COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
Subject COMMERCE
Paper No and Title Paper No 8: Financial Management Module No and Title Module No 17: Combined Cost of Capital
Module Tag COM_P8_M17
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
TABLE OF CONTENTS
1. Learning Outcomes
2. Combined Cost of Capital – Concept 3. Calculation of Combined Cost of Capital
3.1 Historical Weights 3.2 Marginal Weights
4. Weighted Marginal Cost of Capital 5. Practical Illustrations
6. Summary
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
1. Learning Outcomes
After studying this module, we shall be able to:
Learn the concept of Overall or Combined Cost of Capital
Calculate the Combined Cost of Capital or Weighted Average Cost of Capital
Know alternative weighting schemes for calculation of WACC
Learn the concept of Weighted Marginal Cost of Capital
Solve practical illustrations
2. Combined Cost of Capital - Concept
Once the company calculates the specific cost of capital for individual sources of finance in the firm’s capital structure, like the cost of debt, cost of preference share capital, cost of equity share capital and cost of retained earnings, the next step is to calculate the company’s overall cost of capital by combining all these individual costs together depending upon the weights that each source of finance has in the firm’s overall capital structure. That is the reason, the terms weighted average cost of capital and overall or combined cost of capital is used interchangeably. The firm can calculate the overall cost of capital for different alternative capital structures and choose the one that minimizes the cost, because the lower a company's WACC, the cheaper it is for a company to fund new projects.
Weighted Average Cost of Capital (WACC) simply refers to the cost that would be undertaken by the firm on an average to raise money. The importance of the WACC in the evaluation of projects makes the concept of WACC a significant one. Determining an accurate cost of capital is very important as it is used to analyze the capital budgeting decisions of a firm to see whether a future project will yield profits or not. In various capital budgeting decisions, Cost of Capital is taken as the key factor in evaluating and deciding the project to be chosen out of various alternative proposals that the management have. The firm, naturally, will choose the project that gives a higher return on investment. In no case, such project would have return on investment that will be less than the cost of capital incurred for its financing.
WACC can be used as a tool by investors to take their investment decision. They can compare the company’s overall cost of capital or WACC with the return that it can produce for its investors.
For instance, if a company produces a return of 17% and has a WACC of 12%, that means the company is creating value for its investors. However, if the company is able to produce a return of only 10% as against its WACC of 12%, the company is shedding value, which indicates that investors should put their money elsewhere.
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
WACC can also be used as a hurdle rate to assess Return on Invested Capital, ROIC performance.
The return on invested capital measure gives a sense of how effectively the funds employed by a firm are being utilized to generate returns. WACC is used as a cut off rate by comparing it with the company's return on capital (ROIC). It would reveal whether invested capital is being used effectively. WACC plays a key role in Economic Value Added, EVA calculations as well.
3. Calculation of Combined Cost of Capital
WACC is a way to calculate the Combined Cost of a company's capital that gives different weight to different components of capital based upon their proportion in the company’s capital structure instead of taking the simple average of all costs together. The simple average cost of capital may not be appropriate because there is hardly a firm that employs equal proportion of various sources of finance.
The basis of determining WACC is to determine the specific costs of each of the sources of long term financing for the firm individually, assign weights to these individual sources of finance depending upon the degree to which the firm uses these sources, and then, simply add up the weighted costs, that is the product of individual cost with their respective weights.
Therefore, following are the Four Steps involved in calculation of WACC:
1. Calculate the specific cost of each source of fund
2. Find out the weight or proportion of each source of fund in the total capital structure of the firm.
3. Multiply the specific cost of each source of funds with their respective proportion.
4. Add the weighted component cost calculated in Step 3 above to get WACC.
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
For instance, think of a company that makes use of only two sources of financing; debt and equity. Let E be the value of all of the common stock of the firm and D be the value of all of the debt of the firm (We can assign the value to debt and equity either on the basis of their Book Value or Market Value). Thus E+D must be the total value of the firm. Let Kd be the after tax cost of debt financing and let Ke be the costs for equity financing. The WACC for this firm will be:
d
e K
D E K D D E
WACC E
This equation is the same as saying:
In the previous modules on cost of capital, we have learnt the calculation of specific cost of capital for each individual source of finance. Now, next step is the assignment of weights. The weights can be assigned on the following three basis:
Historical Weights
Marginal Weights
Target Weights
Historical Weights
These are based upon existing capital structure. It assumes that additional finance will be raised in the same proportion as the proportion of funds in the existing capital structure. It is based upon the assumption that the existing capital structure is optimum.
Marginal Weights
WACC = (percent of the firm that is equity) times (cost of equity) plus (percent of the firm that is debt) times (cost of debt)
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
These are based upon the proportion of funds in which the new capital will be raised. It is quite logical because it is very unlikely that a company is able to raise additional funds in the same proportion as they are in the existing capital structure.
