A Study on Cost of Capital

Transcription

1 International Journal of Empirical Finance Vol. 4, No. 1, 2015, 1-11 A Study on Cost of Capital Ravi Thirumalaisamy 1 Abstract Cost of capital which is used as a financial standard plays a crucial role in capital budgeting decisions. It is the discount rate applied for evaluating the desirability of investment projects. An investment project can be accepted if it has a positive net present value. Besides, financial decisions taken by the management of a firm are appropriately evaluated using the weighted average cost of capital. The cost of capital influences debt policy of a firm. While designing the proportion of debt and equity in the capital structure, a firm aims at minimizing the overall cost of capital. The cost of capital is widely used in deciding about the method of financing at any particular point of time. It plays an important role in dividend decision. Cost of capital is one of the important metrics which decides the amount of investment in current assets. Keeping the importance of cost of capital in corporate finance, the present study has been undertaken covering ten manufacturing companies listed in Bombay Stock Exchange, India. Financial data are collected for 10 years from 2004 to The results of regression analysis indicate the factors significantly influencing various components of cost of capital. Keywords: Cost of Capital, Cost of Equity, Cost of Debt, Cost of Retained earnings, Weighted Average Cost of capital, Leverage 1. Introduction There are various sources of funds for a firm to build up its capital structure. All these sources are not free of cost. There is a cost associated with each type of funds a firm may employ. Thus, cost of capital is the aggregate of the costs of all long-term sources of funds. A firm while taking up an investment project will decide the method of financing it. Such investment projects that would earn a return higher than the cost involved in financing the project are selected. Hence it becomes inevitable for a finance manager to measure cost of capital. Cost of capital is referred to as the rate of return which a company should earn from the deployment of long-term funds such as equity, debt. Rate of return refers to the discount rate used to discount the estimated future cost inflows so as to determine the present value of future cash flows which are compared to investment outlay while deciding if the investment can be accepted or not. A firm must estimate the cost of capital for deciding several decisions like leasing, long term financing and working capital policy. Cost of capital helps the management to increase the value of the firm. Thus, firms feel the impact of cost of capital on all of its underlying decisions. Future cost of capital refers to the expected cost of funds to be raised in future to finance an investment project. Historical cost of capital refers to the cost involved in acquiring funds in the past. In all finance decisions, future cost of capital is more significant and relevant. The cost of capital is the minimum acceptable rate of return on new investment made by the firm from the view point of creditors and investors in the firm s from the view point of creditors and investors in the firm s securities. In order to arrive at the average cost of capital, cost of various components of capital including equity, debt, preference capital and retained earnings, must be computed. 1 Faculty in Accounting & Finance Modern College of Business & Science, Post Box Number: 100, Al-Khuwair 133, Sultanate of Oman, 2015 Research Academy of Social Sciences 1

2 R. Thirumalaisamy Cost of equity capital is expressed as the minimum rate of return that should be earned on the equity capital by the firm. If the firm invests in projects having an expected return less than the required return, the market price of the stock will suffer over the long-run. Equity capital cost is not fixed. The minimum rate of return expected by the equity share holders will depend on the earnings level of the company and management decision. Cost of debt capital is the fixed interest charges net of tax relief available, because loan interest is treated as a business expense. Cost of debt capital is the coupon rate of interest which is fixed. It is the minimum rate that must be earned on debt capital by the firm. Cost of retained earnings is the opportunity cost that represents sacrifice of the dividend income which the shareholders would have otherwise received immediately. If a firm is unable to generate investment opportunities that provide a return equal to equity capital cost, stockholders presumably can find stocks of other companies with some degree of risk that can promise such a return. After computing costs of individual components of capital, it is necessary to combine all the individual costs to determine the overall or weighted average cost of capital. Weighted average cost of capital is the average cost of all the sources of funds employed by the firm. The weighted average cost of capital has an impact on all of the underlying decisions of a firm and encompasses all of the activities of a corporation Thus, cost of capital is the weighted average costs of various sources of long-term finance which is calculated to help the management in financing decision and investment decisions and also used as a link between investment decision and financial decision. Statement of the Problem The area of weighted average cost of capital is so perennial that more research work can be expected to come. There is no considerable work on the cost of capital. All the articles and work done in this area are more conceptual. Cost of capital is the growing field which needs greater attention of the researchers to get it improved. Financial Manager of any concern should take into account the cost of capital while framing any financial or investing policy. Thus, the finance manager cannot become successful unless he is acquainted with as to how the cost of capital is to be managed to maximize shareholders wealth. However, only theoretical aspects of the term cost of capital does not facilitate him in this regard. With this background, the study has been undertaken with the following objectives. Objectives The following are the objectives of the study. a. To ascertain the factors influencing cost of equity, cost of debt, cost of retained earnings and weighted average cost of capital. b. To examine the relationship between various costs of capital. c. To probe into the variability in costs of capital. 2. Methodology Sample of the study comprises ten randomly selected manufacturing companies listed in Bombay Stock Exchange, India. The following data for a period of ten years from 2004 to 2013 have been collected for the study form the Stock Exchange Official Directory published by Bombay Stock Exchange. They are, 1. Net Sales per share [NSPS] 2. Interest [INT] 3. Fixed Assets [FA] 4. Yield (Y) 5. Net Profit [NP] 2

