Module 5. Investment decision

Lesson 29

Cost of Capital

A company's cost of capital is the weighted average cost of various sources of finance used by it, viz., equity, preference, and debt.

Suppose that a company uses equity, preference, and debt in the following proportions, 50, 10, and 40. If the component costs of equity, preference, and debt are 16 percent, 12 percent, and 8 percent respectively, the weighted average cost of capital (WACC) will be:

WACC = (Proportion of equity) (Cost of equity) + (Proportion of preference) (Cost of preference) + (Proportion of debt) (Cost of Debt)

= (0.5) (16) + (0.10) (12) + (0.4) (8) = 12.4 Percent

Bear in mind the following in applying the above formula

  • For the sake of simplicity, we have considered only three types of capital (equity nonconvertible, noncallable preference,; and nonconvertible, noncallable debt). We have ignored other forms of capital like convertible or callable preference, convertible or callable debt, bonds with payments linked to stock market index, bonds that are puttable or extendable, warrants, so on and so forth. Calculating the cost of these forms of capital is somewhat complicated. Fortunately, more often than not, they are a minor source of capital. Hence, excluding them may not make a material difference.
  • Debt includes long – term debt as well as short – term debt (such as working capital loans and commercial paper). Some companies leave out the cost of short – term debt while calculating the weighted average cost of capital. In principle, this is not correct. Investors who provide short – term debt also have a claim on the earnings of the firm. If a company ignores this claim, it will misstate the rate of return required on its investments.
  • Non – interest bearing liabilities, such as trade creditors, are not included in the calculation of the weighted average cost of capital. This is done to ensure consistency and simplify valuation. True, non – interest bearing liabilities have a cost. However, this cost is implicitly reflected in the price paid by the firm to acquire goods and services. Hence, it is already taken care of before the free cash flow is determined. While it is possible to separate the implicit financing costs of non – interest bearing liabilities from the cash flow, it will make the analysis needlessly more complex, without contributing to the quality thereof.

Rationale The rational for using the WACC as the hurdle rate in capital budgeting is fairly straightforward. If a firm's rate of return on its investment exceeds its cost of capital, equity shareholders benefit. To illustrate this point, consider a firm which employs equity and debt in equal proportions and whose cost of equity and debt are 14 percent and 6 percent respectively. The cost of capital, which is the weighted average cost of capital, works out to 10 percent (0.5x14 + 0.5x6). If the firm invests Rs. 100 million, say, on a project which earns a rate of return of 12 percent, the return on equity funds employed in the project will be:

Total return on the project – Interest on debt = 100(0.12) – 50 (0.06) = 18 percent

Equity funds 50

Last modified: Monday, 8 October 2012, 9:08 AM