The concept of Historical weights and Marginal weights can be made clearer with the help of following example:
Suppose there is a company with its present capital structure comprised of Equity and Debt. Out of total capital of Rs. 50,000; debt component is 20,000 and equity component is 30,000. Now, if the company wants to raise additional finance of Rs. 20,000; it has two options:
First, it can raise the additional Rs. 20,000 in the same proportion of its existing capital structure, i.e., Rs. 8,000 or 40% through debt and Rs. 12,000 or 60% through equity.
Second, it can raise additional Rs. 20,000 in any proportion without referring to the existing capital structure.
If the company goes for first option, it would have said to use Historical weights, and if the company goes for second option, it would have said to use Marginal weights.
Target Weights
Target weights are either Book Value or Market value weights based on desired capital structure proportions.
3.1 Historical Weights
The historical weights can further be divided into two types:
Book Value Weights
Market Value Weights
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
WACC calculated using the Book value weights is generally lower than the WACC calculated on the basis of Market value because the market value of the capital components is usually higher than the book value.
For instance, M Ltd. has the following Capital Structure:
Book Value (Rs.) Market Value (Rs.) Equity Share Capital
(25,000 shares of Rs. 10 each)
2,50,000 4,50,000
14% Preference Share Capital (500 shares of Rs. 100 each)
50,000 45,000
Reserves and Surpluses 1,50,000 -
12% Debentures
(1500 Debenture of Rs.100 each)
1,50,000 1,45,000
These are the weights that use accounting values to measure the proportion of each type of capital in the firm’s financial structure
Book value weights
These are the are weights that use market values to measure the proportion of each type of capital in the firm ’ s financial structure.
Market value weights
The expected dividend per share is Rs.1.40 and is expected to grow at 8% forever. The cost of equity is 15.77%. The preference shares are redeemable after 5 years at par and debentures are redeemable after 6 years at par. Cost of preference share is 16.84%. Tax rate is 50% and cost of debentures is 6.66%
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
The WACC (Ko) can be calculated by using the following formula:
On the basis of Book Value Weights:
Ko = (2,50,000/6,00,000)*15.77 + (1,50,000/6,00,000)*15.77 + (50,000/6,00,000)*16.84 + (1,50,000/6,00,000)*6.66
Ko = (0.417*15.77 + 0.25*15.77 + 0.083*16.84 + 0.25*6.66)
Ko = 6.57 + 3.94 + 1.397 + 1.665
Ko = 13.572%
*Internal cash in hand or retained earnings are part of the equity of the firm. Therefore, cost of retained earnings is taken as equal to the cost of equity except in the presence of floatation cost.
There are no flotation costs for the use of retained cash flow, while there are for new issues of stock.
On the basis of Market Value Weights:
Ko = (4,50,000/6,40,000)*15.77 + (45,000/6,40,000)*16.84 + (1,45,000/6,40,000)*6.66
Ko = (0.7031*15.77 + 0.0704*16.84 + 0.2265*6.66)
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
Ko = 11.0878 + 1.1855 + 1.5085
Ko = 13.782%
Under market value weights, there is no separate cost of retained earnings. It is the same as cost of equity because retained earnings belong to equity shareholders only and therefore, it is included in the market value of equity.
However, the insufficiency of the Retained Earnings to cover the required equity financing, will increase the WACC because a new stock issue will be needed and this involves floatation costs which are now included in the cost of equity.
Both Book Value weights and Market value weights have some advantages over the other, but they are also not free from the flaws. There are some drawbacks as well for both of them.
Let us first discuss the merits and limitations of Book Value weights.
The book value weights are generally preferred by managers for calculating WACC because of the following advantages associated with Book Value weights:
The book value information is easily available from the company’s annual report.
It is simple to use.
The capital structure targets are usually fixed in terms of book value.
It is easier to evaluate the performance of a management in procuring funds by comparing on the basis of book values.
However, there are some limitations of Book Value weights as well, which can be seen as:
Book values are based on arbitrary accounting policies and thus, do not reflect the true economic value.
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
They cannot be justified on theoretical grounds.
On the other hand, Market Value weights are preferred and considered to be theoretically superior to Book Value weights because they reflect true economic values and are also not affected by the accounting policies. The other points favoring Market Value weights are:
The sale price of securities is more close to the market value.
Costs of specific sources of finance which constitute the capital structure of the firm are also calculated using prevalent market prices.
But, Market Value weights are also not free from the limitations. There arises difficulty in using them because:
Market Value is subject to frequent and wide fluctuations, so they need to be normalized first to calculate the weights.
Sometimes, current Market Value is not available easily.
3.2 Marginal Weights
Marginal weights refer to the proportions in which the firm wants or intends to raise additional funds from different sources without any reference to the proportion of funds in the existing capital structure of the company. The basis of assigning weights is new and hence called marginal weights. Marginal weights are better because it is the new capital being raised for new investment that is important so the weighted cost of new capital is of relevance.
