Components of Cost of Capital

The term cost of capital refers to the maximum rate of return a firm must earn on its investment so that the market value of company’s equity shares does not fall. This is a consonance with the overall firm’s objective of wealth maximization. This is possible only when the firm earns a return on the projects financed by equity shareholders funds at a rate which is at least equal to the rate of return expected by them. If a firm fails to earn return at the expected rate, the market value of the shares would fall and thus result in reduction of overall wealth of the shareholders. Thus, a firm’s cost of capital may be defined as “the rate of return the firm requires from investment in order to increase the value of the firm in the market place”.

The three components of cost of capital are:

1. Cost of Debt

Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained later.

(a) Debt issued at par: The computation of cost of debt issued at par is comparatively an easy task. It is the explicit interest rate adjusted further for the tax liability of the company. It may be computed according to the following formula:

Kd = (l-T)R

Where,

  • Kd = Cost of debt;
  • T = Marginal tax rate;
  • R = Debenture interest rate.

The tax is deducted out of the interest payable, because interest is treated as an expense while computing the firm’s income for tax purposes. However, the tax adjusted rate of interest should be used only in those cases where the “earning of the firm before interest and tax” (EBIT) is equal to or exceed the interest. In case, EBIT is in negative, the cost of debt should be calculated before adjusting the interest rate for tax.

(b) Debt issued at premium or discount: In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realized on account of issue of such debentures or bonds. Such cost may further be adjusted keeping in view the tax applicable to the company. Cost of debt can be calculated according to the following formula:

Kd= I(1-T)/NP

Where,

  • Kd    = Cost of debt after tax.
  • I       = Annual interest payment.
  • NP   = Net proceeds of loans or debentures.
  • T      = Tax rate.

2. Cost of Preference Capital

The computation of the cost of preference capital however poses some conceptual problems. In case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while in case of preference shares, there is no such legal obligation. Hence, some people argue that dividends payable on preference share capital do not constitute cost. However, this is not true. This is because, though it is not legally binding on the company to pay dividends on preference shares, it is generally paid whenever the company makes sufficient profits. The failure to pay dividend may be better of serious concern from the point of view of equity shareholders. They may even lose control of the company because of the preference shareholders getting the legal right to participate in the general meetings of the company with equity shareholders under certain conditions in the event of failure of the company to pay them their dividends. Moreover, the accumulation of arrears of preference dividends may adversely affect the right of equity shareholders to receive dividends. This is because no dividend can be paid to them unless the arrears of preference dividend are cleared. On account of these reasons the cost of preference capital is also computed on the same basis as that of debentures. The method of its computation can be put in the form of the following equation:

Kp=Dp/Np

Where,

  • Kp  = Cost of preference share capital
  • Dp  = Fixed preference dividend
  • Np  = Net proceeds of preference shares.

In case of redeemable preference shares, the cost of capital is the discount rate that equals the net proceeds of sale of preference shares with the present value of future dividends and principal repayments.

3. Cost of Equity Capital

The computation of the cost of equity capital is a difficult task. Some people argue, as observed in case of preference shares, that the equity capital does not involve any cost. The argument put forward by them is that it is not legally binding on the company to pay dividends to the equity shareholders. This does not seem to be a correct approach because the equity shareholders invest money in shares with the expectation of getting dividend from the company. The company also does not issue equity shares without having any intention to pay them dividends. The market price of the equity shares, therefore, depends upon the return expected by the shareholders.

Conceptually cost of equity share capital may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment in a project in order to leave unchanged the market price of such shares.

From the preceding discussion, it is implied that in order to find out the cost of equity capital, one must be in a position to determine what the shareholders as a class expect from their investment in equity shares. This is a difficult proposition because shareholders as a class are difficult to predict or quantify. Different authorities have conveyed different explanations and approaches.

In order to determine the cost of equity capital, it may be divided into new equity and existing equity. The following are some of the appropriate according to which the cost of equity capital can be worked out:

(a) Dividend price (D/P) approach

According to this approach, the investor arrives at the market price of an equity shares by capitalizing the set of expected dividend payments. Cost of equity capital has therefore been defined as “the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share”.

In other words, the cost of equity capital will be that rate of expected dividends which will maintain the present market price of equity shares.

This approach rightly emphasizes the importance of dividends, but it ignores the fact that the retained earnings have also an impact on the market price of the equity shares. The approach therefore does not seem to be very logical.

The cost of new equity can be determined according to the following formula:

Ke =D/NP

Where,

  • Ke= Cost of equity capital;
  • D= Dividend per equity share;
  • NP = Net proceeds of an equity share.

In case of existing equity shares, it will be appropriate to calculate the cost of equity on the basis of market price of the company’s shares. In the present case, it can be calculated according to the following formula:

Ke = D/MP

Where,

  • Ke= Cost of equity capital;
  • D= Dividend per equity share;
  • MP = Market price of an equity share.

(b) Dividend price plus growth (D/P + g) approach

According to this approach, the cost of equity capital is determined on the basis on the expected dividend rate plus the rate of growth in dividend. The rate of growth in dividend is determined on the basis of the amount of dividends paid by the company for the last few years. The computation of cost of capital according to this approach can be done by using the following formula:

Ke = (D/NP) + g

Where,

  • Ke = Cost of equity capital;
  • D= Expected dividend per share;
  • NP = Net proceeds of per share;
  • g= Growth in expected dividend.

It may be noted that in case of existing equity shares, the cost of equity capital can also be determined by using the above formula. However, the market price (MP) should be used in place of net proceeds (NP) of the shares as given above.

(c) Earning price (E/P) approach

According to this approach, it is the earning per share which determines the market price of the shares. This is based on the assumption that the shareholders capitalize a stream of future earnings (as distinguished from dividends) in order to evaluate their share holdings. Hence, the cost of capital should be related to that earnings percentage which could keep the market price of the equity shares constant. This approach, therefore, takes into account both dividends as well as retained earnings. However, the advocates of this approach differ regarding the use of both earnings and the market price figures. Some simply use of current earning rate and the current market price of the share of the company for determining the cost of capital. While others recommend average rate of earnings (based on the earnings of the past few years) and the average market price (calculated on the basis of market price for the last few years) of equity shares.

The formula for calculating the cost of capital according to the approach is as follows:

Ke =E/NP

Where

  • Ke= Cost of equity capital;
  • D= Earnings per share;
  • NP = Net proceeds of an equity share.

However, in case of existing equity shares, it will be appropriate to use market price (MP) instead of net proceeds (NP) for determining the cost of capital.

(d) Realized Yield Approach

According to this approach, the cost of equity capital should be determined on the basis of the returns actually realized by the investors in a company on their equity shares. Thus, according to this approach the past records in a given period regarding dividends and the actual capital appreciation in the value of the equity shares held by the shareholders should be taken to compute the cost of equity capital.

This approach gives fairly good results in case of companies with stable dividends and growth records. In case of such companies, it can be assumed with reasonable degree of certainty that the past behavior will be repeated in the future also.