost of debt.
Focus on net proceeds, which accounts for issuance costs.
Example: If a company issues bonds worth ₹10,00,000 at a 10% interest rate and the tax rate is 30%, the after-tax cost of debt is:
Kd = (10,00,000 × 10%) × (1 - 0.30) = 7%Cost of Preference Shares (Kp)
Definition: This is the return required by preference shareholders, who get fixed dividends but have no voting rights.
Formula:
Kp = Dividend on Preference Shares / Net Proceeds from Preference SharesKey Points:
Dividends are not tax-deductible.
Always use net proceeds (issuance costs deducted).
Example: If a company issues preference shares at ₹100 each, pays a dividend of ₹12, and incurs ₹2 as issuance cost, the cost of preference shares is:
Kp = 12 / (100 - 2) = 12.24%Cost of Retained Earnings (Kr)
Definition: This represents the opportunity cost of reinvesting profits instead of paying them as dividends.
- When taxable Kr = Ke (1-tax)
- When non-taxable Kr = Ke
Formula (using CAPM):
Ke = Risk-free Rate + Beta × (Market Return - Risk-free Rate)Key Points:
Reflects the rate of return investors expect on equity investments.
Beta measures the stock’s volatility relative to the market.
Example: If the risk-free rate is 6%, market return is 12%, and beta is 1.2:
Ke = 6% + 1.2 × (12% - 6%) = 13.2%Cost of Equity (Ke)
Approaches:
a. Dividend Price Approach (No Growth):
Formula:
Ke = Dividend / Market Price of Shareb. Dividend Price Approach (With Growth):
Formula:
Ke = (Dividend / Market Price of Share) + Growth RateKey Points:
Growth rate can be estimated using historical data or industry trends.
Example (With Growth): If a company pays a dividend of ₹50, share price is ₹500, and growth rate is 5%:
Ke = (50 / 500) + 0.05 = 15%c. Earnings Price Approach:
Formula:
Ke = Earnings per Share (EPS) / Market Price of ShareExample: If EPS is ₹60 and share price is ₹500:
Ke = 60 / 500 = 12%d. Capital Asset Pricing Model (CAPM)
Formula:
Ke = Risk-free Rate + Beta × (Market Return - Risk-free Rate)Insights:
CAPM considers systematic risk.
Suitable for companies in volatile markets.
e. Realized Yield Approach
Definition: Estimates the cost based on historical returns.
Formula:
Realized Yield = (Ending Price - Beginning Price + Dividends) / Beginning PriceKey Points:
Focuses on past performance.
Useful for validating cost estimates.
Example: If a stock was bought at ₹200, sold at ₹220, with dividends of ₹10:
Realized Yield = (220 - 200 + 10) / 200 = 15%Conclusion
Understanding the cost of capital and its components is fundamental for making sound financial decisions. Each metric has its own relevance and application in corporate finance.