COST OF CAPITAL

SPECIFIC COSTS OF CAPITAL FOR

VARIOUS SOURCES OF FINANCE
Cost of Debt
Debt issued at par
If a company sells a new issue of ten-year
debentures with a 9 percent coupon rate of interest
to raise Rs.2,00,000 and realize Rs.100 for each of
Rs.100 face value debenture, the before-tax cost of
this issue would be 9 percent.

 Before-tax cost of debt, kd

= Interest / Principal
.(1)

= Rs18,000 / Rs 2,00,000 = .09= 9%

We could arrive at same results as above by using the
equation
P0= CF1/ (1+k) + CF2 / (1+k)2+ ..+CFn / (1+k)n .(2)
where ;
P0 = Net Cash inflow in period 0
CFi =cash outflows in periods 1,2,
k = Cost of Capital

,n

 Substituting the values we get

2,00,000 = 18,000 / (1+kd) + 18,000 / (1+kd)2 ++2,18,000/(1+kd)10

By using the trial and error method, it can be

found, that the discount rate, k d which solves
this equation is 9 per cent. Thus, Eq.(1) gives
answer equivalent to Eq. (2), if the debt is issued
at par and redeemed at par on the maturity date.

Debt Issued at Discount or Premium

Equations (1) and (2) will give identical results only when
debt is issued at par and redeemed at par. Equation (2)
can be written as follows to compute the before-tax cost
debt:
n

B0 =

INT / (1+k ) + B
t 1

/ (1+kd)n

.(3)

where Bn is the repayment of debt on maturity and other

variables as defined earlier. Equation (3) can be used to
find out the cost of debt whether debt is issued at par or
discount or premium.

 ILLUSTRATION I: Assume that a company

decides to sell a new issue of 7-year 15 per cent
bonds of Rs 100 each for Rs.94. Using Equation
(3), kd is calculated as:
7

94 =

15 / (1+kd)t
t 1

+ 100 / (1+kd)7

By trial and error, kd = 16.5 per cent.

Tax adjustment: After-tax cost of debt =kd (1- t)

where t is the tax rate

(4)

Suppose EBIT = Rs.10,000, Debt capital =Rs.50,000, kd = 6%, Tax

rate (t) = 40%. EAIT with and without debt can be calculated as
follows
With debt
Without debt
----------------------------EBIT
10,000
10,000
Interest 6%
3,000
--------------------------7,000
10,000
Tax 40%
2,800
4,000
----------------------EAIT
4,200
6,000
Effective Interest for Debt. = 3000 3000 (40%) = 3000 (1-t).
i.e effective cost of debt = (3000 /50,000) (1-t) = kd (1-t)

Cost of Preference Capital

Irredeemable Preference Share
The preference share may be treated as a perpetual
security if it is irredeemable. Thus, its cost is given
by the following equation:
kp =Dp / P
(5)

where kp is the cost of preference share, Dp

represents the fixed dividend per preference share
and P is the price per preference share.

 A company issues a 10 per cent preference share

capital without a maturity date. The face value per
preference share is Rs.100, but the issue price is
Rs.95. What is the cost of this issue? What would be
the cost if the issue price is Rs.105?
The cost of preference capital is given by Equation (5).
when the issue price is Rs.95, the cost is:
kp = Rs10/Rs95 = .1053 or 10.53 per cent
If the issue price is Rs.105, the cost is:
kp = Rs10/Rs105 = .0952 or 09.52 per cent

Redeemable Preference Share

A formula similar to Equation (3) can be used
to compute the cost of redeemable
preference share:
n

P0 = Dp / (1+kp)t + Pn / (1+kp)n ..(6)

t 1

The cost of preference capital is not adjusted for taxes, because

dividends on preference capital are paid after taxes as it is not tax
deductible.

Cost of Equity Capital

The required rate of return which equates
the present value of the expected
dividends with market value of share is the
equity capital.

Cost of External Equity

Dividend model
When the dividends are expected to grow at a rate of g
perpetually, the value of the share is given by the following
formula:
Po =

D1 / (1+ke)

+ D2 / (1+ke)2

+..+ Dn / (1+ke)n

D0 (1+g)t / (1+ke)t

(7)

t 0

The cost of equity, ke, in Equation (7) is the rate of return.

Simplifying Equation (7), we have

Po = D0 (1+g) / (ke g )
= D1 / (ke g ) ..(8)

Or, ke = D1 / P0 + g .(9)

1.

Equation (9) is based on the following assumptions:

Po is a function of the expected dividends.

2.

D1, is greater than zero (i.e. D1>0)

3.
4.

The dividends grow at a constant rate, g, for ever.

the dividend-payout ratio is constant.

