COST OF CAPITAL (THEORY)

Q.1. How will you compute the cost of debt capital?

Debt has two types of costs:
(a) Explicit or Direct Costs and
(b) Implicit or Indirect Costs

(a) Explicit or Direct Costs refer to the interest rate adjusted for tax savings and the cost of raising funds.
(b) Implicit or Indirect Costs refer to the risk associated with debt, reflected in the increase in expectations of equity shareholders and the rise in cost of equity capital.

EXPLICIT COST OF DEBT CAPITAL -denoted as K_d

Cost of Irredeemable Debt	Cost of Redeemable Debt
Interest x 100% -Tax Rate	Interest x 100%-Tax Rate + RV –Net Proceeds /N
Net Proceeds of Issue	RV + Net Proceeds / 2

Q.2. Do retained earnings have a cost ?

• Cost of Retained Earnings or Reserves are generally taken as the same as Cost of Equity. This is because, if earnings are paid out as dividends without being retained, and simultaneously a rights issue is made, the investors would be subscribing to the issue based on some expected return. This is taken as the indicator of the Cost of Reserves or Retained Earnings.

• If the Growth or Realised Yield approach is adopted, Cost of Reserves is automatically included in "g" and hence Cost of Reserves should not be considered separately

Q.3. What are the Criticism of Dividend Growth Model?

The Dividend growth model is criticised on the following reasons:
1. The future growth pattern is impossible to predict because it will be inconsistent and uneven.
2. Due to uncertainty of future and imperfect information, only historic growth is to used for prediction of future growth.
3. Calculation only cost of equity capital ignoring the cost of other forms of capital may not be valid.

The dividend growth depend on the retained earnings of the company and the growth is difficult to assume.

Q.4. What are Weights to be used in Weighted Average Cost Capital?

The weighed average cost of capital of a company in calculated in two ways.
# Based on weight of costs by the book value of the different forms of capital.
# Based on weight of market value of each form of capital. The market Value approach is more realistic for the reasons given below;
# The cost of funds invested at market prices is familiar with the investors.
# Investments are generally rated by the reference to their earnings yield, and the company has a responsibility to maintain that yield.
# Historic book values have no relevance in calculation of real cost of capital.

The market value represents near to the opportunity cost of capital.

Q.5. Marginal Cost of Capital

The entire theoretical base of the cost of capital leading to the computation of the weighted average cost of capital is based on the premise that, with the adoption of new investment proposals neither the capital structure nor the risk complexion of the firm changes. However in reality, it is not so. The concept of seniority of debt for one causes the creditors to demand greater rate of interest for fresh debt, which is considered riskier.

A schedule showing the relationship between additional financing and the WACC is called the weighted marginal cost of capital. The marginal cost of capital is calculated by taking a weighted average of the marginal costs of each component in proportion to the respective amounts of each that the firm will raise.

The use of WACC assumes that the capital structure of an entity will remain unchanged and that any new investments will have a similar risk profile to existing investments. If a large project is under consideration, and it would fundamentally affect the capital structure of an entity, these assumptions would mean that WACC is no longer the appropriate technique for investment appraisal. Use of W ACC could lead to the acceptance of projects that reduce the entity's value. The relevant cost of capital is now arguably the incremental cost, i.e. the marginal cost reflecting the changes in the total cost of the capital structure before and after the introduction of the new capital.

The schedule of WMCC can be computed as follows:

Step 1.
Estimate the cost of each source of financing for various levels of its use through an analysis of current market conditions and an assessment of the expectations of investors end lenders. (The portion of new financing provided by equity shares will be taken from available retained earnings until exhausted, and then obtained through newequity financing. Since the retained earnings are a less expensive form of equity financing than the sale of new equity shares it should be clear that once retained earnings have been exhausted, the weighted average cost of capital will rise with the addition of more expensive new equity shares.

Step 2.
Determine the pattern of raising additional finance.

Step 3.
Identify the levels of total new financing at which the cost of new components change, given a capital structure.

Step 4.
Calculate the WACC for the various ranges of total financing between the breaking points.

Step 5.
Calculate the overall WMACC.