3 6. Net Worth [NW] 7. Operating leverage [OL] 8. Financial Leverage [FL] 9. Retained Earnings per share [REPS] 10. Equity capital [EC] 11. Deferred Liabilities [SHR] 12. Shareholders reserve [she] 13. Tax rate [TR] 14. Earnings before interest and tax [EBIT] Framework of Analysis International Journal of Empirical Finance Multiple regression has been worked out for those variables which are least correlated between themselves and significantly associated with the cost of capital to ascertain their combined influence on various costs of capital Viz., cost of equity capital, cost of debt capital, cost of retained earnings and weighted average cost of capital. Following variables have been identified as influencing various costs of capital. Financial Leverage Operating leverage Net sales per share Interest Fixed assets Yield Net profit Net worth Earnings per share Market price per share Yield Tax rate Equity capital Equity dividend Net worth Analysis of variance has been worked out to ascertain the variability in cost of equity capital, cost of debt capital, cost of retained earns and weighted average cost of capital in the sample companies. Simple correlation has been made use of to find out the relationship between various costs of capital visa, cost of equity capital, cost of debt capital, cost of retained earnings and weighted average cost of capital in each of the company. Best subset regression has been used to ascertain the best group of variables which are having significant influence on the equity capital cost, cost of debt capital, cost of retained earnings and weighted average cost of capital. 3

