Cost of Capital

The project’s cost of capital is the minimum required rate of

return on funds committed to the project, which depends
on the riskiness of its cash flows. The firm’s cost of capital
will be the overall, or average, required rate of return on
the aggregate of investment projects

It is a concept of vital importance in the financial decision-

making. It is useful as a standard for:

• evaluating investment decisions,

• designing a firm’s debt policy, and
• appraising the financial performance of top management
Three different View Points:

1. Investor’s View Point: “ Measurement of the sacrifice made by him

in capital formation”

2. Firms Point: “ Minimum required ROR needed to justify the use of

capital”

3. Capital Expenditure point: “ Minimum required ROR, hurdle or

target rate or discounting rate used to value cash flows.

“Cost of capital is the minimum required rate of earnings or the cut off
rate of Capital expenditures.”
 Basic concept of Cost of Capital

1. Rate of Return:
2. Minimum rate of return
3. Cost of capital comprises of three components:
R0 = Normal rate of return at zero risk level
b= Premium for business risk
f= premium for financial risk

K = R0 + b + f
 Significance of Cost of Capital

Designing Optimal Corporate Financial Performance Analysis

Capital Structure

Investment Evaluation/ Capital Budgeting

 Classification of Costs

1. Marginal Cost of Capital

2. Average Cost/ Composite/ Overall Cost
3. Book Cost/ Historical Cost
4. Future Cost
5. Specific Cost
6. Spot Cost
7. Opportunity Cost
8. Explicit Cost (IRR)
9. Implicit Cost (opportunity cost)
Computation of Overall Cost of Capital

1. Determination of the type of funds to be raised and their individual

share
2. Computation of cost of each type of funds
3. Assigning weight to each costs
4. Multiplying the cost of each of the sources by the assigned weights
5. Dividing the total weighted cost by the total weights to get overall
Cost of capital
 Computation of Cost of Capital

A. Computation of cost of specific source of finance

B. Computation of weighted average cost of capital
 A. Computation of Specific source of Finance

1. Cost of Debt: (Irredeemable debt)

A. Debt issued at par: (Before tax)

Before tax cost of debt is the ROR required by the lender
Interest paid on debt is tax deductible. Higher the interest charges, the lower will
be the amount of tax payable by the firm.

Kd = I/P
Kd = Before tax cost of debt
I = Interest
P = Principal
 B. Debt issued at par: (After tax)

Kd = I (1-t) /P
Kd = After tax cost of debt
I = Interest
P = Principal

Interest : face of debentures * rate of Interest/100

C. In Case the debt is raised at premium or discount, P will be net proceeds received
From the issue and not the face value of securities

Kd = I/NP

NP = Net proceeds
Q1. a. X ltd. Issues Rs 50000 8% deb. at par. The tax rate applicable to
the co. is 50%.Compute the cost of debt capital.

Kd = I/NP (1-t)

Kd = 4000 (1-.5) /50000 = 4%

B. X ltd. Issues Rs 50000 8% deb. at premium of 10%. The tax rate

applicable to the co. is 60%. Compute the cost of debt capital.

Kd = I/NP (1-t)

Kd = 4000 (1-.60) /55000

Kd = 2.91%
C.X ltd. Issues Rs 50000 8% deb. Issued at 5% discount. The tax
rate applicable to the co. is 50%.Compute the cost of debt capital.

Kd = I/NP (1-t)

Kd = 4000 (1-.5) /47500 = 4.21%

B. X ltd. Issues Rs 10,00,000 10% deb. at premium of 1%. The

flotation cost is 2%. The tax rate applicable to the co. is 60%.
Compute the cost of debt capital.

Kd = I/NP (1-t)

NP = 100000 + 10000 – (2% of 110000)

NP = 107800
Redeemable debts:

1. Before tax cost of redeemable debts

K = {I +1/n(RV – NP)}/1/2(RV +NP)

I = Annual Interest Rate

N = no of years in which debt is to be redeemed
RV = Redeemable value of debt
NP = Net proceeds of debentures

2. After Tax cost of Redeemable debts

K = {I(1- t) +1/n(RV – NP)}/1/2(RV +NP)

Q. A co. issues Rs 10,00,000, 10% redeemable debentures at a
discount of 5%. The Cost of flotation amount to rs 30000. The
debentures are redeemed after 5 years. Calculate before tax and
after tax cost of debt assuming a tax rate of 50%.

A. Before tax

K = {100000 + 1/5 (10,00,000-920000)/ ½ (1000000 + 920000)} =

12.08%

B. After Tax

K= {1,00,000 (1 -.5) + 1/5 (10,00,000-920000)/ ½ (1000000 +

920000)}

6.875%
 Cost of Preference Shares

Cost of irredeemable preference shares

Kp = D/P

Kp = Cost of preference capital

D = Annual Preference Dividend
P = Preference Share Capital (Proceeds)
Q. Aco. issues 10000, 10% preference shares of Rs 100
each. Cost of issue is Rs 2 per share. Calculate cost of
preference capital if these shares are issued at par,
Premium 10% and at discount 5%.

