Accounting for cost of capital

Accounting for cost of capital

Introduction
Investment decision is major decision for an organization. Under investment decision process, the cost and benefit of prospective projects Is analyzed and the best alternative is selected on the basis of the result of analysis. The benchmark of computing present value and comparing the profitability of difference investment alternatives is cost of capital. Cost of capital is also known as minimum required rate of return, weighted average cost of capital, cut off rate, hurdle rate, standard return etc. cost not capital is determined on the basis of component cost of each source of financing and proportion of these sources in capital structure.

Meaning of cost of capital
Business firms raise the needed fund from internal sources and external sources. Undistributed and retained profit is the main source of internal fund. External fund is raised either by the issue of shares or by the issue of debenture (debt) or by both means. The fund collected by any means is not cost free. Interest is to be paid the fund obtained as debt (loan) and dividend is to be paid on the fund collected through the issue of shares. The average cost rate of difference sources of fund is known as cost of capital.

From the view point of return, cost of capital is the minimum required rate of return to be earned on investment. In other words, the earning rate of a firm which is just sufficient to satisfy the expectation of the contributors of capital is called cost of capital. Shareholders and debentures holders 9leaders) are the contributors of the capital. For example, a form needs Rs. 5,00,000 for investing and Rs. 2,00,000 from the firm can collect Rs. 3,00,000 from shares on which it must is raised and invested in the project, the firm  debentures on which  it must pay 7% interest. If the fund is raised and invested in the project, must earn at least Rs. 50,000 which becomes suffering to pay 36,000 dividend (12% of Rs. 3,00,000) and Rs. 3,00,000 share and Rs. 2,00,000) debentures). The required earning (Rs. 50,000) is 10% of the total fund raised (Rs.3, 00,000 share and Rs.2, 00,000 debentures). This 10% rate of return is called cost of capital.

In this way, cost of capital is only the minimum required rate of return of earned on investment and it is not the actual earning rate of the firm. As per above example, if the firm is able to earn only 10% all the earning will go in the hand of contributors of capital and no thin will be left in the business. Had the earning rate been more than 10%, the firm would have been able to retain the excess earning in the business. Therefore, any business firm should try to maximum the earning rate by investing in the project that a provide the rate of return which is more than the cost of capital.

Significance of cost capital
Cost of capital considered as standard of comparison for making difference business decision. Such importance of cost capital as been presented as below:
Making investment decision: cost of capital is used as discount factor in determining the net present value. Similarly, the actual rate of return of a project is compared with the cost of capital of the firm. Thus, the cost of capital has a signification role in making investment decisions.

Designing capital structure: the proportion of debt a d equity is called capital structure. The proportion which can minimize the cost of capital and maximize the value of the firm is called optimal capital structures. Cost of capital helps to design the capital structure considering the cost of each sources of financing. Investment expectation effect of tax and potentially of growth.

Evaluation the performance: cost of capital is the benchmark of evaluating the performance of difference departments. The department is considered to best with can provide the highest position net present value to the firm. The activities of difference departments are expanded or dropped out on the basis of their performance.

Formulating dividend policy: out of the total profit of a firm, a certain portion is paid to shareholders as dividend. However, the firm can retain all the profit in the business if it has the opportunity of investing in such project which can provided higher rate of return in comparison of cost of capital. On the other hand, all the profit can be distributes as dividend if the firm has no opportunity investing the profit. Therefore, cost of capital plays a key role formulating the dividend policy.

Component or specific cost of capital
The individual cost of each source of financing is called component cost of capital. The component cost is also known as the specific cost of capitals which include the individual cost of debt, preference share, and ordinary share and retained earnings. Such components of cost capital have been presented in the following chart:

Cost of debt
The cost of obtaining and using interest paying liabilities is known as cost of debt. Generally, companies borrow debt through the issuance of debentures and bonds. Thus, the cost of debt is the cost associated with the interest payment and other cost of issuing the debentures and bonds.

It is important to note that the cost of debt is computed on after tax basis because interest is a tax deducting expense. In other words, the company can deduct the interest from the income while calculating the tax. Payment of interest saves the tax which is called tax shield or tax benefit. The amount of such tax haled is equal is equal to interest x tax rate. Thus the net cost of debt is computed on the basis of interest x (1-tax rate). This rule does not apply in case of ordinary any performance shares.
Before computing the cost of debt, it is essence trial to understand the essential features of debt which are as follows:
Face value par value (FW): the value mentioned in the debentures certificate is known is par value of face value of the debentures. The debentures can be issued at any price; however, the amount of interest is calculated on the basis of face value. In brief, the principle per debentures is called face par value.