4 3. Review of Literature R. Thirumalaisamy Franco Modigliani and Merton H. Miller (1958) laid the theoretical foundations for many of the subsequent developments on the weight average cost of capital. They have combined firms having the same operation risk. They assumed that the shares of different companies give rise to different probability distribution of earnings. They developed three propositions. Propositions 1 According to this proposition, the market value of any firm is independent of its capital structure. The weighted average cost of capital has nothing to do with capital structure or financing mix of any firm. Propositions 2 This proposition claims that the expected rate of return on the stock of any company is a linear function of leverage. Propositions 3 This proposition explains that the firm will exploit an investment opportunity if the rate of return on investment is larger than the cut off rate given that there are no taxes and transaction costs; information is available at no cost; securities are completely divisible and all firms are in the same risk class. David Durand (1959) criticized the assumptions made by Modigliani and Miller. He identified that those assumptions are not constructive in arriving the true cost of capital. He further stated that the assumptions of Modigliani and Miller are subtle and restrictive and highly difficult to implement. He debates that Modigliani and Millers proof depends on the existence of the unique risk class which is highly difficult to identify. Another criticism leveled against the assumptions of Modigliani and Miller is that the tax free environment and perfect capital market seldom exists. Ezra Solomon (1963) also criticized the propositions developed Modigliani and Miller and he advocated an alternative formulation for cost of capital. He developed the concept of weighted average cost of capital by analyzing the effect of change in financial leverage on a company s cost of capital. Ezra Solomon adopted a different approach to analyze changes in leverage by keeping equity fixed. He differs from Modigliani and Miller s view in this aspect. Modigliani and Miller altered the capital structure by substituting debt for equity. However, under his assumed conditions he showed that the overall cost of capital of a more levered company is lower than that of a less levered company. He also insisted that the home-made leverage would substitute the firm s leverage. Solomon included the essence of the formulations which gained wider acceptance in the area of cost of capital. Franco Modigliani and Miller (1963) corrected their marginal theory developed in They included tax effect and derived an acceptable measure of the cost of capital. They established in their contributions that with the existence of taxes, the cost of capital changes. Fred. Weston (1963) analyzed leverage and growth of firms. He compared his findings with that of Modigliani and Miller. He established that the leverage is negatively correlated with growth. The growth lowers the cost of equity capital. Both Modigliani & Miller and Fred Weston instituted that the cost of equity capital is a positive function of leverage. As leverage is increased, cost of capital is pushed up by the rising cost of equity function, but is pulled down because of the lower cost of equity function. Again, it is pulled down because the lower cost of debt is weighted more heavily. He made use of multiple regression analysis and partial correlation to identify the influence of leverage and growth on cost of capital. He concluded that leverage does not have any influence on firms cost capital. He indicated that leverage is a negative linear function of earnings growth. The lack of correlation between cost of capital and leverage is due to the counter balancing influence of earnings growth on leverage. The partial correlation measures revealed that both leverage and earnings growth are significantly correlated with the cost of capital. 4

5 International Journal of Empirical Finance Miller and Modigliani (1966) corrected the second major criticism leveled against their initial work in 1958 which was that their work was not operationally useful. They showed the practical usefulness of their formulations by applying the concept of cost of capital to 63 utility companies and proved that their measure was operationally useful which answered all of the major criticisms leveled against their work. In the year 1969, Sharma and Rao studied the relationship between capital structure and cost of capital. They found that cost of capital is affected by the debt apart from its tax advantages. In 1981, I.M. Pandey who carried out a study on cost of capital established the same result. Reily and wecker (1973) developed a theory on cost of capital based on Solomon s model. They focused on mathematical error of using the weighted average cost of capital. They confirmed mathematical reasons for existence of difference between the overall capital cost and weighted average cost of capital. They stated that the true cost of capital is identical to the weighted average cost of capital only when Solomon s assumptions hold good. According to them, overall cost of capital is the internal rate which equates all of the future payments to all capital sources with the amount of money currently being supplied by all of these sources. Ang. James (1973) analyzed the reason for the difference between true cost of capital and weighted average cost of capital. His empirical study confirmed that the degree to which the weighted average cost of capital deviates from the true cost of capital is sizable, even for moderate levels of leverage, the downward bias of WACC is quite significant. Myers, Stewart (1974) has developed a formulation to measure the cost of capital when there is a change in leverage and the firm is able to forecast the exact quantum of debt. He considered both the effects of investment decision and financial decision on cost of capital considering both levered and unlevered cash flows. Linke and Kim (1974) claimed that the conclusions derived by Reilly and Wicker and James are incorrect. Linke and Kim developed a concept which states that the two costs weighted average cost of capital and true cost of capital are identical. Beranek, William (1977) examined the possibility of shareholder wealth maximization by minimizing the weighted average cost of capital. According to him, it is advantageous to use book value rather than market cost of capital. Charles W. and Lawrence D. Schall (1978) have mainly concentrated on the problem of the concept of cost of capital. They concluded that there is no useful purpose served by cost of capital when referring to a minimum rate of return required on investment. During 1997, Chandra Shekar attempted to test the impact of financial leverage on cost of capital. Twenty Indian companies from general engineering industry have been taken up as the sample. The annual time series data from the Bombay Stock Exchange Directory have been used for the analysis. The analysis of data has been carried out by the techniques of correlation and regression. Period covered in the study is from to The results are that the debt capacity of a firm significantly influences its cost of capital in a negative manner. The results of correlation and of regression analysis reveal a strong and negative causal relationship between financial leverage and cost of capital. 4. Determinants of Cost of Capital - Regression Analysis Multiple regression analysis has been worked out to ascertain the nature of influence of the independent variables on the cost of equity capital, cost of debt capital, cost of retained earnings and the overall cost of capital. Determinants of Cost of Equity Capital Table 1 indicates the influence of independent variables like earnings per share, market price per share, yield, tax rate, equity capital, equity dividend and net worth on the dependent variable cost of equity capital. 5

