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How Interesting Part I-cost of Capital Cost of capital is the minimum rate of return on an investment required to keep the market value of equity capital unchanged.
Let’s see the types of cost of capital, how it gets calculated and how the rate of return, cost of capital is related to market value of the security.
First see for equity capital,
Let A Ltd requires total investment of Rs. 100 lakh and the debt equity ratio of the company is 3:2, debt has interest rate of 15%, tax rate is 40% and expected EBIT is Rs. 29 Lakhs.
Debt 3 ------ = ---- , Equity 2
Debt Fund = 100x3/5 = 60 lakhs Equity Fund=100x2/5= 40 lakhs
Now,
EBIT = 29 lakhs Less Interest @ 15 % on 60 lakhs 9 lakhs Hence, EBT = 20 lakhs
Less tax @40%= 8 lakhs NIAT ( Earnings for equity shareholders) = 12 lakhs
Hence, rate of equity return (k) = 12*40/100 = 30 %
Now, if the market value of equity increases after this return, then k (cost of capital) would be lower than 30% and if market value of equity decreases then cost of capital will be greater than 30%. Lets assume that market value of equity capital increases to 50lacs then the required cost of capital would be 12*100/50=24%
Lets assume that the market value of equity has reduced to 30lacs then k would be 12*100/30=40%
K= is the rate of discount at which the sum of the present value of all the future streams of returns from that source of finance plus its redemption value equals its present market value.
Now Cost of capital for debt fund, 0 Pc= ? Da / (1+r) ª + P0 / (1+r)? a=1
Pc= Present market value, Dt= Interest or dividend per security in the a th year, a=1,2,……….n. P0= Redemption value at the year end 0(=n); O=Total number of years.
e.g. A Company has 12% debentures (Rs. 100 each) redeemable after 3 years at a premium of 10%% tax rate 50% . Calculate the pretax cost of capital and post tax cost of capital: P0=98, 3 P0=98=? 12/(1+r)³ + 110/(1+r)³ , log 98= log12+ log(1+r)ª+log110; A=1
98 = 12/1+r +12/(1+r)² +12/(1+r)³+110/(1+r)³
98 = 12( 1/1+r +1/(1+r)²+1/(1+r)³)+ 110/(1+r)³
let 1/(1+r) = x,
98 = 12(x+x²+x³) + 110 x³ 122x³+12x²+12x -98 = 0
When x=1, 122+12+12-98=0 =>146-98=48 It is not true, and x must be <0, Put x = .05 ð 15.25+3+6-98=0 ð 24.25-98=0 ð 0.5 Put x=0.8 62.464+7.68+9.6-98=0 79.744-98=0 => x?0.8 Putx = .86 77.59+8.875+10.32-98 hence x is near to 0.86, Say x=.86, 1/1+r =.86 1+r=100/86 r=100-86/86=14/86*100 =16% There are other funds also for which K is required to be known for each company and for each of its resources. The other funds are its reserves and surplus, its non real funds like depreciation etc. This is just to discuss about cost of capital for equity fund and debt fund. The other fund and how the cost of capital is gets calculated will be discussed in the next part of the article. The next part will also discuss the same and its relation as well as use in different managerial topics keeping the interest for the same term on the level while enhancing the intention and test to know more about what this small thing is and how it gets used in different managerial perspectives.
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Article Tags: Minimum, Rate Of Return, Required, Unchanged, Equity Capital, Cost Of Capital, K, To Keep, The Market Value Article Source: http://www.articlesbase.com/tutoring-articles/how-interesting-part-icost-of-capital-457041.html About the Author:
ICWA, 5years Industrial experience in Auditing,Marketing,Accounting, Research,Publication,Teaching and Finance.
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