What is Cost of capital/prefrence share/debt?

Cost of Capital

Explicit and Implicit cost of capital

Explicit cost of capital of any source is the discount rate that equates the present value of cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.It is the internal rate of return cash inflows and outflows.

I=C1/(1+k)n + C2/(1+K)N+CN/(1+K)N

I=net amount of cash inflow at time zero.

C=Cash outflow at different years.

K=Explicit cost of capital

N=Number of years.

Example- A company issues debentures of RS 100 each .The coupon rate of interest is 10%.Maturity period 3 years.The debentures are issued at Rs 100 and redeemable at Rs 100.Calculate the explicit cost of capital.

100=10/(1+K)1+10/(1+K)2+110/(!+K)3

The discount rate which solves the equation is 10% so K is 10%.

Implicit cost of capital is also known as the opportunity cost of capital.It is rate associated with best investment opportunity.

Eg. Mr X has a choice of investing Rs 1000 in the shares or bank deposits.at 12%.If he invests 1000 in shares  implicit cost of capital is 12%

 

Cost of Debt

Debentures,Bonds,Fixed deposits,Term loans ets..Debt may be issues and redeemed at par premium or discount.

1.Debt issued at par and redeemed at par/Cost of perpetual debt(irredeemable debt.)

The before tax cost of debt(BTCD) is simply the interest offered to the suppliers of money.

BTCD= Interest/Net proceeds.

Eg. A company issues 3 years debentures of Rs 100 at 15% coupon rate .Calculate BTCD.

BTCD=15/100=15%

2.Debt issued and redeemed at discount or at a premium & Cost of existing debt.

BTCD = I + RV-NP/N

             ____________

             RV+NP/2

RV= Redeemable value     NP=Net proceeds from the issue.

N=Number of years            I=Annual interest charges in rupees.

Eg. Wipro issues 5 years 12% debentures of Rs 100 each for Rs 105.The debentures are redeemed at par.The company has spend Rs 5 per debenture as flotation cost.

BTCD= 12+100-100/5/100+100/2=12%

Cost of Preference Capital

These shares carry preferential rights with regard to payment of dividend and repayment of capital at the time of winding up.The measurement of the cost of preference capital poses some conceptual difficulty. In the case of debt, there is a binding legal obligation on the firm to pay interest, and the interest constitutes the basis to calculate the cost of debt. However, in the case of preference capital, payment of dividends is not legally binding on the firm and even if the dividends are paid, it is not a charge on earnings; rather it is a distribution or appropriation of earnings to preference shareholders. One may be, therefore, tempted to’ conclude that the dividends on preference capital do not constitute cost. This is not true .The cost of preference capital is a function of the- dividend expected by investors. Preference capital is never issued with an intention not to pay dividends. Although it is not legally binding upon the firm to pay dividends on preference capital, yet it is generally paid when the fim1 makes sufficient profits. The failure to pay dividends, although does not cause bankruptcy, yet it can be a serious matter from the common (ordinary) shareholders’ point of view. The nonpayment of dividends on preference capital may result in voting rights and control to the preference shareholders. More than this, the firm’s credit standing may be damaged. The accumulation of preference dividend arrears may adversely affect the prospects of ordinary shareholders for receiving any dividends, because dividends on preference capital represent a prior claim on profits. As a consequence, the fim1 may find difficulty in raising funds by issuing preference or equity shares. Also, the market value of the equity shares can be adversely affected if dividends are not paid to the preference shareholders and, therefore, to the equity shareholders. For these reasons, dividends on preference capital should be paid regularly except when the firm does not make profits, or it is in a very tight cash position.

Irredeemable Preference Share & Redeemable Preference Share

Irredeemable Preference Share

The preference share may be treated as a perpetual security if it is irredeemable. Thus, its cost is given by the following equation (for a perpetuity):

kp = DIV+RV-NP/N/RV+NP/2

where kp is the cost of preference share, DIV is the expected preference dividend, Rv is redeemable value,NP is net proceeds now and N is number of years for maturity.

Redeemable Preference Share

Redeemable preference shares (that is, preference shares with finite maturity) are also issued in -practice. A formula similar to above Equation can be used to compute the cost of  redeemable preference share:

K=D/NP  

where D is dividend outflow each year and NP is net proceeds from the issue.

The cost of preference share is not adjusted for taxes because preference dividend is paid after the corporate taxes have been paid. Preference dividends do not save any taxes. Thus, the cost

of preference share is automatically computed on after-tax basis. Since interest is tax deductible and preference dividend is not, the after-tax cost of preference is/ substantially higher than the

after-tax cost of debt

Cost of Equity Capital

Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new

shares. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders’ required rate of return will be the same whether they supply funds by purchasing new shares or by foregoing dividends which could have been distributed to them. There is, however, a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the firm than the internal equity.

Is Equity Capital Free of Cost?

It is sometime argued that the equity capital is free of cost. The reasons for such argument are that it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest rate or preference dividend rate, the equity dividend rate is not fixed. It is fallacious to assume equity capital to be free of cost. As we have discussed earlier, equity capital involves an opportunity cost; ordinary shareholders supply funds to the firm in the expectation of dividends (including capital gains) commensurate with their risk of investment. The market value of the shares deter-mined by the demand and supply forces in a well functioning capital market reflects the return required by ordinary shareholders. Thus, the shareholders’ required rate of return, which equates the present value of the expected dividends with the market value of the share, is the cost of equity. The cost of external equity could, however, be different from the shareholders’ required rate of return if the issue price is different from the market price of the share. In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factors: First, it is very difficult to estimate the expected dividends Second, the future earnings and dividends are, expected to grow over time. Growth in dividends should be estimated and incorporated in the computation of the cost of equity. The estimation of growth is not an easy task.