1. Kp = 100000/ 980000 * 100 = 10.2%

2. Kp = 100000/(1000000+100000-20000) * 100 = 9.26%

3. Kp = 100000/(1000000 - 50000-20000) * 100 = 10.75%

Cost of redeemable preference shares:

K = {D+1/n(RV – NP)}/1/2(RV +NP)

A company issues 10000, 10% preference shares of RS 100 each

redeemable after 10 years at a premium 5%. The cost of issue is
Rs 2 per share. Calculate the cost of preference Capital.

Kp = 100000 + 1/10(1050000 – 980000)/ ½ (1050000 + 980000) * 100

10.54%
 Cost of equity share capital

Cost of External Equity:

• Dividend Yield method or Dividend/price ratio Method

• Dividend Yield plus growth in dividend method
• Earning yield method
• CAPM

Cost of Internal Equity:

• Dividend Growth Model
a. Normal Growth
1. Retention Ratio: (Earning per share – Dividend Per
share)/Earning per share

RP = 1 – Dividend Payout ratio

Dividend payout ratio = Dividend per share/Earning per share

2. Price earning ratio: MP of equity shares/ Earning

per share = P/E

PE ratio = 1/ rate of return on retained earning

3. Rate of return on retained earnings ® = Earning

yield

ROR on retained earning = earning per share/MP per share

4. Growth rate (g) = Retention ratio * rate of return on
retained earnings

Growth rate (g) = (1- dividend payout ratio) * (1/ price

earning ratio)

5. Expected Dividend = Actual dividend per share paid

for last year (1+ g)

D1 = D0 (1+G)

D1 = Expected earning * Dividend payout ratio

1. Dividend Yield Method: (Dividend Price Ratio)

Discount rate that equates the present value of expected future dividends
Per share with the net proceeds of a share.

It means investors arrives at a MP for a share by capitalizing dividend

at a normal rate of return.

Ke = D/NP

D = Expected dividend per share

NP = Net proceeds per share
Q. A co. issues 1000 equity shares of Rs 100 each at a
premium of 10%. The co. has been paying 20% dividend to
equity shareholders for the past 5 years and expects to maintain
the same in the future also.

K = D/NP = 20/110 = 18.18%

Limitation:

1. It does not consider future earning

2. It ignores earning on retained earning
3. It does not take into account the capital gain
Q1. XYZ ltd. Is currently earning Rs 1,00,000 its current share MP
of Rs 100 Outstanding equity shares is 10,000. The Co. decided to
raise an additional capital of RS 2,50,000 through issue of equity shares
to the public. It is expected to pay 10% per share as flotation cost.
Equity capital is issued at a discount rate of 10%, Per share. The co. is
interested to pay a dividend of RS 8 per share. Calculate the Cost of
equity
 K = D/Np * 100

K = 8/ (100 -10-10) * 100

K = 10%
 2. Earning Yield Method (Earning Price Ratio)

Earning yield method equates the present value of expected future

Earnings per share with the net proceeds

K = Earning per share/Net proceeds

Q. A firm is considering an expenditure of RS 60 lakhs for expanding
its operations. The relevant information is as follows:

Number of existing equity shares 10 lakhs

Market value of existing shares 60
Net earnings 90 lakhs

Compute the cost of existing share capital and of new equity

capital assuming that New shares will be issued at a price of Rs 52 per
share and the costs of new issue Will be Rs2 per share

Cost of equity share capital

Ke = EPS/MP

EPS = 90,00,000/10,00,000 = Rs 9

K = 9/60 * 100 = 15%

Cost of new equity capital:

K = EPS/ NP = 9/(52 -2 ) *100 = 18%

Limitation:

1. All earning are not distributed to the equity shareholders as dividend.

2. Earning per share may not be constant
3. Share price also does not remain constant
Q2. A firm is currently earning Rs 1,00,000 and its share is selling at
MP of Rs 90. The firm has 10,000 shares outstanding and has no debt.
Compute the cost of equity.
 K = E/MP * 100

K = 10/90 = 11..11
C. Dividend yield plus growth in dividend method:

When dividend of the firm grow at constant rate and the dividend
Payout ratio is constant.

Ke =D1/NP + G

Ke = D0(1+g)/NP + G

Where,
D1 = expected dividend per share at the end of the year
D0 = Previous year’s dividend
G = Rate of growth in dividend
Q. A co. plans to issue 1000 new shares of Rs 100 each at par. The
flotation costs are expected to be 5% of share price. The co. pays a
dividend of Rs 10 per share initially and the growth in dividends is
expected to be 5%. Compute the cost of new issue of equity shares.