6 R. Thirumalaisamy Table 1: Determinants of Cost of Equity Capital -Regression Analysis Variables Regression Coefficients t Value Constant EPS MPPS Y R EC EQD NW P Value = R 2 Value = Adjusted R 2 Value = When earnings per share increase by one thousand rupees cost of equity capital goes up by the rate of When market price per share increases by one rupee, cost of equity capital decreases by the rate of A rupee increase in yield is associated with a decrease in cost of equity capital by the rate of For an increase of one thousand rupees in taxes, cost of equity capital lowers by the rate of An increase of one thousand rupees in equity capital reduces cost of equity capital by the rate of When equity dividend increases by one thousand rupees cost of equity capital increased by the rate Cost of equity of capital increases by the rate of , when net worth increases by one thousand rupees. The impact of all these independent variables on the cost of equity capital is significant as the calculated P value was lower than the critical value of The adjusted R 2 indicates that this model has more reliability and important variables have been included for the analysis as it does not differ much from R 2. All these variables collectively contribute 99.3% of variation in the cost of equity capital. Best Subset Regression In order to identify the most influencing variables, best subset regression was run. It has identified earnings per share, equity capital, and equity dividend as the best influencing variables on cost of equity capital. CEC = EPS EC 0.129EQD P Value = R 2 Value = Adjusted R 2 Value = When equity earnings per share increased by one thousand rupees, cost of equity capital increased by rate. When equity capital increased by one thousand rupees, cost of equity capital increased by rate. When equity dividend increased by one thousand rupees, cost of equity capital decreased by rate. R 2 indicates that these three variables collectively contribute 96.95% of variation in the cost of equity capital. The adjusted R 2 indicates that this model is more reliable and important variables have been taken for the analysis as the difference between R 2 and adjusted R 2 are smaller. The influence of these variables on the cost of equity capital was significant as the calculated P value was lower than the critical value of Determinants of Cost of Debt Capital Table No. 2 indicates the influence of various independent metrics like financial leverage, interest, deferred liabilities, tax rate, earnings before interest and tax, yield, fixed assets on the cost of debt capital. 6

7 International Journal of Empirical Finance Table 2: Determinants of Cost of Debt Capital Regression Analysis Variables Regression Coefficients t Value Constant FL INT DL TR EBIT Y FA P Value = R 2 Value = Adjusted R 2 = An increase of one thousand rupees in financial leverage, would lead to increase in cost of debt capital by the rate of 481. A rupee increase in interest is associated with an increase in cost of debt by the rate of When deferred liabilities increase one thousand rupees the cost of debt capital would decrease by the rate of When tax rate increases by 1, the cost of debt capital decreases by the rate of Earnings before interest and tax increased by one thousand rupees, cost of debt capital increased by rate. A rupee increase in fixed assets would result in decreasing the cost of debt capital by the rate of The impact of all these independent variables on the cost of dept capital was not significant as the calculated P value was higher than the critical value of All these independent variables collectively contribute 77.07% of variation in the cost of debt capital. This model indicates that some more variables are to be included to improve the reliability of this model as adjusted R 2 deviates much from R 2. Best Subset Regression To identify the most influencing variables, best subset regression was carried out. It has identified the following variables. CDC = INT DL EBIT P Value = R 2 VALUE = ADJUSTED R 2 = This model explains that when interest amount increases by a rupee, cost of debt capital increases by the rate of A rupee increase in deferred liabilities would lead to a decrease in cost of dept capital by the rate of When earnings before interest and tax increase by one rupee, cost of dept capital increases by the rate of The influence of these variables on the cost of equity capital is significant as the calculated P; value is lower than the critical value of R 2 value (0.8062) indicates that the variables collectively contribute 80.62% of variation in the cost of dept capital. This model is considered more reliable and important variables have been included for the analysis as there is a marginal difference found between R 2 and Adjusted R 2. Determinants of Cost of Retained Earnings The table 3 indicates the influence of independent variables including retained earnings per share, yield, fixed assets, equity capital, deferred liabilities, net worth and shareholders reserve on the dependent variable -cost of retained earnings. 7