Coupon rate: the interest rate stated in the debentures certificate is known as coupon rate. Coupon rate is the simple interest rat and the amount of interest is determined on the basis of the couple rate not on the basis of the prevailing market interest rate.

Maturity (N): the time period of the loan or life of the debenture is the maturity period of the debt. For example, if a company issued debentures on Jan 1, 2010 and these debentures are repayable on Dec 31,2020, then the total time period from the date of issue (Jan 1, 2010) to final date (dec 31, 2020) is called maturity period which is 10 years.

Call provision: call provision is the clause stated in the debt contract under which the company can refund the amount of debt before the mutually period. The time at which the amount is refunded is called call period (NC) and the amount refunded is called call price (CP).

Net proceed (NP): the amount received by the company issuing the debentures after deducting all issuing expenses (except interest) is called net proceed.net proceed is compute on the basis of the following factors:
i.    Face value of premium on issue
ii.    Discount or premium on issue
iii.    Issue cost or flotation cost
On the basis of above information net proceed can be computed as below:
Net proceed (NP) = gross selling price- flotation cost
=face value+ premium (or- discount) - flotation cost

Cost of perpetual debt
The debt on which maturity period is not give is called perpetual or irredeemable debt. The cost of such bond is computed as below:
Condition I: when the bond is selling at face value:
Kdt= interest rate x (1-tax rate) = kb (1-t)
Condition II: when the bond is selling below or above the face value:
Kdt= 1/NP x (1-t)

Cost of debt issued on redeemable condition
In most cases, the face value of debt is referenced at the end of maturity period. However, some bonds and debentures are repayable at premium or discount. In such condition, the amount of interest is computed on the basis of face value and the cost is compute on the basis of redemption value.
Cost of callable debt
The debt which is refundable by the company before the maturity period is called callable debt. The time at which the amount is refunded is called call period (NC) and the amount refunded is called call price (CP).

Cost of preference share or preferred stock
Preference shares are those shares which have the prior right on the dividend and refund of capital in case of liquidation of company. Like debentures, preference shares have the following features:

Face value or par value: the value or price stated on the share certificate is called face value. The dividend is computed on the basis of face value. The share's market price may be difference from the face value depending upon the financial condition of the issuing company.

Dividend rate: the rate of dividend payable on preference share is predetermined. On the basis of such dividend rate and face value of share, the amount of dividend is determined as below:
Dividend per share (DPS) = face value x dividend rate
Total dividend = face value x dividend rate x no of preference share

Maturity period: maturity period is mentioned on the preference shares if such shares are redeemable after some years in future. Generally, maturity period is not mentioned on the preference share and such share are called irredeemable shares.

Net proceed (NP): the amount by the company issuing the preference shares after deducting all issuing expenses is called net proceed. Net proceed is computed on the basis of the following factors:
i.    Face value of the share
ii.    Discount or premium on issue
iii.    Issuing cost or flotation cost

On the basis of above information net proceed can be computed as below:
Net proceed (NP)= gross selling price – flotation cost

Cost of perpetual preference shares
Like debt, the preference in which maturity period is not mentioned is called perpetual preference share, the cost such preference share is determined as given below:

Condition I: when the preference share is selling at face value:
Kp= dividend rate
Condition II: when the preference share is selling below or above the face value;
KP= DPS/MPS or D/NP

Cost of redeemable preference shares
Like debt, the preference in which maturity period is mentioned is called partial preference share.
Cost of ordinary/ equity shares or common stock
The shares on which dividend rate is not predetermined and maturity period is not stated are called ordinary shares. Ordinary shareholders are the real owners of the company any they have the voting right. Ordinary shareholders received the receive the residual income. I.e. the income left after paying the interest to debt-holders and dividend to preference shareholder. Thus, the amount of dividend payable to ordinary shareholders is pre-determinable.

Since, the amount of dividend payable to ordinary shareholders is pre-determinable; the cost of ordinary share is calculated either on the basis of earning per share or by estimating the expected dividend on the basis growth rate of past dividend. Difference approaches of calculating cost of ordinary shares are as given below:
a.    Earning yield approach
When the earning per share or net income after tax is given and there is no information regarding the dividend of ordinary share, the cost of ordinary share can be calculated on the basis of earning and market price of shares as shown below:
Ke = earnings per share/ market price share

b.    Dividend yield approach
When the dividend per share or total equity dividends given there is no information regarding the growth rate, the cost of equity share can be calculated on the basis of dividend and market price of shares as shown below:
Ke= dividend per share/ market price share

c.    Dividend yield plus growth rate approach
This is the most popular method of determining the cost of equity share. Under this method, the cost of equity is determined on the basis of the following information:

Current dividend (D0) = the dividend which has been recently paid and reference as last year's dividend, previous dividend, past dividend etc.
Growth rate in dividend (g): the rate at which the annual earning or dividend is increasing. When the growth rate is not given, ct can be computer on the basis of past dividend or earning.
Expected dividend (d1): the dividend which will be paid to the shareholders in the recent future is called expected dividend. It is also referred as next dividend, coming dividend, future dividend; subsequent dividend etc. on the basis of current dividend and past growth, the expected dividend can be computed as below:
Expected dividend= current dividend (1+ growth rate)

Net proceed or net market price (NP): the net selling price of share after deducting all kinds of issuing expenses is known as net proceed. The expense incurred in the process of issuing the share is called floatation cost. Flotation cost includes brokerage fee, commission and other publicity and administration expenses. Net proceed is determined as follows:
Net proceed (NP) = gross selling price – flotation cost

Determination of growth rate
When growth rate is not given, it can be computed by using the following two methods:
i.    When  dividend payout ratio and return on investment is given:
Growth rate= = ( 1- dividend payout ratio) x rate of return
ii.    When past years dividend or earning is given, the growth rate can be determined by solving following equation:
Dn = D0 (1+g) n 

Cost of retained earning
The portion of net profit distributed to shareholders is called dividend and the remaining portion of the profit is called rationed earning. In other words, the amount of undistributed profit which is available for investment is called retained earnings or plashing back of profit. Retained earnings are considered as internal source of long-term financing and it is a part of shareholders equity.

Generally, the retained earnings are considered as cot free source of financing. It is because neither netiher dividend nor interest is payable on retained profit. However, this statement is not true. A shareholder of the company that retains more profit expects more income in future than the shareholders of the company that pay more dividends and retains less profit. Therefore, there is an opportunity cost of retained earnings. In other words, retained earnings is not a cost free source of finaing.The cost of retained earning must be at least equal to the shareholders rate of return on re-investment of dividend paid by the company.

In the absence of any information relating to addition cost of re-investment and extra burden of personal tax, the cost of retained earnings is considered to be equal to the cost or equity. However, the cost of retained earnings differs from the cost of equity when there is foliation cost to be paid by the shareholders on re-investment and personal tax rate of shareholders exists.

i.    Cost of retained earnings when nether is no flotation cost and personal tax rate applicable for shareholders (not for company):
Cost of retained earnings (Kr) = cost of equity (Ke) = D1/NP + g
ii.    Cost of retained earnings when there is flotation cost and personal tax rate application for shareholders (not for company)
Cost of retained earnings (Kr) = cost of equity x (1-fp) (1-tp)

Weighted average cost of capital (WACC)
Generally, projects are evaluated on the basis of overall cost of capital, not on the basis of specific cost of capital. The product of components cost of capital is known as weighted average cost of capital. In other words, weighted average cost of capital is the minimum required rate of return to be earned on investment. Therefore, it is computed on the basis of the proportion of the funds from which the funds has been raised and their respective proportion.

To make clear the concept of weighted average cost of capital, the previous example can be re-mentioned here. For example, a firm needs Rs. 5, 00,000 for investing in a new project. The firm can collect Rs. 3,00,000 from share on which it must pay 12% dividend and Rs. 2,00,000 from debentures collect Rs. 3,00,000 from shares on which it must pay 12% dividends an d Rs. 2,00,000 from debentures on which it must pay 7% interest. If the fund is raised and invested in the project, the firm must earn at least Rs. 50,000 which becomes sufficient to pay Rs. 36,000 dividend (12% of Rs. 3, 00,000) and Rs. 14,000 interest (7% of Rs. 2, 00,000). The required earning (Rs. 50,000) is 10% of the fund raised (Rs. 3, 00,000 share and Rs. 2, 00,000 debentures). This 10% rate is called weighted average cost of capital.

Weighted average cost of capital is computed as follows:
Step I: calculation of component or specific cost of capital.
•    After tax cost of debt (kdt)
•    Cost of preference share(Kp)
•    Cost of equity share (ke)
•    Cost of retained earnings (kR)
Step II: calculation of proportions or weight of source of capital:
•    Proportion or weight of debt (Wd) = amount of debt/ total capital
•    Weight of preference share (Wp) = amount of preference share/ total capital
•    Weight of equity share (We)= amount of equity share/ total capital
•    Weight of retained earnings (Wr)= amount of retained earnings/ total capital
Step III: calculation of weighted average cost of capital (WACC):
WACC= wd x kdt + Wp x Kp + We x Ke + Wr x Kr