Ke =D1/NP + G

K = {10/(100- 5) + 5%}

K = 15.53%
Q. The shares of a company are selling at Rs 40 per share and it had
paid a dividend of Rs 4 per share last year. The investor’s market
expects a growth rate of 5% per Year.

a. Compute the co’s equity cost of capital

b. If the anticipated growth rate is 7% per annum, calculate the
indicated market price per share.
K = D1 /MP + g

D1 = D0(1+G)/ MP + G

= 4 (1.05)/40 + 5%

= 4.20/40 + 5%

= 15.5%

K = D/ MP + g

15.5% = 4(1.07)/ MP + 7%

MP = 4.28/8.5% = Rs 50.35
Cost of Internal Equity: (Retained Earning)

K = DIV1/P0 + G

K = Expected dividend yield + Capital gain

Weighted Average cost of capital:

It is a weighted average cost of various sources of

funds where the weights are being the proportion
of each source of funds in the capital structure
Weighted Average Cost of Capital

Q1. A firm has the following capital structure as the latest statements shows:

Sources of Funds Rs After Tax Costs

Debt 30,00,000 4
Preferences Shares 10,00,000 85
Equity Share 20,00,000 115
Retained Earnings 40,00,000 10
Total 100,00,000

Based on the book values compute the cost of capital

Source of weights Weights Specific Cost Weighted Cost
(%)
Debt .30 (30,00,000/100,00,000) .04 .012
Preferences .10 .08 .008
Shares
Equity Share .20 .11 .022
Retained .40 .10 .040
Earning
1.00 .082

Overall Cost of Capital (K0) = Total Weighted Cost * 100

.082 * 100 = 8.2 %

Tulsian ltd has the following capital structure as per its balance sheet as at 31st March

Rs in lakhs
Equity share capital (fully paid share of Rs 10 each) 4
18% preference SC (fully paid shares of Rs 100 each) 3
Retained earning 1
12.5% Debentures (fully paid of Rs 100 each) 8
12% term loan 4
20

Additional information:

a. Currently quoted prices in the stock exchange

Equity @ Rs 64.25, Preference @ Rs 90, Debentures @ Rs 95
b. For the last year, the company had paid equity dividend of Rs8 per share
which is expected to grow @5% p.a. forever
c. The corporate tax is 30%
1. Cost of 12.5 % Debentures = I (1-t)/NP = 12.5 (1-.3)/95 =
.0921

2. Cost of 12% Term Loan = 48000 (1-.3)/4,00,000 = .084

3. Cost of 18% preference SC = 18/90 = .2

4. Cost of equity SC = D (1+g)/P + g = 8 (1+ .05)/64.25 + .05

= 18.07%

5. Cost of retained earnings = 18.07%

a. Statement showing the WACC (using Book value)

Source of Capital Amount Weights After tax WACC

cost
Equity Share capital 4 .20 (4/20) .1807 .0361
Retained earnings 1 .05 .1807 .0090
18% pref Share 3 .15 .2000 .0300
125 deb 8 .40 .0921 .0368
12% term loan 4 .20 .0840 .0168
20 1.00 .1287

WACC = 12.87%
 WACC (using market value)

Source of Capital Amount Weights After tax WACC

cost
Equity Share capital 25.70 (4*64.25) .6425 .1807 .1161
18% pref Share 2.70 .0675 .2000 .0135
125 deb 7.60 .1900 .0921 .0175
12% term loan 4.00 .1000 .0840 .0084
40 15.55%
Factors Affecting WACC:

1. Controllable factors : (Internal Factor)

Capital Structure policy
Dividend Policy
Investment Policy

2. Uncontrollable Factors: ( External Factor)

Tax Rates
Level of Interest Rates
Market Risk premium
Q2. XYZ company supplied the following information and requested you to compute
the cost of capital based on book values and market values.

Source of Finance Book Value Market Value After Tax

Cost (%)
Equity Capital 10,00,000 15,00,000 12
Long term Debt 8,00,000 7,50,000 7
Short term debt 2,00,000 2,00,000 4
Total 20,00,000 24,50,000
 Computation of cost of capital based on book value

Source of Finance Book of Weights Specific Weighted

Value cost Cost
Equity Capital 10,00,000 .50 .12 .060
Long term debt 8,00,000 .40 .07 .028
Short Term debt 2,00,000 .10 .04 .004
Total 20,00,000 1.00 0.092

