Capital Analysis

Capital is the source of fiancé through which resources are provided. It may be debt financing or equity financing. The cost of debt financing is interest which is the before tax cost of capital, while after tax cost of capital is r (1-t). If the interest rate or yield to maturity is 6.5% and the rate of tax is 40%, it means that before tax cost of capital is 6.5% and after tax cost of capital is 3.9%. In equity finance the cost of capital is dividend. If the rate of dividend is 10%. The after tax cost of capital and before tax cost of capital are same, which is 10% as there is no tax shield available, as the dividend is not the expense, rather it is distribution of profit. The cost of equity can also be calculated by using the capital assets pricing model, which is known as CAPM. In this case under the CAPM, the cost of equity is 10.33% If a project is financed only from debt financing the cost of capital will be 3.9% and if it is only financed from equity the cost will be 10.33%. When there is no debt the WACC is equal to the cost of equity, as there is no tax shield available on cost of equity, therefore it is always on higher side but when the debt is introduced, the WACC started to fall down as the weightage of low cost of financing is increasing. The cost of debt financing is always on lower side due to tax shield. But if financing is done 40% from debt and 60% from equity, then the cost of capital will be 7.76%. The increase in debt financing will reduce the overall cost of capital. For example if we raise the portion of debt financing to 60%, now the cost of capital will be 6.47%. You can see that the percentage of financing provided from a source determines the weightage of financings. In the scenario overall initial investment is needed around $1200 million, to of which the $200 million is assumed to be provided from working capital and remaining $1000 million is financed from debt and equity in the ratio of 40:60, therefore the cost of capital used is 7.76%. But as the whole amount is not needed at the start of the project, but is financed gradually in three years time therefore the interest has been calculated accordingly.