USE OF WMCC FOR DECISION MAKING
The WMCC should be used in conjunction with the firm's available investment opportunities in order to choose investments to be implemented. As long as a project's internal rate of return is greater than the weighted marginal cost of new financing to be used to finance the project, the project should be accepted. As a firm increases the amount of money available for investment, in capital projects, the return on the projects will decrease since generally the first project accepted would have the highest return, next project selected would have second highest return, and so on. On other words, the return on investment will decrease as the firm accepts additional projects. At the same time as more projects are accepted, the weighted marginal cost of capital will increase since greater amounts of new financing will be required. The firm would therefore accept projects up to the point where the marginal return On its investment just equals its weighted marginal cost of capital, since beyond that point its investment return will be less than its capital cost.

Q.6. Detailed discussion & analysis on CAPM & Beta.

The CAPM argues that total risk can be divided into specific and market risk, the latter subdivided into business and financial risk. As per CAPM, specific risk, which is also known as unsystematic risk, can be reduced through diversification whereas market or systematic risk cannot be reduced through diversification. Market risks can be due to regular business operations or due to the presence of debt in the capital structure e.g. shareholders of a company, which has a high incidence of debt in its capital structure, shall face higher risk due to a high interest payment the company shall need to make. The CAPM predicts the relationship between the risk and expected return on risky assets. It provides a useful decision-making framework for investors, by providing a measure for risk that can be quantified and operationalised by them. The model is built on the platform that appropriate risk premium on an equity will be computed by its contribution to the overall risk of an investors portfolio. If an investor's portfolio represents market portfolio, then the only risk, which shall remain, is the systematic risk (β or Beta). It represents that risk which cannot be eliminated by diversification. Therefore, contribution of a single security to the risk of a large diversified market portfolio depends only upon its systematic risk as measured by its β /beta (sensitivity of a security with that of the market). Hence it can be said that the risk premium of equity is proportional to its beta (β), that is, risk premium increases as beta/ β increases and vice versa.

Assumptions of the CAPM

The most important assumptions underlying the CAP model are as follows;
1. All investors aim to maximise their expected utility of wealth.
2. All investors operate on a common single period planning horizon.
3. All investors select from alternative investment opportunities by looking at expected returns and risk.
4. All investors are rational risk averters.
5. AH investors can lend and borrow unlimited amounts at a common rate of interest.
6. There are no transaction costs entailed in trading securities.
7. No investor can influence the market price by the scale of his own transactions.
8. All securities are highly divisible i.e. can be traded in small units.

CRITICISM OF THE CAPM
AS with most financial theories, there are a number of difficulties in putting them into practice and the CAPM is no exception. Some of the problems which managers face while using this model are as follows;

• The CAPM is a single period model. Although it can be adopted for a multi period use, the assumptions necessary shall reduce the reliance that can be placed on the model.

• CAPM ignores transaction costs.

• Beta value is a historical value. The use of historical values for future projections has its own limitations. There are chances that companies change considerably over a period of time in their capital structures and cost structures or through changes, which affect their core market.

• It is hard to accept that only market risk matters because specific risk can be diversified away. This level of diversification of project investment is just not available to most companies. Also, although institutional investors may be able to spread their investments over a wide range of shares, many individual investors may be willing to accept total risk if justified by the likely returns. However, CAPM does not allow for irrational behaviour.

• Even within one year, there can be significant variations from the mean in respect of market returns and even in risk free returns, so that it is quite often difficult to determine the excess return or even the risk free rate, which is itself likely to vary for macroeconomic reasons.

• CAPM depends on an efficient investment market. However, the various stock market crashes which the Indian and foreign markets have witnessed of late put a serious question mark over market efficiency.

The assumption that a well-diversified portfolio is subject to systematic risk alone is also questionable. A large investment in a company facing corporate collapse can well put a dent on a well-diversified portfolio also.

• Volatile companies shall use a high hurdle rate for investment decision-making. This could lead to loss of valuable investment opportunities.

Q.7. Origin of Economic Value Added (EVA)

The term Economic Value Added (EVA) is a registered trade mark of Stern Stewart & Co. U.S.A. This term is of recent origin. The recent thinking is that economic value added is the true measure of corporate surplus or effectiveness. Stern Stewart is best known for their proprietary EVA, framework, which FORTUNE magazine has called today's holiest financial idea and getting hotter. AT&T, Coca-Cola, Smith Kline Beechain, Whirpool are some of the companies that have successfully adopted EVA.