The cost of equity is, thus, the dividend yield plus the growth
rate.

 The current market price of a share is Rs.90 and the

expected dividend per share next year is Rs.4.50. If
the dividends are expected to grow at a rate of 7 per
cent, calculate the cost of equity. Using Equation (8)
the cost of equity is:
ke = D1 / P0 + g
ke = Rs4.50 / Rs90.00 + .07

= .05 + .07 = .12 or 12 percent.

Zero growth
The cost of equity of a share on which a constant amount of
dividend is expected perpetually is given as follows:

ke = D1 / P0

Floatation cost.

If the company pays f fraction of the share price as floatation

costs, the cost of new issue of common share will be

.(13)

ke = D1 / P0 (1-f) + g .(14)

The market price for a companys existing shares is Rs.100 per

share. The company plan to issue new shares to raise
additional funds of Rs.100,00. the net proceed per share will be
the market price of the share less the floatation costs, which is
5 per cent of the share price. If the company plans to pay a
dividend of Rs.4.75 and the growth in dividends is expected to
be 6 per cent, calculate the cost of new issue of common
shares.

 Equation ( 14) will be used to calculate the cost the

new issue:
ke = D1 / P0 (1-f) + g .(14)
ke = Rs4.75 / Rs100 (1-.05) + .06

= .05 + .06

= .11 or 11 per cent.

EARNINGS MODEL

The cost of equity is sometimes

measured by the earings-price-ratio.
Thus

ke = E1 / P0 .(15)
There are two situations under which
the earnings-price ratio can be used
as a measure of the cost of equity
capital.

EARNINGS MODEL

The first situation is the one which

satisfies the following conditions:
1. The Ei are stable, and consequently the future
earnings are equal to the current earnings. This
implies g=0.
2. The firm does not employ debt.
3. The b=0 or the dividend payout is 100 per cent (i.e.
E1 = D1).

 Under these assumptions

The equation(9)

ke = D1 / P0 + g can be written as follows:

ke = E1 (1-b) / P0 + 0

(since D1 = E1 (1-b) and g=0)

ke = E 1 / P0

(if b=0)

The second situation is the expansion situation. A firm is said to be

expanding, not growing, if the investment opportunities available to
it are expected to earn a rate of return equal to the cost of equity
(i.e., r =ke).

We know
Po = D1 / (ke g ) ..(8)

= E1 (1-b) / (ke rb )

= E1 (1-b) / (ke ke b )

= E1 (1-b) / ke (1 b )

= E1 / ke

Or ke = E1 / P0

{since D1 = E1 (1-b), and g=rb}

(since r =ke)

Cost of equity capital using CAPM

ke = Rf + (Rm Rf)

Rm=expected market rate return

For example, if risk free rate of return is 9%, market rate of return is
15% and the = 1.2, the cost of equity capital is calculated as
follows:

Ke = 9% + 1.2 (15%-9%) = 9% + 1.2x6%= 9%+7.2%= 16.2%

where,
Rf = risk free rate
= sensitivity of individual securitys return

Firms cost of capital

WACC = (cost of debt ) D/V + cost of equity (E/V)

= kd(1-t) D / V + ke (E / V)
If kd=.08, ke = .16, tax rate 40%, and the firms capital
structure comprises debt capital of Rs 1,00,000 and
equity capital of Rs 2,00,000, the WACC is calculated as
follows:
WACC = .08 (1-.4) 1/3 + .16 (2/3)=0.0016 + 0.1067

= 0.1083 =10.83%

FLOTATION COSTS, COST OF CAPITAL

AND INVESTMENT ANALYSIS

Illustration I:
Suppose that a firm is considering an investment project, which
involves a net cash outlay of Rs 450,000, and that it is expected to
generate an annual net cash inflow of Rs150,000 for 7 years. The
projects target debt ratio is 50 %. The floatation costs of debt and
share issues are estimated at 10 % of the amount raised. To finance
the project, the firm will issue 7 year 15 per cent debentures of
Rs250,000 at par (Rs100 face value), and new shares of
Rs250,000. The issue price of a share is Rs 20 and the expected
dividend per share next year is Rs1.80. Dividend is expected to
grow at a compound rate of 7% foreover. Assume that corporate tax
rate is 50%. What is the NPV of the project?

WACC adjusted for floatation costs

Before tax cost of debt is given by the following equation:

n

B0 (1-f) = INTt / (1+kd)t + Bn / (1+kd)n

And the cost of equity as follows:

ke = D1 / P0 (1-f) + g

Where f is the fraction of flotation costs

t 1

.(3)

WACC adjusted for floatation costs

Before tax cost of debt is

7

100(1-.10) =

By trial and error, we find kd= 17.6%

And after tax cost of debt = kd(1-t) = 0.176 (1-0.5) = 0.088 = 8.8%.

