Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks

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Corporate Finance FIN 622

Lesson 18

COST OF CAPITAL & CAPITAL STRUCTURE

The following topics will be discussed in this lecture.

Cost of Capital & Capital Structure

Components of Capital

Cost of Equity

Estimating g or growth rate

Dividend growth model

Cost of Debt / Bonds

Cost of Preferred Stocks

COST OF CAPITAL

The required return is necessary to make a capital budgeting project such as building a new factory

worthwhile. Cost of capital would include the cost of debt and the cost of equity.

The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix

of the two). This is the rate of return that a firm would receive if it invested its money someplace else with

similar risk.

CAPITAL STRUCTURE

Capital structure of a typical company may consist of ordinary shares, preference stock, short term and long

term loan, bonds and leases. These components in capital structure have their own cost and if we add all

the individual components cost after adjusting with the weight age of each, the resultant value is known as

weighted cost of capital. As you have already covered in your earlier lessons that normally we use WACC as

discount rate to find the present value of future cash flows emerging from a project, so it is of immense

importance to calculate the correct WACC. And you are also aware that if the WACC is incorrect it may

lead to serious consequences.

In order to compute the WACC we need to calculate the individual components cost. First of all we take up

the Equity part of the capital and will see how we can compute the cost of equity.

COST OF EQUITY

In financial theory, the return that stockholders require for a company is called cost of equity. The

traditional formula is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the

asset and bearing the risk of ownership.

Let's look at a very simple example: let's say you require a rate of return of 10% on an investment in stock

A. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a combination of

dividends and share appreciation you require a $1.00 return on your $10.00 investment. Therefore the stock

will have to appreciate by $0.70, which, combined with the $0.30 from dividends, gives you your 10% cost

of equity.

We shall discuss two methods we can use to determine the cost of equity.

First, we'll take up dividend growth models and then security market line approach to calculate the cost of

equity.

Assuming that dividends will grow at a constant rate in future (growth rate =g), price per share Po (current

price) can be found by the following formula:

Po = Do x (1 + g) / Re g

Po = D1 / Re g

Where D1 is the dividend after period 1 and Re represents return on equity.

We can re-arrange this equation in order to calculate the Re as under:

Corporate Finance FIN 622

Re = D1 / Po + g

This equation tells us that we need three variables to work out the cost of equity. These are current price

Po, dividend in period 0, and Do and growth rate.

Most complex variable in the above equation is to determine the "g" variable. You can obtain the Po and

Do very easily from internal or external sources. We can use some statistical techniques to forecast g using

the historical data. More precisely using trend and regression analysis we can obtain the value of g.

The primary advantage of dividend growth model is that it is very simple to understand and use. However,

there are some problems also associated with this approach.

It is only applicable to the firms which pay dividend regularly if not constantly. Therefore, a firm with no

dividend history will find it useless.

The other problem is an unrealistic assumption of constant growth of dividends. We may not find any such

company which has a history of constant growth in dividends. These two limitations make this model to be

used in selected scenarios, for example, where the company may have distributed the dividends consistently

in the past.

The other problem is that the estimated cost of equity is very sensitive to the estimated growth rate.

Finally, this approach does not take into account the risk level. There is no direct adjustment for the risky-

ness of the investment. For instance, there is no adjustment for the degree of certainty or uncertainty in

estimated growth rate for dividends

The other way to compute the cost of equity is SML (security market line) which tells us that the required

rate of return on a risky investment depends on three things.

The risk free rate, Rf

ii)

Market risk premium, (Erm Rf)

iii)

Systematic risk of the asset known as beta, B

Using SML we can write the equation as under:

Ere = Rf + Be x (Erm Rf)

Where

Ere = is expected return on equity.

Be = is Beta of equity.

This method is also suffering from advantages and disadvantages. First it explicitly adjusts the risk and

second, it is applicable to companies other than just those with steady dividend growth. Thus it may be

useful in wider circumstances.

The SML approach heavily relies on two things the market risk premium and beta coefficient. And if our

estimates are not very accurate then the cost of equity number will be incorrect and misleading as well.

The demerit of both dividend model and SML is that both consider past data to predict the future.

Economic conditions and indicator in future are not the same as were in past. However, both methods do

provide us relative guidance in computing the cost of equity.

Before we move ahead to cost of debt, let's take a look how we can raise capital in the long run. From a

firm's perspective, followings are the ways to build the capital:

venture capital

issuing share to public IPOS

subsequent issue of share right issue

private placement of shares

Corporate Finance FIN 622

bank loans

debt instruments

leases

There are some rules and regulations for raising capital for each of the above categories. We shall discuss

here some of the issues relating to Equity capital issuing shares through IPOs and subsequent issue of

shares like right issue.

· company must be listed on stock exchange

· must be registered with security & exchange commission of Pakistan SECP

· company issues prospectus

· underwriting the share issue

Underwriter refers to a firm that acts as intermediary between a company issuing shares and

the public.

underwriter normally perform following services

· devising method for issuing shares

· setting the price of new shares

· marketing / selling of securities

Underwriters may buy securities for less than the price set by the company and then selling

them to public. if any amount of shares not subscribed by the public then underwriter takes

up the under-subscribed shares.

Often underwriter forms a group to share the risk, known as syndicate.

COST OF DEBT:

Debt component of capital may include several line items like preferred stocks, loans from various financial

institutions with varying terms and cost. Some of the loans may be having fixed or floating interest rate. The

other items in the debt are bonds and leases.

The effective rate that a company pays on its current debt can be measured in either before- or after-tax

returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one

part of the company's capital structure, which also includes the cost of equity.

A company will use various bonds, loans and other forms of debt, so this measure is useful for giving an

idea as to the overall rate being paid by the company to use debt financing. The measure can also give

investors an idea as to the risky-ness of the company compared to others, because riskier companies

generally have a higher cost of debt.

To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal tax rate (before-

tax rate x (1-marginal tax)). If a company's only debt were a single bond in which it paid 5%, the before-tax

cost of debt would simply be 5%. If, however, the company's marginal tax rate were 40%, the company's

after-tax cost of debt would be only 3% (5% x (1-40%)).

Like loans, bonds may have several issues of varying terms, carrying different interest cost with wide gap

between their cost and market value. Leases may have the same characteristics like loans and debts.

To find the cost of debt, we need to calculate the cost of each class of debt and then finding the weighted

average of the cost of debt. For example, if there are five bond issues outstanding at any time, we will

calculate the cost of each issue and then move to weighted average of cost of bond by using their individual

weight in total bond capital.

COST OF PREFERRED STOCK:

To start computing the cost of debt, we take up the first item in debt family preferred stock, which is

fairly straightforward calculation.

As we know that preferred stocks carry fixed dividend every period. There's no variation in dividend level.

This means that dividend from preferred stock is essentially perpetuity.

· cost of preferred stock can be calculated from the following

· R = D/ Po

Corporate Finance FIN 622

for example if the dividend is R 3.50/- per share and current market price is rs.40/-, then the Rp

will be:

· Rp = 3.50 / 40 = 8.75%

We shall take up the two main issues for calculating cost of debt for loans and leases in other hand outs to

be delivered in future.

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