From the desk of Dr.

Harjit Singh

Cost of Capital
It is the minimum rate of return that a firm must earn on its investments for the market value of the firm to remain unchanged. It is the price for obtaining capital. Or it is a compensation for time and risk. For Example: Debt, Equity, and preference Share capital has a cost. Significance of Cost of Capital: It is useful as a standard for:i. Evaluating Investment Decisions ii. Designing a firms debt policy, and iii. Appraising the financial performance of top management. In short, it is the required rate of return.

Exercises
1. Cost of Debt (At Par) Kd = INT/Bo Where Kd = Cost of Debt INT = Interest Bo = Issue Price Example 1 A company decides to sell a new issue of 7 year 15% bonds of Rs. 100 at par. Calculate cost of debt (Kd). Cost of Debt (After Tax) The interest paid on debt is Tax deductable. Higher the interest charges, the lower will be the amount of tax payable by the firm. It implies that the government indirectly pays a part of the lenders required rate of return. After tax Cost of Debt = Kd (1-t) Where t = Corporate Tax Rate Example 2 In the example No. 1, if t = 40% then calculate Cost of debt after tax.

2.

3.

Cost of Bonds (Issued at discount) Kd = INT (1 - t) + (Rv - Bo)

n

Where 100

INT Rv Bo n

= = = =

Interest Redeemed Value Issue Price No of Years

Rv + Bo 2 Example 3 In question No.1, if instead of Rs. 100/-, bonds are issued at Rs. 95. Calculate cost of debt. 4. Cost of Preference Shares (Irredeemable) Kp = PD Where Po

Kp = Cost of Preference Shares PD = Expected Preference Dividend Po = Issue Price of Preference Shares

Example 4 A company issues 10% irredeemable preference shares. The face value per share is Rs. 100/-, but the issue price is 95. Calculate: (i). What is the cost of preference share. (ii). What is the cost if issue price is Rs. 105.

5.

Cost of Preference Shares (Redeemable) In case of redeemable preference shares, Kp

PD + Rv - Bo n Rv + Bo 2 100

Where

PD = Preference Dividend Rv = Redeemed Value Bo = Issue Price n = No of Years

Example 5 A company wants to redeem preference Shares at Rs 100/- (at par). The issue price is Rs. 96. Preference Dividend is 16%. Time period is 5 Years. Calculate Cost of preference shares (Kp). 6. Cost of Equity (Ke) Ke = DIV1 + g Po Where Ke = Cost of Equity DIV1 = DIVo (1 + g) G = Growth Rate Po = Market Price

Example 6 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 constant rate of 8 percent. Calculate shareholders rate of return. ******