The cost of equity

ke = D1 / P0 (1-f) + g = 1.80 / 20(1-.01) + 0.07 = 0.10 + 0.07 = 0.17

t 1

15 / (1+kd)t + 100 / (1+kd)7

.(3)

 Flotation cost adjusted WACC = 0.088x0.5+0.17x0.5=

0.13= 13%
The NPV of the project using the discount rate of 13% is
NPV = -450,000 + 150,000 (PVFA 13%, 7)

= -450,000 + 150,000x4.423 = 213,450

This is not a correct procedure.

 The correct procedure is to adjust the investment

projects cash flows for the flotation costs and use the
weighted average cost of capital, unadjusted for the
flotation costs, as the discount rate.
The flotation costs = 0.1(250,000+250,000) = Rs50,000
Thus the net cash outlay of the project

= 450,000+50,000 = Rs500,000

 Since the component costs are not adjusted for flotation

costs, the after tax cost of debt = 0.15(1-0.5) = 0.075
And the cost of equity
ke = 1.80 / 20 + 0.07 = 0.16 =
WACC, without the adjustment of flotation costs, will be
= 0.075x0.5 + 0.16x0.5 = 0.1175 or 11.75% = 12%(appx.)

NPV = -500,000 + 150,000 (PVFA 12%, 7)

= -500,000 + 150,000x4.564 = 184,600.

How capital structure affects beta

If you owned a portfolio of all the firms
securities, you wouldnt share the cash flows
with anyone. You wouldnt share the risk with
anyone either; you would bear them all. Thus
the firms asset beta is equal to the beta of a
portfolio of all the firms debt and its equity.

 The beta of this hypothetical portfolio is just a weighted average of

the debt and equity betas:
assets = portfolio = (D / V) debt + (E /V) equity
If debt =o , assets = (E /V) equity
Or equity = assets (V/E) = assets (E+D)/E
Levered Beta

equity = assets ( 1+ D/E)

.(1)

Unlevered Beta

assets = equity / ( 1+ D/E)

.(2)

Estimating the cost of capital of a project

The projects risk is similar to the risk of
the firm
If the projects risk is the same as the risk of the
firm, then the firm is the appropriate proxy for
the project and the projects WACC is simply the
firms weighted average cost of capital.

When Risk is different from the Firm

Steps to Follow

How To

Step 1:
Estimate the projects
relative proportions of debt
(D)
and
equity
(E)
financing:
D/V and E/V
using proxy firms

Use the proxies market values of debt and equity.

The market value of debt is calculated from data
on outstanding debt using the bond valuation
formula.
The market value of equity is the share price
times the number of share outstanding.
Take the mean of the proxies ratios.

Step 2:
Estimate
the
projects after-tax
cost of debt:
kd (1-t)

Take the mean of the

proxies borrowing rates.
Use the marginal corporate
tax rate for t

Step 3:
Use the CAPM
Estimate the projects Unlever the proxies equity beta using
cost of equity: ke
equation
assets = equity / ( 1+ D/E) to get their
unlevered asset betas.
Relever the mean of the proxies asset
betas at the projects target debt-toequity ratio using equation
equity = assets ( 1+ D/E)

to get the

projects equity beta.

Apply the CAPM
ke = Rf + e(Rm Rf)

to the projects equity beta to get the

projects cost o equity ke.

Step 4:
WACC
Calculate the projects = (cost of debt ) D/V
weighted average cost of
+ cost of equity (E/V)
capital (WACC)
= kd(1-t) D / V + ke (E / V)

 Step 1: Suppose the proportion of Debt and equity of the

project is 2:1.
Step 2: After-tax cost of debt is 12%
Step 3: Project cost of equity
Unlever proxys equity Beta:
assets = equity / ( 1+ D/E) to get their unlevered asset
betas.
Let proxys equity beta be 0.8 and D/E ratio be 1:1
assets = 0.8 / ( 1+ 1/1) = 0.4.

Relever the proxys asset betas at the projects target

debt/equity ratio using equation
equity = assets ( 1+ D/E) to get the projects equity beta.

equity = 0.4 (1+2/1) = 1.2

= 9% + 1.2 (15%-9%)

Apply the CAPM:

ke = Rf + e(Rm Rf)
(if Rf=9% and Rm=15%)

=9%+7.2%=16.2%
Step 4: WACC= kd(1-t) D / V + ke (E / V)
=12%(2/3) + 16.2(1/3)=8%+5.4%=13.4%