The cost of capital of a firm is the minimum rate of return which the firm must earn on its investments in order to satisfy the expectations of investors who provide funds to the firm.
It is the weighted average of the cost of various sources of finance used by it. The method of computing the cost of capital is to compute the cost of each type of capital and then find the weighted average of all types of costs of capital.
In other words, two steps are involved in determination of cost of capital of a firm:
(i) computation of cost of different sources of capital,and
(ii) determining overall cost of capital of the firm by weighted average or total cost divided by total fund.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The capital funding of a company is made up of two components: debt and equity. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so weighted average cost of capital tells the return that both stakeholders, equity owners and lenders can expect.
WACC, in other words, represents the investors’ opportunity cost of taking on the risk of putting money into a company. This is the weighted average cost of capital.
Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.
The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken to be proportion of each source of funds in the capital structure. While, making financial decisions this overall or weighted cost is used. Each investment is financed from a pool of funds which represents the various sources from which funds have been raised.
Any decision of investment thus, has to be made with reference to the overall cost of capital and not with reference to cost of a specific source of fund used in that investment decisions.
The weighted average cost of capital (WACC) is calculated by :
1) Calculating cost of specific sources of funds, e.g. cost of debt, etc.
2) Multiplying the cost of each source by its proportion in capital structure.
3) Adding the weighted component costs to get the firm’s WACC. Thus, WACC is ,
K0 = K1W1 + K2W2 +………….
K1, K2 are component costs and W1, W2 are weights.
The weights to be used can be either book value weights or market value weights. Book value weights are easier to calculate and can be applied consistently. Market value weights are supposed to be superior to book value weights as component costs are opportunity costs and market values reflect economic values. However, these weights fluctuate frequently and fluctuations are wide in nature.
Securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, WACC is used as the discount rate applied to future cash flows for deriving a business’s net present value.
WACC can be used as a hurdle rate against which to assess return on investment capital performance. It also plays a key role in economic value added (EVA) calculations.
Investors use WACC as a tool to decide whether or not to invest. The WACC represents the minimum rate of return at which a company produces value for its investors.
Therefore, WACC serves as a useful reality check for investors.
Marginal Cost of Capital
The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the capital is raised in substantial amount in practice marginal cost is referred to as the cost incurred in raising new funds.
Marginal cost of capital is derived, when the average cost of capital is calculated using the marginal weights. The marginal weights represent the proportion of funds the firm intends to employ.
To calculate the marginal cost of capital, the intended/proposed financing proportion should be applied as weights to marginal component costs. The marginal cost of capital should, therefore, be calculated in the composite sense.
When a firm raises funds in proportional manner and the component’s cost remains unchanged, there will be no difference between average cost of capital (of the total funds) and the marginal cost of capital. The component costs may remain constant upto certain level of funds raised and then start increasing with amount of funds raised.
For example, the cost of debt may remain 7% (after tax) till Rs. 10 lakhs of debt is raised, between Rs. 10 lakhs and Rs. 15 lakhs, the cost may be 8% and so on. Same is the case with equity capital. When the components cost start rising, the average cost of capital will rise and the marginal cost of capital will however, rise at a faster rate.
Modigliani and Miller approach to Cost of Capital:
Modigliani and Miller’s argue that the total cost of capital of a particular corporation is independent of its methods and level of financing.
According to them a change in the debt equity ratio does not affect the cost of capital. This is because a change in the debt equity ratio changes the risk element of the company which in turn changes the expectations of the shareholders from the particular shares of the company. Hence they contend that leverages has little effect on the overall cost of capital or on the market price.
Modigliani and Miller made the following assumptions and the derivations there from:
(i) Capital markets are perfect. Information is costless and readily available to all investors, there are no transaction costs; and all securities are infinitely divisible. Investors are assumed to be rational and to behave accordingly.
(ii) The average expected future operating earnings of a firm are represented by a subjective random variable. It is assumed that the expected values of the probability distributions of all investors are the same. Implied in the MM illustration is that the expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.
(iii) Firms can be categorised into “equivalent return” classes. All firms within a class have the same degree of business risk.
(iv) The absence of corporate income taxes is assumed.
Their three basic propositions are :
(i) The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalizing the expected stream of operating earnings at a discount rate considered appropriate for its risk class.
(ii) The cost of equity (ke) is equal to capitalization rate of pure equity stream plus a premium for financial risk. The financial risk increases with more debt content in the capital structure. As a result, ke increases in a manner to offset exactly the use of less expensive source of funds.
(iii) The cut-off rate for investment purposes is completely independent of the way in which the investment is financed. This proposition alongwith the first implies a complete separation of the investment and financing decisions of the firm.
The theory propounded by them is based on the prevalence of perfect market conditions which are rare to find. Corporate taxes and personal taxes are a reality and they exert appreciable influence over decision making whether to have debt or equity.
Relationship between the financial leverage and firm’s required rate of return to equity shareholders with corporate taxes is given by the following relation:
rE = r0 + D/E(1-TC)(rO-rB)
rE = required rate of return to equity shareholders
r0 = required rate of return for an all equity firm
D = Debt amount in capital structure
E = Equity amount in capital structure
TC = Corporate tax rate
rB = required rate of return to lenders