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The term cost of capital refers to the maximum rate of return a firm must earn on its
investment so that the market value of company’s equity shares does not fall. This is a
consonance with the overall firm’s objective of wealth maximization. This is possible
only when the firm earns a return on the projects financed by equity shareholders
funds at a rate which is at least equal to the rate of return expected by them. If a firm
fails to earn return at the expected rate, the market value of the shares would fall and
thus result in reduction of overall wealth of the shareholders. Thus, a firm’s cost of
capital may be defined as “the rate of return the firm requires from investment in
order to increase the value of the firm in the market place”.
1. Cost of Debt
Debt may be issued at par, at premium or discount. It may be perpetual or redeemable.
The technique of computation of cost in each case has been explained later.
(a) Debt issued at par: The computation of cost of debt issued at par is comparatively
an easy task. It is the explicit interest rate adjusted further for the tax liability of the
company. It may be computed according to the following formula:
Kd = (l-T)R
Where,
Kd = Cost of debt;
T = Marginal tax rate;
R = Debenture interest rate.
The tax is deducted out of the interest payable, because interest is treated as an
expense while computing the firm’s income for tax purposes. However, the tax
adjusted rate of interest should be used only in those cases where the “earning of the
firm before interest and tax” (EBIT) is equal to or exceed the interest. In case, EBIT is
in negative, the cost of debt should be calculated before adjusting the interest rate for
tax.
(b) Debt issued at premium or discount: In case the debentures are issued at premium
or discount, the cost of debt should be calculated on the basis of net proceeds realized
on account of issue of such debentures or bonds. Such cost may further be adjusted
keeping in view the tax applicable to the company. Cost of debt can be calculated
according to the following formula:
Kd= I(1-T)/NP
Where,
Kp=Dp/Np
Where,
Conceptually cost of equity share capital may be defined as the minimum rate of
return that a firm must earn on the equity financed portion of an investment in a
project in order to leave unchanged the market price of such shares.
From the preceding discussion, it is implied that in order to find out the cost of equity
capital, one must be in a position to determine what the shareholders as a class expect
from their investment in equity shares. This is a difficult proposition because
shareholders as a class are difficult to predict or quantify. Different authorities have
conveyed different explanations and approaches.
In order to determine the cost of equity capital, it may be divided into new equity and
existing equity. The following are some of the appropriate according to which the cost
of equity capital can be worked out:
According to this approach, the investor arrives at the market price of an equity shares
by capitalizing the set of expected dividend payments. Cost of equity capital has
therefore been defined as “the discount rate that equates the present value of all
expected future dividends per share with the net proceeds of the sale (or the current
market price) of a share”.
In other words, the cost of equity capital will be that rate of expected dividends which
will maintain the present market price of equity shares.
This approach rightly emphasizes the importance of dividends, but it ignores the fact
that the retained earnings have also an impact on the market price of the equity shares.
The approach therefore does not seem to be very logical.
The cost of new equity can be determined according to the following formula:
Ke =D/NP
Where,
Ke = D/MP
Where,
According to this approach, the cost of equity capital is determined on the basis on the
expected dividend rate plus the rate of growth in dividend. The rate of growth in
dividend is determined on the basis of the amount of dividends paid by the company
for the last few years. The computation of cost of capital according to this approach
can be done by using the following formula:
Ke = (D/NP) + g
Where,
According to this approach, it is the earning per share which determines the market
price of the shares. This is based on the assumption that the shareholders capitalize a
stream of future earnings (as distinguished from dividends) in order to evaluate their
share holdings. Hence, the cost of capital should be related to that earnings percentage
which could keep the market price of the equity shares constant. This approach,
therefore, takes into account both dividends as well as retained earnings. However, the
advocates of this approach differ regarding the use of both earnings and the market
price figures. Some simply use of current earning rate and the current market price of
the share of the company for determining the cost of capital. While others recommend
average rate of earnings (based on the earnings of the past few years) and the average
market price (calculated on the basis of market price for the last few years) of equity
shares.
The formula for calculating the cost of capital according to the approach is as follows:
Ke =E/NP
Where
According to this approach, the cost of equity capital should be determined on the
basis of the returns actually realized by the investors in a company on their equity
shares. Thus, according to this approach the past records in a given period regarding
dividends and the actual capital appreciation in the value of the equity shares held by
the shareholders should be taken to compute the cost of equity capital.
This approach gives fairly good results in case of companies with stable dividends
and growth records. In case of such companies, it can be assumed with reasonable
degree of certainty that the past behavior will be repeated in the future also.