Cost of Capital = 0.092*100 = 9.2%

 Cost of Capital Based on Market value weight

Source of Book of Weights Specific Weighted

Finance Value cost Cost
Equity Capital 15,00,000 .613 .12 .074
Long term debt 7,50,000 .307 .07 .022
Short Term debt 2,00,000 .080 .04 .003
Total 24,50,000 1.000 .099

Cost of Capital = 100 * 0.099 = 9.9%

 Marginal Cost of Capital

a. Marginal COC is nothing but weighted average cost of new or incremental

capital suing marginal weights

b. It may be defined as cost of raising an additional rupee of capital

c. The marginal weights represent the proportion of each source of new funds
which the firm intends to employ

d. The problem of choosing between book value weights and the market value
weights does not arise.
Marginal Cost of Capital : Cost of additional Funds to be raised:
Q3. HLL has provided the following information and requested you to calculate
a. WACC using book value weights
b. Weighted marginal cost of capital

Source of Amount Weights After Tax Cost

Finance
Equity Capital 14,00,000 .452 9
Preference 8,00,000 .258 12
Capital
Debentures 9,00,000 .290 16

HLL wishes to raise an additional capital of Rs 12,00,000 for the expansion of

the project. The details are as follows:

Equity Capital Rs 6,00,000

Preference Capital Rs 3,00,000
Debentures Rs 3,00,000
Source of Amount Weights After Tax Cost ()
Finance
Equity Capital .50 .09 .045
Preference .25 .12 .030
Capital
Debentures .25 .16 .040
Total .115

WACC = 0.115*100 = 11.5 %

Q A firm finances all its investments by 40% debt and 60% equity.
the estimated required rate of return on equity is 20% after tax and
that on debt is 8% after tax. The firm is considering an investment
proposal costing Rs 40,000 with an expected return that will last
forever. What amount must the proposal yield per year so that the
MP of the share does not change? Show calculations to prove your
point.

The min overall required ROR is:

Debt .40*.08 = .032
Equity .60*.20 = .120
Weighted average .152

Thus, the investment proposal must earn .152 * 40000 = Rs 6080

Per year.
Annual Return before taxes Rs 6080

Less Interest .08*.40*40000 Rs 1280

ROE 4800

After tax rate of return on equity

4800/ (.60 * 40000)

4800 / 24000 = .20
Q. The servex co has the following capital structure on 30th June 2004:

(Rs’ 000)
Ordinary shares (2,00,000 shares) 4,000
10% preferences shares 1,000
14% debentures 3,000
8,000

The share of the co. sells for Rs 20. It is expected that co. will pay next
Year a dividend of Rs 2 per share, which will grow at 7% forever.
Assume a 50% tax rate.

You are required:

a. Compute a WACC based on existing capital structure
b. Compute new WACC if the co. raises an additional RS 2,00000 debt
by issuing 15% deb. This would result in increasing the expected
Dividend to Rs 3 and leave the growth rate unchanged but the price
of share will fall to 15 per share
 WACC = Existing capital structure

Source of After tax cost Weights weighted cost

Finance
Ordinary .17 .500 .0850
10% preference .10 .125 .0125
14% Debenture .07 .375 .0262
WACC .1237

Cost of ordinary share is

K = DIV/p + G = 2/20 + .07 = .17

K = 100/1000 = .10

K = 420(.50)/3000 =.07
 WACC : Changed growth rate

Source of Finance Amount After tax Weights weighted

cost cost
Ordinary 4,000 .27 .40 .108
10% preference 1,000 .10 .10 .010
14% Debenture 3,000 .07 .30 .021
15% debenture 2,000 .075 .20 .015
WACC .154
Cost of ordinary shares is

K = 3/15 + .07 = .27

Cost of 15% deb

K = 300(.50)/2000 = .075
 WACC : Changed growth rate

Source of Amount After tax Weights weighted

Finance cost cost
Ordinary 4,000 .30 .40 .120
10% preference 1,000 .10 .10 .010
14% Debenture 3,000 .07 .30 .021
15% debenture 2,000 .075 .20 .015
WACC .166

Cost of ordinary share is:

Ke = 3/15 + .10 = .30

No. Purpose Formula
1 Before tax cost of debt K = I / NP
2 After tax Cost of debt K = I (1 –t)/ NP
3 Before tax cost of K = {I + (RV – NP)/n}/ (RV + NP )/2
redeemable debt
4 After tax cost of K = {I(1-t) + (RV – NP)/n}/ (RV + NP )/2
redeemable debt
5 Cost of irredeemable K = D/NP
preference
6 Cost of redeemable K = {D + (MV –NP)/n}/(MV + NP)/2
preference
7. Cost of equity Ke = D/NP
Dividend yield Ke = D0(1+g)/NP + G
Dividend yield plus K = EPS/Net proceeds
growth in dividend
Earning yield method
8. Cost of retained earning K = D/NP + G
9. WACC K = XW/W