8 R. Thirumalaisamy Table 3: Determinants of Cost of Retained Earnings Regression Analysis Variables Regression coefficients t Value Constants REPS Y FA EC DL NW SHR P Value = R 2 Value = Adjusted R 2 = When retained earnings per share increased by a rupee, cost of retained earnings increases by the rate of When yield increases by one, the cost of retained earnings decreases by the rate of An increase in fixed assets by one thousand rupees leads to a decrease in the cost of retained earnings by the rate of which was not significant. When equity capital increases by one thousand rupees, the cost of retained earnings decreases by the rate of Deferred liabilities and net worth were having positive influence on the cost of retained earnings when shareholders reserve increased by a rupee, the cost of retained earnings decreases by the rate The impact of all these independent variables on the cost of retained earnings was significant as the calculated P value (0.0045) was lower than the critical value of All these independent variables collectively contribute 99.87% of variation in the cost retained earnings. The adjusted R 2 was closer to R 2. This reveals that this model was highly reliable and appropriate variables have been selected for the study. Best Subset Regression To identify the most influencing variables, best subset regression was carried out. CRE = REPS NW SHR P VALUE = R 2 VALUE = ADJUSTED R 2 = It is inferred that when retained earnings per share increase by one rupee, cost of retained earnings increases by the rate of When net worth increases by one thousand rupees, cost of retained earnings increases by the rate of When shareholders reserve increases by one thousand rupees, cost of retained earnings decreases by the rate of R 2 indicates that these variables collectively contribute 93.52% of variation in the cost of retained earnings. Adjusted R 2 indicates that this model was more reliable and important variables have been included in the study as adjusted R 2 does not deviate much from R 2. Influence of these variables on the cost of retained earnings was significant as the calculated P value is smaller than the critical value of Determinants of Weighted Average Cost of Capital Table 4 indicates the relationship between independent variables viz., financial leverage, operating leverage, net sales per share, interest, fixed assets, yield, net profit, net worth and the dependent variable weighted average cost of capital. 8

9 International Journal of Empirical Finance Table 4: Determinants of Weighted Average Cost of Capital Regression Analysis Variables Regression Co-Efficient t Value Constants FL OL NSPS INT FA Y NP NW P value = R 2 Value = Adjusted R 2 Value = When financial leverage increases by one rupee, weighted average cost of capital decreases by the rate of If a rate is increased in operating leverage, the weighted average cost of capital decreases by the rate of One rupee increase in net sale per share is associated with a decrease in weighted average cost of capital decreased by the rate of When interest amount is increased by one rupee, the weighted average cost of capital decreases by the rate of which was not significant. If rate is increased in yield, the weighted average cost of capital increases by the rate of When net profit increases by one rupee, the weighted average cost of capital increases by the rate of which was not significant. If Rs. One thousand is increased in net worth, the weighted average cost of capital decreases by the rate of which was also not significant. Among the independent factors financial leverage, operating leverage, net sales per share, interest, fixed assets, and net worth were having negative impact on weighted average cost of capital. Whereas yield and net profit were having positive impact on weighted average cost of capital. The eight independent variables collectively contribute 81.24% of the variation in the weighted average cost of capital. The impact of these independent variables on the weighted average cost of the capital was not significant as the calculated P value (0.7928) was higher than the critical value of The very high difference between R 2 and adjusted R 2 reveals that some more variables are to be added to improve the reliability of the regression model. Best Subset Regression To identify the most influencing variables, best subset regression was carried out. It has identified net sales per share, net profit and net worth are the most influencing variables on weighted average cost of capital. WACC = NSPS NP NW P Value = R 2 Value = Adjusted R 2 Value = This model explains that when net sales per share increases by one rupee, weighted average cost capital decreased by the rate of An increase in net profit by one rupee would cause an increase in weighted average cost of capital by the rate of Net worth is found to be negatively influencing weighted average cost of capital by the rate of R 2 indicates that these variables collectively contribute 73.4% of variation in the weighted average cost of capital. The R 2 was very closer to the adjusted R 2, this indicates that this model was highly reliable 9