The other features justifying Marginal weights system are:
The firm may be using some source of finance in its existing capital structure, which may not be available currently. So, there is no use of including its weight for calculating the WACC.
It is practically very difficult for the firm to raise the additional funds in the same proportion as employed in the existing capital structure, because the current scenario
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
might not favour the same. The reasons can be the firm’s poor performance or bad state of capital market, which does not allow firm to raise capital in the existing proportion.
This will give more freedom to the finance manager to raise funds after analyzing the costs and benefits associated with different sources of finance. For instance, if the new debt is available at a cheaper interest rate, the manager can finance the additional capital more through debt as compared to equity.
However, the Marginal weights system also suffers from the following limitation:
The main problem is that if we go by marginal weighting, we may resort to too much borrowing and accept many projects because of lower cost at the moment. But, at a later date, company may have the problem of raising more finance. Marginal weights ignore long term view.
Thus, the fact that today’s financing affects tomorrow’s costs, is not considered in using marginal weights.
Following points should be noted while calculating the overall cost of capital:
For computational convenience, it is best to convert the weights into decimal form and leave the individual costs in percentage terms.
The weights must be non-negative and sum to 1.0. In other words, WACC must account for all financing costs within the firm’s capital structure.
The firm’s additional equity stock weight, we, is multiplied by either the cost of retained earnings, Kr, or the cost of new common stock, Ke. Now, which cost is used depends on whether the firm’s additional equity stock will be financed using retained earnings, Kr, or new common stock, Ke.
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
4. Weighted Marginal Cost of Capital
Weighted Marginal Cost of Capital refers to the incremental cost of raising additional amount of capital by the firm. So, while calculating the combined cost of capital, we should take the new cost of different sources of finance instead of taking their existing cost. It is the weighted average of marginal cost of each source of capital.
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
5. Practical Illustrations
Q.1. The capital structure of H Ltd, as on 31st March 2013 is as follows:
Sol. a) Before finding out the WACC, we have to calculate the specific costs of debt and equity.
Now, WACC (Ko ) can be calculated by using the formula.
*Reserves and Surpluses are taken as a part of Equity.
b) New Cost of Equity will be,
Equity share capital Rs. 100 lacs
(10 lacs shares of Rs. 10 each)
Reserves and Surpluses Rs. 20 lacs
14% Debentures of Rs. 100 each Rs. 30 lacs
For the year ended 31st March 2013, the company paid equity dividend at 20% and dividends are expected to grow by 5% every year. The current market price per share is Rs. 80 and tax rate applicable for the company is 50%.
You are required to compute the following:
a) Weighted Average Cost of Capital using Book Value weights.
b) The company plans to raise a further capital of Rs. 50 lacs by way of long term loan at 16%. But, this will increase the risk perception of investors and market price of equity share will fall to Rs. 50 per share. What will be the New WACC?
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
Cost of New 16% Loan is New WACC can be calculated .
Conclusion: The overall cost of capital has increased.
Sol. First of all, we will calculate the specific cost of individual sources of finance.
Existing WACC can be calculated.
Now, with the issue of fresh loan to finance the expansion program, the proportion or weight of different sources will change. The new weights can be calculated as:
Equity Share Capital:
Preference Share Capital:
12% Debentures:
14% Secured Loan:
Cost of 14% Loan:
Q.2. The capital structure of A Ltd. is composed of 12% debentures, 9% preference shares and some equity shares of Rs. 100 each in the ratio of 3:2:5. The company is planning to raise additional capital to finance its expansion program by issuing 14% secured loan. As a result of this, the proportion of different above sources would go down by 1/10, 1/15 and 1/6 respectively. Find out the WACC of the firm given that the tax rate is 50% and expected dividend at the end of the year is Rs 9 with a growth rate of 5% per annum. It is to be noted that the new loan is not going to affect the expected dividend, growth rate and market price of the share.
COMMERCE PAPER No. : 8 FINANCIAL MANAGEMENT
MODULE No. : 17 COMBINED COST OF CAPITAL
New WACC can be calculated as:
Therefore, New WACC has decreased from 10.6% to 9.4%.
6. Summary
WACC simply refers to the cost that would be undertaken by the firm on an average to raise money.
Determining an accurate cost of capital is very important as it is used to analyze the capital budgeting decisions of a firm to see whether a future project will yield profit or not.
The basis of determining WACC is to determine the specific costs of each of the individual sources of long term financing for the firm, assign weight to these individual sources of finance depending upon the degree to which the firm uses these different sources, and then, simply add up the weighted costs, that is the product of individual cost with their respective weights.
The assignment of weights can be done on Historical cost basis, Marginal cost basis or on the basis of Target capital structure.
The historical weights can further be divided into Book Value Weights and Market Value Weights.
WMCC is the weighted average of marginal cost of each source of capital.