10 R. Thirumalaisamy and important variables have been included. P value indicates the influence of these three variables on the weighted average cost of capital was significant as the calculated P value was lower than the critical value of Relationship between the Components of Costs of Capital In order to ascertain the relationship existing between various components of costs of capital viz, cost of equity capital, cost of debt capital, cost of retained earnings and the overall cost of capital, correlation analysis has been run. The results are summarized in Table 5. The results reveal that cost of equity capital was negatively correlated with cost of debt capital and cost of retained earnings, while cost of equity capital was positively correlated with weighted average cost of capital. Table 5: Components of Costs of Capital - Correlation Analysis CEC CDC CRE WACC CEC CDC (0.9540) CRE ( ) (0.5369) WACC (1.9044)* ( ) ( ) * Significance at 5% level ** Significance at 1% level Cost of debt capital was positively correlated with cost of retained earnings, while cost of retained earnings was negatively correlated with weighted average cost of capital. Weighted average cost of capital has got positive relationship with the cost equity capital, while it has got negative relationship with cost of debt capital and cost of retained earnings. This implies that weighted average cost of capital will increase with increase in cost of equity capital and with decrease in cost of debt capital and cost of retained earnings and vice versa. Weighted average cost of capital has been significantly correlated with cost of equity capital as calculated t value (1.9044) is higher than the table value at 5% level of significance. References Ang, J. S. (1974). The Weighted Average versus True Cost of Capital: Reply. Financial Management, 3-1, Spring, Chandrasekhar (1997), Financial leverage: It s Determinants and its Impact on cost of capital and shareholders Return, Journal of Accounting & Finance, Vol xi No2 pp Charted Financial Analyst., March PP86-88 Durand David. (1959), The Cost of Capital, Corporation Finance, and The Theory of Investment- Comment, American Economic Review, Volume MLI, No 4 September, pp Ezra Solomon (1963), Leverage and The Cost of capital, The Journal of Finance, Volume 18, No. 2. Pp Franco Modigliani and Merton H. Miller (1958), The Cost of Capital, Corporation Finance and the Theory of Investment, The American Economic Review, Vol. 48, No. 3, pp Franco Modigliani and Merton H. Miller (1963), Corporate Income Taxes and the Cost of capital: A Correction The Economic Review, Vol. 53, No. 3, pp

11 International Journal of Empirical Finance Linke Charles M. and moon K. kim (1970), More On The Weighted Average Cost of Capital - A Comment and Analysis. Journal of Financial and Quantitative Analysis, Volume 9. No. 6. Pp Merton H. Miller and Franco Modigliani (1966), Some Estimates of the Cost of Capital to the Electric Utility Industry, The American Economic Review, Vol. 56, No. 3. Pp Myers, Stewart. C (1974), Interactions of Corporate Financing and Investment Decisions Implications for Capital Budgeting, The Journal of Finance, Value 29, No.1. March, pp Nantell, Timothy J and C. Robert Carlson (1975), The Cost of Capital as Weighted Average, The Journal of Finance, Volume. 30, No.5 pp Pandey, I. M. (2009). Essentials of Financial Management, 1E. Vikas publishing house PVT ltd. Ibid., P;412 Ibid., P:422 Ibid., P422 Reilly, Raymond and William E. Wicker (1973), On the Weighted Average Cost of Capital, The Journal of Finance, Volume 30, No. 5. Pp Subir Kumar Banerjee (1999), Financial Management S. Chand & Company Ltd. New Delhi. Weston, J. Fred, (1963) A Test of Cost of Capital Propositions, Southern Economic Journal, Vol.XXX, No. II, pp